Monday Digest
Posted 22 July 2024
Shock, rotation, growth?
An astounding week, that started with an attempted assassination of Donald Trump, ended with the largest global IT outage in history. As a result, markets now assume Trump will be president – and have priced in the tax cut benefits to small cap US stocks. The outage caused lots of disruption, but little market volatility as yet.
It adds further pressure to mega-tech stocks, which have struggled following a massive market rotation into small caps. The global system failure might also push more money into cybersecurity (even though this particular episode wasn’t an attack), following Google’s $23bn acquisition of Wiz. We need to keep an eye on the long-term implications of this trend.
The assassination attempt has made Trump the presumptive next president in markets’ view, and there is clear excitement about another round of corporate and personal tax cuts – benefitting the small-cap Russell 2000. We welcome a rotation away from the previously dominant mega-cap tech stocks, but markets are arguably ignoring the negatives of a Trump presidency – most notably, a deterioration of US fiscal metrics and potential bond market volatility. Bond markets are calm at the moment, but that could change.
The large-to-small cap rotation is a momentum story, and we have noticed that, in recent years, momentum has become a dominant market driver. That might have something to do with the presence of AI in trading strategies, which is a slightly concerning thought (since AI-driven behaviour typically becomes very unpredictable). Nvidia is a good example: its rally has driven down its risk premia dramatically, despite being an historically volatile stock. This pattern is the same across the mega-caps, which are typically more volatile than the rest of the US stock market.
Those trends might flip if rotation continues, but we worry that mega-cap losses might start to dwarf the small-cap gains – because of the former’s sheer size. That could negatively affect market conditions or consumer confidence (through the balance sheet effect). Greater market equality might be a long-term benefit, but we need to be vigilant.
Small cap rotation
Small cap US stocks continued outperforming the tech mega-caps last week – in stark contrast to the Magnificent 7’s incredible rally for most of this year. Weaker inflation data prompted the switchover, as markets now think the Federal Reserve might cut rates this month, or by September at the latest.
That goes against the usual narrative somewhat: small caps are thought to lose out when economic activity weakens (as in a disinflation environment) because they are sensitive to near-term growth, while ‘growth’ stocks like tech are thought to be benefit when rates fall. Instead, markets clearly think rate cuts will be a big boon for small companies – possibly because borrowing costs are now such a burden that the effect of changing them is bigger.
Small caps were also boosted by expectations that Donald Trump will win the presidency, with his agenda of tax cuts and deregulation. We think there might be fiscal and bond market problems with this further down the line (he wants to expand the deficit, but his foreign policy could deter the capital inflows needed to do so), but markets are not showing signs of fear yet.
Losses for the Mag7 are harder to explain (they should benefit from tax cuts too) but we think they are mostly about momentum. The relative balance of expected earnings growth has shifted enough to make investors question the mega-caps’ huge valuations, which have become stretched after a phenomenal rally this year. We wrote a while ago that market concentration in the Mag7 was mostly because no one could match their profit growth – but this may no longer be the case. Hopes for a better balance in economic profit distribution has allowed the rotation that many have been clamouring for all year long. That inevitably drags money away from tech – but that could well be a good thing.
Renminbi strength is political, not economic
Chinese growth looks weak after disappointing GDP numbers – and many think it is weaker than the official figures say. Deflation is still a big problem; month-on-month inflation has been negative since April. The communist party’s third plenum (a key economic meeting) was remarkably quiet about the problem this week. Beijing clearly favours a gradual approach, more in keeping with Xi Jinping’s long-term deleveraging goals. Stimulus has been stop-start in recent years, as the government is reluctant to inflate the credit bubble again.
Deleveraging an economy is much smoother if export demand is strong – but that has been battered by tariffs and trade wars. These are only set to get worse if Donald Trump wins a second term, or the EU imposes its planned tariffs. In this weak environment, you would normally expect the currency to fall in adjustment, making exports more attractive. But the renminbi has remained stable against the dollar – and appreciated massively against the weak yen, making Chinese exports to Asia (where most of Chinese trade is) more expensive.
Beijing’s reluctance to devalue its currency – thereby tightening financial conditions – is surprising, and seems to be the result of other political goals, rather than an aim in itself. Devaluation would undermine domestic confidence in the economy and international perceptions of the currency. Trump would undoubtedly jump on it and call Beijing a currency manipulator, while the EU would potentially dial up tariff talk.
In terms of selling goods to the west, therefore, there would be little benefit – since the currency discount would be nullified by tariffs. The situation is different among Asian neighbours, of course, but is the Chinese economy detached enough from the west to rely on this trade? In the months and years to come, answering that question will be crucial.