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Index IDEA: Will higher rates slow down an already slowing US small cap equity market?

US small cap stocks have lost steam in 2017 after a sharp increase to close out 2016 following the US presidential election, as reflected by the US small cap Russell 2000® Index. After an index return of 6.5% in 2016 leading into the November 8 presidential election, the index rose sharply, increasing its return by 14.2% from the election through the end of the year. In 2017, however, the index return has been just 0.6% and has actually declined 1.7% month-to-date as of March 14.

In addition, analysis from XTF on asset flows into US-listed exchange traded products (ETPs) which track the US small cap equity market show a similar trend. $8.8 billion in net assets flowed into US small cap ETPs in 2016 leading up to the November 8 presidential election. This number increased to $15.3 billion between election day and the end of the year. And in 2017, US small cap ETP flows have remained strong, with $8.4 billion in net flows through March 14.

And now many market participants may be wondering whether cold water from Janet Yellen and the FOMC in the form of higher short-term lending rates may further cool an already cooling US small cap market.

Recent analysis from global index provider FTSE Russell provides historical perspective on this question. 

The table below shows how US small cap stocks as measured by the Russell 2000 Index have responded to periods of increasing interest rates since 1994. Index returns in each of the last four cycles have been negative after one month, but in the three most recent cycles, index returns were up by double-digits after one year. The 2015 cycle had the largest trough-to-peak swing, down -12.3% after one month, but up 22% after twelve months – a remarkable 34.3 percentage point turnaround.

Mat Lystra, senior index research director, FTSE Russell, said:

“Historical analysis tells us that rising interest rates do not necessarily correspond with a decline in value for US small caps. This is particularly true after one year, once the market has been given time to assess the news and economy overall.”

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