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capitalizing on sector rotation - small caps in a trump-era, low-rate economy

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Tuesday, July 30, 2024

Capitalizing On Sector Rotation - Small Caps in a Trump-Era, Low-Rate Economy

تم إعداد هذا المنشور من قبل سنشري للاستشارات

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Investors’ attention over the first half of 2024 was broadly captivated by large-cap companies, particularly the
Magnificent 7. This rally was sparked by the euphoria surrounding Artificial Intelligence (AI), resilient financial
performance in an environment of high interest rates, and growing evidence of disinflation in various economic reports.
Now, the second half of the year is shaping up to be a dynamic period for the U.S. markets given the heightened prospect
of a Fed pivot to rate cuts and the political saga unfolding in the run up to the presidential elections. Wall Street is buzzing
with murmurs about “The Great Rotation” as market participants shift their attention to small-cap companies from their
larger counterparts.

Represented by the Russell 2000 Index, small caps have finally managed to break out above their two-year trading
range. Fed Chairman, Jerome Powell’s Congressional testimony was the primary catalyst that lent a leg up to the equity
gauge. Powell’s remarks acknowledging the considerable easing in the labour market across key measures was viewed
as an encouraging sign. Recent data suggests a marked slowdown in hiring and three straight months of rising
unemployment. Powell provided a boost to small caps by cautioning that maintaining current interest rates for too long
might hinder economic growth. Lower-valuation companies, which typically have higher debt levels, stand to benefit
when the central bank begins reducing borrowing costs. Although Powell did not oer a timeline, his tone suggested it
was a matter of “when” instead of “if” the Fed would slash rates this year. Consequently, markets estimate a 97%
probability that the first interest rate cut could occur in September.

Federal Reserve Interest Rate probability

Date: 23rd July 2024:
Source: Bloomberg

The growing likelihood of former President Donald Trump winning the upcoming U.S. presidential election is also
promising for small-cap stocks. A failed attempt to assassinate Trump in addition to Biden’s dismal performance during
the presidential debate and eventual withdrawal from the race only bolstered Trump’s chances of securing a win. Vice
President Kamala Harris has now stepped into the race. The Biden/Harris campaign entered July with about $96 million
on hand. However, donors are starting to back out. Instead, Trump’s campaign is attracting hefty contributions, and the
polls so far indicate the possibility of a Republican victory. Trump’s proposed policies include lowering the corporate tax
rate to as little as 15% from the current 21% and aim to diminish the power of financial regulators. Such policies are
conducive to a strong performance by smaller companies

The Russell 2000 Index soared to a 52-week high of $2,278.12 on 17th July 2024, which also marks its highest value
since January 2022. The index surged 11.5% over the five trading days leading up to 17th July 2024, outpacing the S&P
500 by 9.9 percentage points during the same period. This marks the largest five-day gap between the two indexes since
at least 1986. The following table illustrates the exceptional performance of the sectors within the Russell 2000 since 10th
July 2024:

Sectoral Performance since Powell’s Congressional
Testimony on 10^th July to 19^th July 2024

Shares of financial and biotechnology firms make up significant portions of the small-cap sector, accounting for
approximately 15% and 9% of the Russell 2000 index, respectively.

Financial stocks - These have been standout performers, rising by 11.26% over this period. In doing so, they eectively
surpassed their 2022 apex that had acted as crucial resistance to previous rallies. Even smaller regional banks appear to
be recovering from the significant challenges they faced earlier this year, including large-scale deposit withdrawals and
concerns about commercial real estate loans.

Biotech companies - These are often capital-intensive, requiring significant investments in research and development to
bring new drugs to market. Lower interest rates make it more aordable for biotech companies to obtain loans or raise
capital through debt financing. This extra funding can be utilized to speed up drug development, expand operations, or
acquire other companies, thereby boosting profitability.

Energy companies - Trump has traditionally supported reducing regulations on fossil fuels, including coal, oil, and natural
gas. This often involves loosening restrictions on drilling and mining, which can lower operational costs and boost
production for energy companies. Additionally, there may be tax incentives and subsidies for the fossil fuel sector,
improving profitability. Trump's emphasis on U.S. energy independence could also lead to policies that promote domestic
oil and gas production, including backing infrastructure projects like pipelines and oshore drilling, which would benefit
energy companies

Others - Bitcoin miner and crypto companieshat have faced obstacles in going public in the U.S. could emerge as a
clear beneficiary under a second Trump administration. It might also pave the way for increased banking support of
crypto firms. Gold mining companies might perform well since precious metals often attract buyers in a low-interest-rate
environment.

Wall Street is starting to believe that the extraordinary performance of the top seven tech giants in the U.S. might have hit
a wall after a prolonged period of dominance over the past year and a half.

With investors booking profits in these high-valued tech stocks, the capital is being funneled into the more overlooked
areas of the stock market such as the U.S. small caps.

*CMP as of 19 July 2024.
Date: 22 July 2024
Source Bloomberg

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