Is the “Trump Trade” Finished?

While dramatic turns and surprises may make for great reality television and may be very helpful for media ratings, they are less than ideal in the markets. We’re now getting a lot of bombshells out of Washington, D.C., and it is becoming increasingly difficult to think that the pro-growth policies and “Trump agenda” are not at risk.

Year-to-Date Reversals1

Trump Reflation Trade 2017

  • The Russell 2000 Index was a rather dramatic market signal that showcased a strong response to President Trump’s November 8, 2016, victory, and there were a number of supportive catalysts for U.S. small-cap stocks after the election and at the end of the year. Rising rates—specifically, a rising U.S. 10-Year Treasury note yield—were driven by increasing growth expectations, something typically quite bullish for small-cap stocks. Additionally, corporate tax reform was seen as very possible given Republican majorities in both the U.S. House of Representatives and the Senate, and small-cap stocks tend to pay higher effective tax rates than large-cap stocks, thereby benefiting more from lower statutory rates. Also, the Bloomberg Dollar Index—a measure of the performance of the U.S. dollar against a diversified basket of currencies—was up 5.7% from November 8, 2016, to December 31, 2016. Since small caps derive the vast majority of their revenues from inside the U.S. rather than outside, this was yet another reason why the Russell 2000 Index did so well. In fact, there were 15 days in a row of positive gains on this index, the longest such streak since 1996.2

As of this writing (June 2, 2017):

  • The U.S. 10-Year Treasury note interest rate has fallen since the start of 2017 from 2.44% to 2.15%.
  • The Bloomberg Dollar Index is down 5.8%.
  • With each passing week, it is looking more and more challenging for corporate tax reform to be completed in 2017.

So the Russell 2000 Index—the performance of which was one of the strongest symbols of the “Trump trade”—has faltered.

You Need to Take Risk to Put Yourself in the Way of Potential Rewards

It’s clear that, in the initial euphoria of President Trump’s victory, many international markets didn’t participate—and there wasn’t any strong reason why they should have. The Russell 2000 Index exemplified the “sentiment flows.”

For example, the specter of political risk in Europe was hanging over developed international markets. Even though for years we had been discussing the story supportive of developed international equities, it seemed like there was always a reason why the more expensive U.S. market was perceived to be less risky going forward. In other words, the higher multiples/valuations were “worth it” because the view of the market was that the rest of the world was riskier.

Now that we’re coming into the summer of 2017, we can see that those courageous and able to look beyond the apparent U.S. luster in the aftermath of President Trump’s victory—investing beyond U.S. borders even in the face of the perceived risks—have largely outperformed those who stuck with their home bias.

Not All Small-Cap Stocks Are in the U.S.

It seems like an obvious truth—and it’s noteworthy that the MSCI ACWI Small Cap Index is only 51% weighted to the U.S.3—but many investors that we speak to do all sorts of differentiated U.S. equity strategies and then simply “buy the benchmark” for their international exposures. For many, international small caps represent a new piece to their asset allocation puzzle.

Outperformance AND Lower Current Valuation

The MSCI EAFE Index is the most widely followed developed international benchmark that we tend to see in our discussions—and it has been doing well this year. But the WisdomTree International SmallCap Dividend Index has beaten it.

Small Cap Valuation

For those investors who believe that the Trump agenda may be in trouble, why would they contemplate buying into (or holding) a market cap-weighted approach to U.S. small caps, such as the Russell 2000 Index, with a forward P/E ratio of nearly 29.0x? Developed international small caps are certainly not without risk—but at a forward P/E of approximately half as much, it’s possible that a lot of that risk has been priced in.

Align with the Momentum of the Summer

While these things are never certain, relative to where we were at the start of 2017, developed international markets are tending to shift from more negative to positive expectations. U.S. expectations were very positive and may be shifting to become more negative. Tapping into this shift with developed international small caps could bring helpful diversification into one’s small-cap allocation.

 

1Unless otherwise noted, Bloomberg is the data source for all bullet points.

2Source: Lu Wang Lu, “U.S. Stocks Rise to Record as Trump Rally goes on for Third Week,” Bloomberg Markets, 11/25/16.

3Source: Bloomberg, with data as of 4/30/17, due to availability of monthly constituent data for MSCI indexes.

 

Important Risks Related to this Article

Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty.

Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development.

Diversification does not eliminate the risk of experiencing investment losses.

Small Caps Looking for a Catalyst

Sailing into a blue sea of future

U.S. stocks are off to another stellar year. Look below the surface, however, and the rally has had a somewhat unusual flavor. Some of the better performing stocks are in the more defensive industries, such as utilities and health care, while small caps—a strong performer in late 2016—are trailing. Year-to-date the S&P 500 has gained over 5%, versus barely 1% for the Russell 2000 Index. Nor is this just a U.S. phenomenon. Globally, the small cap rally has stalled (see the chart below).

What accounts for the reversal in fortune and will it continue?

