Our CIO and Chief US Equity Strategist explains that in the event
of a Republican sweep in this fall’s U.S. elections, investors
should not expect a repeat of 2016 given the different business
environment.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan
Stanley’s CIO and Chief US Equity Strategist. Along with my
colleagues bringing you a variety of perspectives, today I'll be
talking about why investors should fade the recent rally in
small caps and other pro cyclical trades.
It's Monday, July 22nd at 11:30am in New York.
So let’s get after it.
With Donald Trump’s odds of winning a second Presidency rising
substantially over the past few weeks, we’ve fielded many
questions on how to position for this outcome. In general, there
is an increasing view that growth and interest rates could be
higher given Trump's focus on business-friendly policies,
de-regulation, higher tariffs, less immigration and additional
tax cuts.
While the S&P 500 has risen alongside Trump's presidential
odds this year, several of the perceived industry
outperformers under this political scenario have only just
recently started to show relative outperformance. One could
argue a Trump win in conjunction with a Republican sweep could
be particularly beneficial for Banks, Small Caps, Energy
Infrastructure and perhaps Industrials. Although, the
Democrats' heavy fiscal spending and subsidies for the Inflation
Reduction Act, Chips Act and other infrastructure projects
suggest Industrial stocks may not see as much of an incremental
benefit relative to the past four years. The perceived
industry underperformers are alternative energy stocks and
companies likely to be affected the most by increased
tariffs. Consumer stocks stand out in terms of this latter point,
and they have underperformed recently. However, macro factors are
likely affecting this dynamic as well. For example, concerns
around slowing services demand and an increasingly value-focused
consumer have risen, too.
It's interesting to note that while these cyclical areas that are
perceived to outperform under a Trump Presidency did work in
2016 and through part of 2017, they did even better during
Biden's first year. Our rationale on this front is that the
cycle plays a larger role in how stocks trade broadly and at the
sector level than who is in the White House. As a comparison, we
laid out a bullish case at the end of 2016 and in early 2017
when many were less constructive on pro cyclical risk assets than
we were post the 2016 election. It’s worth pointing out that the
global economy was coming out of a commodity and
manufacturing recession at that time, and growth was just
starting to reaccelerate, led by another China boom. Today,
we face a much different macro landscape. More specifically,
several of the cyclical trades mentioned above typically
show their best performance in the early cycle phase of an
economic expansion like 2020-2021. They show strong, but
often not quite as strong performance in mid cycle periods
like 2016-17. They tend to show less strong returns later in the
cycle like today. Our late cycle view is further supported by the
persistent fall in long term interest rates and inverted yield
curve.
We believe the recent outperformance of lower quality, small cap
stocks has been driven mainly by a combination of softer
inflation data and hopes for an earlier Fed cut combined with
dealer demand and short covering from investors on the back of
Trump’s improved odds. For those looking to the 2016 playbook, we
would point out that relative earnings revisions for small cap
cyclicals are much weaker today than they were during that
period.
Back in December when small caps saw a similar squeeze higher, we
explored the combination of factors that would likely need
to be in place for small cap equities to see a durable,
multi-month period of outperformance. Our view was that the
introduction of rate cuts in and of itself was not enough of a
factor to drive small cap outperformance versus large caps. In
fact, history suggests large cap growth tends to be the best
performing style once the Fed begins cutting as nominal growth is
often slowing at this point in the cycle, which enables the
Fed to begin cutting. We concluded that to see durable small
cap outperformance, we would need to see a much more
aggressive Fed cutting cycle that revived animal spirits in a
significant enough way for growth and pricing power to inflect
higher, not lower like recent trends.
We are monitoring small cap earnings expectations and small
business sentiment for signs that animal spirits are
building in this way. Rates and pricing power are still
headwinds; while small businesses are not all that sanguine about
expanding operations, they are increasingly viewing the economy
more positively — an incremental positive and something
worth watching. We will continue to monitor the data in
assessing the feasibility of this small cap rally continuing.
Based on the evidence to date, we would resist the urge to
chase this cohort and lean back into large cap quality and
defensives.
Thanks for listening. If you enjoy the podcast, please leave us a
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Market with a friend or colleague today.
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