'Cries of pain' at smaller firms are being drowned by exuberance elsewhere in the market - but rising defaults point to a recession coming, SocGen says

• Smaller firms are struggling under the weight of interest rates and rising defaults are a recessionary signal.
• According to Societe Generale, credit conditions at small companies are in line with what's seen in a downturn.

Big Tech and the "Magnificent Seven" stocks powering big gains for the S&P 500 this year may be getting all the attention from investors, but there's another, arguably more important, corner of the market that's quietly struggling—and its troubles are a sign a recession is probably looming.

That's according to Societe Generale's Albert Edwards, who pointed out in a note on Thursday that not only would the benchmark stock index be staring at a loss without the contributions of the biggest tech gainers, but their rally this year has actually masked "cries of pain" at smaller firms throughout the economy.

"Mega-cap-weighted whoops of delight have drowned out the cries of pain elsewhere," Edwards wrote. "You only need to turn your gaze to the smaller listed and unlisted companies to witness the torture being inflicted by the Fed's interest rate garrotting."

The equal-weighted S&P 500 is down about 5% this year, in line with the small-cap Russell 2000 index.

Firms with less than 100 employees, while perhaps less flashy than an AI leader like Nvidia, are important to the economy as they generate more than half of all employment growth—and these firms are struggling right now under the weight of high interest rates.

"[M]any investors, including those focused on the high yield market, appear to have got it into their heads that the rising default/bankruptcy rate is a lagging indicator that is in fact pointing to the start of a new economic cycle. Really?"

"The notion that we are at the start of a new economic cycle seems preposterous to me," Edwards said, later adding that, "credit conditions for small companies are at levels consistent with recession."

This year, the number of corporate bankruptcy filings has surpassed the highs seen in 2020, and smaller companies in particular are feeling the crunch of the Fed's higher-for-longer interest rate regime.

Once the pandemic stimulus relief runs dry, more companies could become vulnerable to bankruptcies, particularly the "zombie companies on extended life support."

Societe Generale predicts speculative grade defaults could rise far above the current 4.7% rate as well as the implied market peak of 5.2%.

Tighter credit conditions typically precede or accompany sliding profits for smaller companies, he added, and that in turn leads to declines in employment growth.

"Post-pandemic labour shortages (reflected in payroll resilience) should not disguise the fact that smaller companies are being trampled underfoot – not by the Magnificent 7, but the 7 Fed Horseman of the Apocalypse," Edwards said.