Payroll Surprise Gives Small Caps a Reprieve

A surprise drop in US nonfarm payrolls has given the stock market a breather from worrying about near-term interest-rate hikes. The July payroll numbers fell short of expectations, with a contraction of 23,000 jobs against forecasts for an 83,000 gain.

This unexpected outcome drove the two-year Treasury yield to a three-week low and led futures traders to abandon bets on a September Federal Reserve rate increase.

Small-cap stocks rallied in response, with the iShares Russell 2000 ETF (NYSE:IWM) leading the charge. The index has risen by around 22% year-to-date, outperforming its larger-cap peers such as State Street SPDR S&P 500 (NYSE:SPY) and Invesco QQQ Trust (NASDAQ:QQQ).

However, Goldman Sachs analyst Ben Snider cautions that small caps are structurally tied to interest rates. Russell 2000 companies devote roughly 31% of earnings before interest, taxes, depreciation, and amortization to interest expense, a figure significantly higher than the S&P 500's 7%.

The upcoming inflation report on Wednesday will serve as the next test for small caps. A benign result would reinforce the case for a Fed hold ahead of September, but it won't resolve the dilemma facing these firms.