Small Caps Earnings Growth Falls But Financials Look Good
Even though the Russell 2000 was down slightly on Friday, the small caps are still in the best streak since the post-election run. The chart below shows the rally after the election was justified given the accelerated earnings growth after the earnings recession in 2015-2016. Unless the tax cut is passed, the Russell 2000 is going to continue its string of decelerating growth. That deceleration should continue in Q3 because small firms were the most affected by the hurricanes. Secondly, the ECRI leading indicator report is implying that growth will further decelerate. The ECRI has had a great track record of predicting Russell 2000 earnings growth implying that this rally has gotten out of hand.
As we’ve discussed, Russell 2000 earnings growth relies on the financials much more than the S&P 500 and relies on technology much less. The chart below shows the return on assets of the S&P 500 financials to give you an idea of where the sector is headed and for the small caps as well. As you can see, there has been a rebound in the past 18 months. The net interest margins of the banks improved substantially with the two rate hikes this year. The chart shows the relationship between the 10/2 yield curve and the financials ROA, but there’s no reason why this divergence can’t continue. We’re still some ways away from another recession. Once the yield curve starts to fall flat, the Fed will stop raising rates and the banks will start to lose profit growth again. The 9 basis point increase in financial services return on assets is mostly caused by trading related profit growth. This is on 1% year over year growth in assets. This all implies momentum for Russell 2000 earnings.
We’ve discussed how the companies with the highest tax rates haven’t been doing well despite the possibility of tax cuts. The chart below shows the breakdown among low taxed and high taxed companies. Another point worth mentioning is domestically focused small caps would possibly benefit more than large caps from tax cuts. Since small caps have done better than large caps in the past few weeks, that trend differs from the tax rate breakdown. The reason why I say there’s a possible benefit for small caps over large caps is because there’s three dynamics at play. The small caps benefit more from the lowered corporate tax rate. The internationally focused large caps benefit from the repatriation tax holiday. The third aspect is that the U.S. economy will outperform after tax cuts are passed. That makes it so that small caps do better than large caps.
