Russell Down Over 5% in August, What's Next?

August was an uncharacteristically dour month for US equities, with the small-cap index suffering a substantial 5.20% loss as investors are still worried about the longevity of regional banks.

Leading the Way Lower

US markets had an unusually disappointing month, with all major indices in the red for the period. But the underperformance was led primarily by the Russel 2000, which is more sensitive to general risk events, such as the outlook for rate hikes and China's (lack of) economic recovery. One of the larger elements to weigh on the premier small-cap index was banking shares after key banks suffered two downgrades during the month. In an environment of high-interest rates that has pushed market funds to record highs at the expense of bank deposits, smaller banks are seen as particularly vulnerable.

In the wake of the collapse of SVB back in March, many depositors fled to the larger banks. Smaller regional banks then hiked interest rates on deposits to retain funds, impacting their profitability. Some deposit flows have stabilised since March, and certain regional banks saw their deposits rise. But it wasn't enough to reassure investors to keep the sector moving higher. While flows have improved, regional banks are still more vulnerable in this interest rate environment.

The Shadow in the Diagnosis

While banks generally passed the Fed's stress test in July with flying colours, allowing many of them to raise dividends for having "too much" savings, the test revealed some vulnerabilities. Many smaller banks were not prepared to borrow from the Fed in an emergency. What had initially reassured investors that the SVB contagion would not spread was the Fed setting up a stop-gap measure to buy up unrealised losses from low-interest bonds that had depreciated due to higher interest rates. However, with most vulnerable banks not able to make use of those funds due to technical difficulties, investors in smaller banks got worried.

The last week saw total bank deposits rise, but it wasn't enough to offset the general trend lower, leaving deposits at the lowest level since peaking in April of last year. Total lending, a key indicator for economic activity, was lower, mainly due to large banks offering fewer loans. Small banks have been picking up lately despite the higher interest rates. While this might help boost the bottom line for smaller banks during economic resilience, increased debt and falling deposits could weigh on the index should further economic stress appear.

Russell Hangs on Potential Triangle Completion

The Russell 2000 might continue to be dragged down through the usually pessimistic month of September, especially if last week's gains reversed quickly under 1830. Doing so will open up access to the 1700-1815 zone, potentially weakening the index on the back of a fadeout towards 2025. If bulls prevail, reclaiming the lost top could accelerate long bets for an attempt at 2060 and 2140, breaking the long-term range on a potential ascending triangle; the triangle may or may not have been completed at 1830.

Source: SpreadEx / US RUSSELL 2000

Key Takeaways

In August, the US equities market experienced a significant downturn, with the Russell 2000 small-cap index leading the way with a 5.20% loss, primarily driven by concerns about the longevity of regional banks. Banking shares were particularly affected after key banks received downgrades, and smaller banks faced challenges due to high interest rates pushing market funds to record highs at the expense of bank deposits. The recent total rise in bank deposits did not offset the overall downward trend, leaving deposits at their lowest since April last year and regional banks, hence Russell 2000, vulnerable in this interest rate environment.