US Small-Cap Stocks Rally and Deal-Making Persists Amid Election Season

What's Behind The U.S. Small-Cap Comeback?

Whether the shift in Russell 2000's relative performance will be sustained depends on the many drivers of returns and the continuation of the benign macro backdrop that has supported the US equity rally this year. On July 11 and 16, the Russell 2000 small-cap index lurched 3.6% and 3.5%, respectively, its two largest single day moves of the year as of the time of writing (23 July 2024). It helped the Russell 2000 outpace the Russell 1000 index thus far in July in a shift from their relative performance during the first half of 2024 as shown in Exhibit 1. Exhibit 2 illustrates the dramatic nature of the July moves in the Russell large-cap and small-cap indices and their style cohorts. Month-to-date, leadership has shifted from large-caps to small-caps and from Growth to Value in both size segments. Exhibit 2: Russell indices cumulative return, July 1-23, 2024 (rebased 30 June 2024, USD) These moves seem to be related to changes in expected US monetary policy. On July 11, the June consumer price inflation (CPI) for the US was released and was lower than the May CPI. Coming on the back of two successive months of disinflation, it provided markets greater confidence in the Fed's expected monetary easing trajectory. On July 16, the June retail sales numbers were released, which were unchanged from May when expectations were for it to decline. As an indicator of the aggregate health of the US consumer, it provided markets one data point for expecting the benign growth picture to be sustained. Over the last year, the Russell 2000 index has had two other similarly large daily moves as in July (Exhibit 3) that happened close to the release of lower CPI data. In each instance, the 10-year US Treasury yield declined on expectations of an end to the rate hiking cycle and prospects for monetary easing. Further, the associated move in Russell 2000 was larger than the move in Russell 1000. indicated on the chart. Exhibit 3: The Russell 2000 index's four largest daily total returns, July 2023 - July 2024 Exhibit 4 illustrates the relationship between long-term interest rates, that have been top of mind for investors since the Fed began tightening policy rates, and the relative performance of Russell large-cap and small-cap indices over the last year. The table beneath the chart delineates this timeframe into five periods based (approximately) on the shifts in the trajectory of long-term interest rates. It shows the total returns and relative return for these indices along with the change in the 10-year US Treasury yield for each period that is also indicated on the chart. Exhibit 4: Russell 1000 and Russell 2000 relative return (USD, LHS), 10-year US Treasury yield (%, RHS), July 2023 - July 2024. From the end of June 2023 to the end of April 2024, covering the first three periods, as the 10-year Treasury yield rose, Russell 1000 outperformed Russell 2000, and as the long-term yield fell, the large-cap index underperformed the small-cap index. However, in May and June of this year (during the fourth period) we saw this pattern reverse. As long yields declined once again after the April market pullback, Russell 1000 continued to outperform Russell 2000 fueled by AI tailwinds and healthy earnings among mega-caps and tech companies in a much narrower equity rally than the one we saw earlier in the year, as we discussed in our quarterly Russell US Indexes Spotlight. In fact, a handful of Russell 1000 sectors such as tech hardware and software and electricity (in the Utilities industry) contributed the bulk of the large-cap index's returns. Further, at the end of June, the Russell 1000 index traded at historically high forward valuations. By contrast, despite the market beginning to price in lower rates, the Russell 2000 stayed downbeat in Q2. At the end of June, the small cap to large cap valuation premium was among the lowest 5% of observations over the last 20 years. The other point to note about the July 2024 moves is that they did not just represent moves into the Russell 2000 at the expense of the Russell 1000. We compared the daily moves in the market-cap-weighted Russell indices with the moves in their equal-weighted counterparts (Exhibit 5). Although Russell 1000 lost -0.7% on July 11 and gained only +0.8% on July 16, the equal-weighted Russell 1000 index rose by +1.7% and +1.8%, respectively, on those days. This suggests that there was a broadening of the rally even within the large cap Russell 1000 index. Exhibit 5: Russell 1000 and Russell 2000, market-cap weighted and equal-weighted indices' total return (%) The drivers of returns, such as interest rate expectations and AI tailwinds, that the market chooses to prioritize at any given point matter. AI optimism and the focus on mega-cap tech earnings and prospects may have contributed to the tech heavy Russell 1000's continued outperformance of Russell 2000 during May and June when long interest rates fell, leading to a divergence in the relationship observed previously. In July, the small-cap index closed much of that relative underperformance. In addition, the stretched valuations among large-caps collectively may help to partly explain why when the market priced in another bout of good news on interest rates on July 11, the Russell 2000 index rallied more than its large-cap counterpart. In other words, the starting point for valuations matter. Further, there was a broadening of the rally even within the Russell 1000 index, suggesting that the contrast in performance in July from earlier may not be strictly between large-caps and small-caps, but between the leaders of the US equity rally YTD and the rest. The shift in relative performance in July between Russell 1000 and Russell 2000 was dramatic. Whether it will be sustained depends on the many drivers of returns and the continuation of the benign macro backdrop that has supported the US equity rally since the end of last year. Disclaimer © 2024 London Stock Exchange Group plc and its applicable group undertakings ("LSEG"). 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Deal-Makers Hold Their Nerve As Election Season Takes Off

