This week in the markets: markets stage a massive rotation out of mega caps; US politics is turned on its head by Joe Biden’s withdrawal from the Presidential race; China cuts interest rates to boost its faltering economy; and earnings season moves onto the front foot.
A sizeable shift in investor focus out of the mega caps which have led the market for years to smaller companies which have lagged behind has been triggered by an unexpected drop in US inflation and hopes for the start of an interest-rate cutting cycle by the Federal Reserve.
In the 10 days since inflation emerged lower than expected at 3%, the Russell 2000 index of smaller companies has risen by around 7% while the headline S&P 500 index, which is dominated by the so-called Magnificent Seven tech stocks, has fallen by about 2%. That is an unusually large divergence in a short space of time and a complete reversal of the overarching market narrative of recent years which has seen a handful of big growth shares lead the market higher while the majority of shares have languished.
The catalyst for that rotation was a bigger than expected decline in US inflation which cemented expectations of an imminent change in direction for US interest rates. Probably not as soon as next week’s meeting of the monetary policy committee at the Fed but almost certainly by September when the next meeting takes place. After the inflation figures were published on 11 July, the futures markets started pricing in a 100% chance of a rate cut by September.
Coupled with stronger than forecast earnings in the second quarter results season, currently underway and already beating analysts’ expectations, that has fuelled hopes for an economic soft landing and a broadening out of the post-pandemic bull market. For the first time in a long while investors have realised that there is something else to buy other than the mega cap tech stocks and they are taking advantage of the more attractive valuations in the rest of the market.
While the S&P 500 index as a whole trades on nearly 25 times historic earnings - a relatively high valuation - the equal weighted index is much more reasonably priced at about 18 times earnings. With 70 companies in the US benchmark index having reported so far, more than 80% have beaten analysts’ forecasts. The estimated growth rate for the second quarter is now 10% year on year, which will bring the valuation multiple even lower.
One of the big questions now is whether the market can broaden out and go up at the same time. That’s because the mega cap stocks have such a heavy weight in the index that they could drag the average lower even if most companies are rising in value. Investors with a limited exposure to big tech could be making progress even as the headline level of the market is falling.
This would make sense because the mega cap tech stocks are typically defensive companies that do relatively well in a slow growth environment but get overtaken when the economy starts to pick up and there is a cyclical rally in the more economically exposed sectors like industrial and in smaller companies. These are more vulnerable to changes in the economic backdrop because they tend to have higher debt burdens and respond well to falling interest rates.
For many investors, a broadening out of the gains is a good thing. Although the S&P 500 moved ahead by 14% in the first six months of the year, the reliance on a few large companies highlighted the fragility of the rally. It was a difficult environment for active fund managers because they tended to be underweight the big stocks and so found it almost impossible to keep up with the market. They might find it easier to outperform in the next phase of the market.
A good example of the scale of the rotation is Nvidia, which saw its shares drop by 13% in just the five trading sessions following the US inflation data 10 days ago. Investors now face a challenge. Do they stick with companies that stand to benefit from the ongoing AI revolution or move into the broader market which might benefit from falling interest rates but could also be hit if the move in rates is a warning about an economic slowdown to come in 2025. For smaller companies to keep rising a delicate balance will have to be struck: they need the Fed to keep cutting rates but without a big economic downturn that could damage their earnings.
The risk of that was highlighted on Thursday of last week when jobless claims emerged at their highest level since 2021.
Investors in China are facing a similar dilemma. At the beginning of this week, the People’s Bank of China unexpectedly cut a series of interest rates, including the five-year loan prime rate that heavily influences mortgage costs in the country. China is cutting rates in response to a prolonged property slowdown and weak consumer confidence. Last week official data showed the economy grew at 4.7%, below the government’s 5% target.
The latest cuts come days after the Communist Party’s third plenum, a closely watched meeting in which the country’s leadership lays out its policy direction. At last week’s meeting, officials signalled concern over the economy and promised additional support. The pressures they face were underscored by a 4.5% fall in the price of new homes last month, the most in a decade.
The Chinese stock market has rallied in 2024 on hopes for more government stimulus but it remains deeply out of favour having fallen by nearly half since its peak in early 2021.
Meanwhile, away from the markets, but likely to have a big if unpredictable impact on them, was the decision on Sunday by President Joe Biden not to fight for re-election in November’s presidential election. His decision followed weeks of growing pressure from senior Democrats for him to stand down following a faltering performance in a TV debate against his Republican rival Donald Trump and growing concerns about his ability to handle the most demanding job in global politics at the age of 81.
Support, including from big financial donors, has swung behind vice-president Kamala Harris, who Biden endorsed as he bowed out. Whether or not she represents the Democrats in November will be decided at the party’s national convention in August. Prediction markets on Sunday showed her as the clear favourite to win the nomination even though she starts with an approval rating below 39%, about the same as President Biden’s. With just over 100 days to go until the election, she faces an uphill struggle to keep Donald Trump out of the White House.
Although the market reaction to politics is hard to predict, the current ‘Trump trade’ is a bet on the shape of the bond market changing, with yields on longer dated bonds rising while those on short maturity bonds fall. The logic here is that tariffs, immigration restrictions and tax cuts if Trump is returned to the White House would be inflationary and so encourage investors to demand a higher compensation for lending long-term to the US government. At the same time, it is thought that a second Trump presidency would increase pressure on the Fed to keep short interest rates low, despite the official independence of the central bank.
As for the stock market, a Trump victory might be seen as a positive for shares if the former President’s vague talk of a cut in the corporate tax rate comes to anything. In sector terms, much has been made of Trump’s comments that Taiwan should ‘pay for its own defence’ and the impact this might have on semiconductor stocks. But there is uncertainty about the attitude of a Trump administration to big tech companies and little real clarity about what tariffs if any might be in the pipeline and the impact they might have on domestically focused small cap companies. As ever, investors are well advised to keep an eye on developments but not to let the political tail wag the investment dog.