Late last year I suggested that the small cap surge might struggle in 2017. Before focusing on why this should be the case, let me dispense with one suspect: the reversal in the U.S. dollar. In fact, this is a symptom rather than the cause of the recent underperformance.

Small vs Large

As I described late last year, since 2000 the relative performance of small caps has been largely independent of what happens in currency markets. While U.S. small caps have a slight tendency to outperform when the dollar is strengthening, the relationship is fairly weak and not statistically significant.

If a faltering dollar rally is not to blame, what is? I see two culprits.

1. Risk appetite turned.

The turn in the dollar, while not directly the cause of small cap underperformance, is indicative of a broader pattern: The “reflation trade” that began in mid-2016 has been struggling of late. One manifestation of this has been the recent pullback in credit, specifically high yield. This is important. Since 2000, monthly changes in high yield spreads have explained roughly 10-15% of small cap’s relative performance. If appetite for high yield bonds continues to moderate, this is indicative of a dampening in risk appetite, a scenario that does not favor small cap names.

2. Valuations are still stretched.

Neither large nor small cap U.S. stocks are cheap, but small caps look particularly pricey. The Russell 2000 was already expensive last December; at nearly 48x trailing earnings it is even more so today. Instead, many investors are starting to look for better bargains overseas. For those willing to take the incremental risk, at 15x trailing earnings emerging market equities seem the more interesting play, a fact reflected in their outperformance year-to-date.

What could reverse this recent trend? The most obvious catalyst would be events in Washington. Progress on tax reform and infrastructure spending would help convince increasingly skeptical investors that the long hoped-for fiscal stimulus will actually materialize. In the absence of that, investors may be looking at a more modest version of the reflation trade than many discounted last fall. Under this scenario, small caps may not regain their luster anytime soon.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Small-capitalization companies may be less stable and more susceptible to adverse developments, and their securities may be more volatile and less liquid than larger capitalization companies. International investing involves special risks including, but not limited to, currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Why the Small Cap Rally May Fizzle

pouring cola into glass with ice and strip straw on table top; Shutterstock ID 391513618

Small cap stocks are having a stellar year with the Russell 2000 Index up nearly 20% year-to-date. In November, small caps outperformed large caps, as measured by the S&P 500, by roughly 9%, the strongest monthly performance in more than 15 years (source: Bloomberg data, as of 11/28/2016). What’s behind the rally — and more importantly, can it continue?

Many have pointed to the strong U.S. dollar to explain the small cap outperformance. The argument is a strong dollar supports America’s purchasing power, which helps smaller, domestically-focused companies while hurting larger, more export-oriented firms. This explanation has intuitive appeal, but it ignores two issues.

HISTORICALLY WEAK RELATIONSHIP BETWEEN THE DOLLAR AND SMALL CAP RELATIVE PERFORMANCE

Since 2000 the relative performance of small caps versus large caps has actually had a low correlation with changes in the dollar. While the correlation was negative at one point, it has historically been weak, explaining less than 1% of monthly relative returns. In short, although commentators have attributed small caps’ outperformance to a rallying dollar, history suggests otherwise.

SURGE IN RISK APPETITE

It is important to note that risky assets in general, not just small caps, have had a brilliant run. That reflects the change in sentiment we have seen. In fact, risk appetite, as measured by monthly changes in credit spreads, has had a much stronger correlation with the small cap relative performance than the dollar’s strength. Since 2000, monthly changes in high yield spreads have explained roughly 10%-15% of small caps’ relative performance.

Can the small cap rally continue?

Going forward small caps face two significant headwinds. First, the small cap rally is more likely to go on if credit spreads continue to tighten. Unfortunately, a stronger dollar is also a de facto form of monetary tightening, and a further rise in the dollar suggests that spreads are more likely to widen than contract.

The second headwind is valuation. The recent rally has occurred at a time when small caps — along with the rest of the U.S. market — are already expensive. Following the recent gains, the Russell 2000 Index is now trading at roughly 47x trailing price-to-earnings (P/E), compared to a five-year average of approximately 39x. And as with the broader U.S. equity market, recent gains have been driven by multiple expansion — investors willing to pay more per dollar of earnings — only more so. Since the lows in early 2016, the trailing P/E on the Russell 2000 is up by more than 40%. In contrast, while large cap stocks have also undergone significant multiple expansion, the P/E on the S&P 500 is up less than 25% from the 2016 bottom. (All data are from Bloomberg, as of 11/28/2016.)

Yes, small caps may continue to advance on other factors, notably an ongoing rally in bank shares (the Russell 2000 has a heavier weighting to banks). That said, a further advance in the dollar, while a headwind for large cap exporters, is not necessarily a tailwind for small caps. Instead, with valuations stretched and 2017 earnings expectations already aggressive, investors are really betting on continued animal spirits and a benign credit market.

Russ Koesterich, CFA, is Head of Asset Allocation for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2016 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.