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Many equity strategists began the year touting a rebound in small-cap performance, as the consensus believes the Federal Reserve will begin cutting interest rates in the first half of 2024. Now, as the market retreats from its hopes for a rate cut this year, small-cap declines The Russell 2000 Capital Index (^RUT) is up about 3% year to date, a poor performance compared to the S&P 500's gain of more than 5% this year.

“We think the Russell 2000 may be challenged a little bit in the near term, until we get to kind of greater confirmation that inflation is slowing and greater confirmation that OK, the Fed will be able to start cutting interest rates,” the Bank of America president said. Jill Carey Hall, of US SMB Strategy, told Yahoo Finance.

After recent conversations with investors, Hall said the main catalyst for small caps to rise is more clarity on the Federal Reserve's interest rate path.

Market consensus has shifted from expecting seven rate cuts this year in early January, to two rate cuts this year, according to Bloomberg data. The move put a major damper on the rally seen in small-cap stocks to close out 2023, while large-cap stocks are still holding on to gains this year despite the Fed's changed rhetoric.

The main difference between them is the structure of corporate debt. Small businesses have more than 40% of their debt exposed to higher rates either in the form of variable rate loans, which are exposed to current interest rates, or short-term debt that may need to be refinanced amid a rising interest rate environment. This compares to about 75% of S&P 500 stocks that have fixed, long-term debt, according to the Bank of America research team.

Add to that, large-cap companies often have more money that could benefit from higher interest rates, and the Fed not cutting interest rates is simply more costly for smaller companies than larger ones.

“the [Russell 2000] “The index is very sensitive to credit and interest rates,” Hall said. Refinancing risk is a major risk for these companies because large-cap companies have been able to secure a lot of long-term fixed-rate debt…and the longer interest rates stay high, it becomes a bigger and bigger risk to their profits. [smaller cap] companies.”