After Biden, is there still a Trump trade?

Good morning. As both the presidential race and the stock market were being flipped on their heads, I had a lovely week off in Vermont. But Wall Street metaphors, if not Wall Street itself, refused to leave me in peace: I saw a bear. Quite a big one. An omen? Let me know: robert.armstrong@ft.com 

Markets and the presidential race

Unhedged veers away from talking about the influence of politics on markets (and vice versa) for several reasons. Markets are pretty good at capturing what little we can know about political outcomes ahead of time. So there is little if any political alpha. The standard generalisations that analysts go in for (“In an election year markets tend to ... “When the incumbent is unpopular markets have …”) look to me like the mining of a smallish data set. Most importantly, politics are not my area of expertise, and there are plenty of others happy to write at length. 

Sometimes, however, you have to accept the story the universe hands you. And today that story is Biden’s decision not to seek the Democratic nomination and the high (but not overwhelming) probability that the nominee will be Kamala Harris. The most important point about the short-term repercussions of these facts is banal but worth repeating. Markets don’t like uncertainty, and they just got a bit more of it (I say “a bit” because a Biden withdrawal was not unexpected). So today markets might be slightly more likely to be down than up, unless events after I file this newsletter provide some clarity (S&P futures were up a bit Sunday evening). Bitcoin (a 24/7 market) fell when the news hit yesterday, then more than recovered. But whatever the initial reactions are, overreading them would be a mistake. The same goes for early readings from political prediction markets (Trump’s odds of winning the presidency fell, though almost imperceptibly, on PredictIt after the news hit). It’s jitters and noise at this point.

As the days pass and the political situation solidifies, the yield curve will be interesting to watch. This is because the consensus “Trump trade” is a bet that the curve will steepen with Republican victory. The plain vanilla version of this theory attributes the steepening to higher long-term rates, as the tariffs, immigration restrictions, and tax cuts of the Trump platform are thought to be inflationary. The more conspiracist version suggests that Trump will pressure the Fed to keep short rates artificially low (he generally denies this but leaves his options open).

Since Biden’s debate disaster, the yield curve, or rather some yield curves, have indeed steepened. The 10 year-2 year curve, which has been inverted for two years, became notably less negative immediately after the debate, as the long end rose. Since then, however, the long end has fallen again, soothed by a benign CPI inflation report. The curve has continued to steepen a bit only because the short end has fallen even more. If there is a Trump trade signal in the curve, it has been drowned out by good inflation news.  

I believe the case for a Trump victory as a curve steepener is overdone, both because we know less than we think we do about the short term inflation implications of policy (see: the past four years) and because Trump is a hard person to predict (see: the four years before that). Nonetheless, his reputation as a tax-cutting, tariff-raising, immigration-stopping, low-rate-loving nationalist is powerful. The yield curve may respond to Trump’s political fortunes yet.

Stocks in general might respond at the margin to Trump shifting chances of election given his (vague) talk of another cut to the corporate tax rate, which would increase net profits and, all else equal, stock prices. But in his recent (very interesting) interview with Bloomberg he equivocated about cutting the rate from 21 to 15, saying “I think that would be . . . hard.” It doesn’t sound like a priority. 

Other markets that might — might — be sensitive to political influence are semiconductor stocks and small caps. More on this in the next section. But the summary is: if there is a Trump trade, we haven’t seen much of it in markets yet, and the Biden news makes it an even trickier bet, for now.

Small caps go berserk

Small caps have staged an astonishing rally recently: between July 9 and July 16, the S&P 600 small cap index rose 11 per cent, while the S&P 500 gained just 2 per cent. Big tech and semiconductor stocks fell. Much has been written about this remarkable rotation (start with Nick Megaw’s story here and Robin Wigglesworth’s Alphaville post here). The main emphasis has been, quite rightly, on the good inflation data and attendant expectation of interest rate cuts. Small cap stocks tend to be both more indebted than large caps, giving them more to gain directly from lower interest rates, and more economically sensitive, giving them more to lose if higher rates ultimately slow the economy. This interpretation chimes with the fact that the small cap rally cooled after short rates started to rise again last Wednesday. The violence of the move is also suggestive of short covering in small cap stocks.

Even accepting these core explanations, though, important questions remain about this seismic move. Here are four of them: 

Is this a one-time rotation or a leadership change with room to run? Small caps are still historically cheap relative to big caps on a price/earnings basis. Here is a chart of the valuation premium of the S&P 500 over the S&P 600 small cap index over time: 

Whether you think the discount can close further depends how you feel about the much-discussed argument that the quality of companies in the small cap indices has fallen in recent years. The good small caps, it is alleged, have mostly been bought by private equity, leaving loads of junk (here is a good recent rehearsal of the argument, from Spencer Jakab at the WSJ). I do not have an informed opinion about this. I should probably get one. 

Is this a value rally in disguise? Dec Mullarkey of SLC Management notes in an email that within the small cap rally, value stocks outperformed growth stocks significantly, with leveraged sectors like financials, utilities, real estate, and industrials leading the way. The comeback in regional banks has been particularly impressive (Unhedged wrote about their previous underperformance here). Simultaneously with the small cap spurt, S&P 500 large cap value index rose four per cent while the S&P 500 growth index was flat. Perhaps small caps are just the leading edge of a rotation into value generally, given that value stocks also tend to be hurt more by high rates and have more to lose from a monetary policy-led slowdown — and that growth stocks are wildly overbought. 

Is the rally well grounded in expectations for improving small cap earnings? Megaw quotes several investors talking about “growth broadening out” from the tech sector to a wider range of companies. Yes, over time, lower rates will help small cap earnings more. A falling risk of recession is better news for smalls as well. But the economy is slowing, however gently, and as Ryan Grabinski of Strategas points out, that is not generally a time when small company earnings outperform. In short, while the small cap valuation picture is appealing, the earnings picture is cloudy. 

How much of this rotation is politically driven? Many people attributed the move away from semiconductors to Trump’s comments that Taiwan should “pay for its own defence.” It is arguable that small-cap US companies, which are more domestically focused than large caps, might benefit, in relative terms, from higher tariffs. The Trump administration’s view of the big tech companies is quite uncertain (despite Elon Musk’s adulatory comments about the former president). I don’t know how to tell how important these factors are, except to keep watching as events unfold.

One good read 

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