Small-Cap Stocks Face Test Amid Surprising Payrolls Decline

The recent US payrolls report revealed a surprise decline of 23,000 jobs in July, missing forecasts for an increase of 83,000. This unexpected drop drove down the two-year Treasury yield to a three-week low and prompted futures traders to abandon bets on a September Federal Reserve rate hike.

Small-cap stocks, as represented by the Russell 2000 index, are particularly vulnerable to changes in interest rates due to their high reliance on debt financing. According to The Kobeissi letter, these companies dedicate roughly 31% of earnings before interest, taxes, depreciation, and amortization (EBITDA) to interest expense, a significantly higher percentage than the S&P 500's 7%.

Goldman Sachs has expressed concerns that small-cap stocks may be overperforming their fundamentals. The index has become less dependent on its earlier momentum drivers after June's reconstitution reduced the weighting of AI-infrastructure companies to 7% from 15%. Furthermore, nearly a quarter of Russell 2000 constituents are unprofitable, which could indicate underlying issues.

However, RBC analysts argue that the payroll drop does not signal an impending recession. They note that average weekly hours in private industries remained stable, suggesting that firms typically reduce hours before cutting staff. This pattern is more consistent with retirements than layoffs, they claim.

The upcoming July CPI report will be a crucial test of the soft-landing narrative. Economists surveyed by Dow Jones predict a slowdown in headline CPI to 3.4% year-on-year from 3.5% in June, and core CPI easing to 2.5% from 2.6%. A benign result could reinforce the case for a Fed hold ahead of September.