First six-months of 2024 sees global M&A up 18% to $1.5trn.US drives recovery while UK leads European resurgence.Fall in Q2 and lacklustre mid-market signals note of caution. With at least 97 countries going to the polls this year, almost half the world's population will be voting - and at the year's half-way mark, the majority of elections are still to be called. For deal-makers, this presents another 'unknown quantity' in an already highly uncertain environment, characterised by geopolitical unrest, economic stress and inflationary pressures. And yet, so far, M&A markets have shown promise, buoyed by record high stock prices in the US and stabilising interest rates. Looking at the data, LSEG's Deals Intelligence experts, Matthew Toole and Lucille Jones, ask what this all means for the next six months. After a very bumpy few years in M&A markets, including two years of consecutive declines in overall deals activity, all eyes have been on 2024 as improving macro-economic conditions gave hope for a recovery. Six months in, the headline data is promising: global M&A is up 18% on the same period last year, reaching $1.5trn, with mega-deals increasing by 70%. It's been a very US-centric and large-deal oriented recovery so far. All but three of the largest 20 deals in the first half of 2024 involved a US target, all but four were entirely US-domestic affairs. It was the region's largest share of world-wide M&A in almost a quarter-century. Technology was the biggest sector for M&A, with companies racing to get a foothold in AI and related technologies, while strategic mergers between US oil businesses made energy & power the second largest sector by value. However, there is fly in the ointment: 2024 is the biggest of elections years across the world, with most still to be called at the year's half-way mark. Deal-makers are using every window of opportunity they can to get deal processes moving, but there may be more windows on a submarine. By the time Europe has returned from its August break, and the US Labor Day celebrations are finished in September, it will be election-fever time, particularly in the US. A slowing deals trajectory between April and June also gives a note of caution. In the second quarter, worldwide M&A announcements were down 11% from the opening three-months, and a quarter lower than the same period last year, as hopes for interest rate cuts faded. In addition, a pessimist might point to a concerning disequilibrium in the M&A rebound so far. While mega deals might be expected to lead the way, and they certainly have, there is little sign that the smaller or mid-markets are taking the hint. Deals of $500m and less fell by 11% to $360bn compared to the first half of 2023, dropping to levels not seen for more than a decade. Meanwhile the number of mid-market deals fell by almost a quarter. See this interactive graph below: Figure 2: Global M&A by Deals Size, H1 Periods A further boon to the market has been a significant uptick in buyouts, as private equity firms ramped up their activity, after a lull in 2023, to account for almost a quarter of all announced deals in H1. M&A deals backed by financial sponsors totalled $370bn, a 36% year-on-year increase, as a stabilising interest rate and financing environment improved confidence for private equity buyouts. More positively, the recovery is spreading tentatively eastward, across the Atlantic. European M&A deal announcements increased 39% in H1 to reach a two-year high of $343bn. Indeed, Europe was the only region that managed to continue growing throughout the second quarter of the year. The tally has been driven in particular by strong interest in UK target deals, which represented more than a quarter of the region's announced transactions - demonstrating that a strong M&A market does not necessarily rely on political continuity. By contrast, there is no disguising the fact that Asia-Pacific has failed to rebound from the post-Covid M&A boom-bust. The region's M&A tally of $226bn was almost a quarter down on last year and the lowest level for more than a decade. Part of the mega-deal centric recovery is a function of record high US stock markets. So far this year, 22% of M&A deals have used stock, in all or part, as one would expect in a buoyant equity market amid higher interest rates. As a result, some of the largest deals have been paper affairs, such as the all-stock merger of Discovery and Capital One. On the flip-side, an increasingly protectionist trend across the world in recent years has lengthened completion times - and hence market uncertainty - in recent years, with average completion times extending beyond 200 days in 2023. Some of the largest deals have taken up to two years to achieve US anti-trust clearance. However, there are signs that authorities are speeding up their approvals process, with that figure falling in the first half of 2024 to an average 187 days (that's about six-and-a-half months). The general volatility of the market in recent years maps well on to the M&A advisory rankings. With the exception of Goldman Sachs's dominance, there is little clear pattern among the top ten global M&A advisers, with the emergence of boutiques further disrupting the competitive landscape in recent years. So far, equity capital markets have played a subdued role in the recovery, with equity market growth of some 10% driven largely by follow-on and convertible offerings. Pre-IPO filings are starting to pick up in the US, but there will be a very sharp eye given to the available windows of opportunity, amid a packed news calendar. By contrast, debt capital markets have continued to be a major driver of corporate activity from the post-Covid boom onwards. Global debt issuance in the first half grew 11% to a three-year high of $5.4trn, and the number of offerings reached an all-time high of 16,000 bond offerings. Meanwhile, high-yield bonds have had a busy six-months, rising 83% on the same period last year, to hit $222bn, potentially signalling a return to more cash-and-debt funded M&A and buyouts. While there has been some retreat in bond issuance in the second quarter, the market conditions look strong, even prior to any improvement in the interest rate environment. Dealmakers must tread carefully over the next six-months. While there is plenty of uncertainty and volatility in the market, there are also significant pockets of activity and promising windows of opportunity emerging. Wuality insights have never mattered more. Republication or redistribution of LSE Group content is prohibited without our prior written consent. The content of this publication is for informational purposes only and has no legal effect, does not form part of any contract, does not, and does not seek to constitute advice of any nature and no reliance should be placed upon statements contained herein. Whilst reasonable efforts have been taken to ensure that the contents of this publication are accurate and reliable, LSE Group does not guarantee that this document is free from errors or omissions; therefore, you may not rely upon the content of this document under any circumstances and you should seek your own independent legal, investment, tax and other advice. 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