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.
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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.
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