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

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 offer 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: