This week in the markets: Small caps bounce back

School’s out but there’s still plenty to keep investors focused on as we head into the holiday season. Top of the list is a dramatic rotation out of mega cap stocks into smaller companies ahead of a hoped-for interest rate pivot. But politics is front and centre too, as Joe Biden pulls out of the presidential election. China’s moves to stimulate its faltering economy are under the spotlight too.

Small cap rally

In the ten days since US inflation emerged lower than expected, cementing the market’s view that interest rates will start to fall in September, a massive rotation has turned the stock market narrative on its head. The Russell 2000 small-cap index has exploded upwards, rising 7% in a few trading sessions while the mega caps that had led the market higher for so long have retreated.

The trigger for this significant shift in the markets was US inflation data on 11 July, which delivered a lower-than-expected consumer price index (CPI) reading of 3% and pushed the probability of a US interest rate cut by September to close to 100%. A cut next week at the Fed’s July meeting still seems unlikely but the start of an easing cycle at the following meeting in September now looks nailed on.

That is being seen as a positive for smaller, domestically focused companies. These tend to have higher borrowings relative to their size and so are more exposed to movements in interest rates and the general health of the economy. For the first time in a long while, investors believe they have investment choices beyond the handful of mega-cap tech stocks which have represented a safe haven during the recent interest-rate tightening cycle.

At the same time as investors are starting to price in lower interest rates, they are beginning to factor in a broad-based improvement in corporate earnings. With around 70 companies in the S&P 500 having now unveiled their second quarter profits, 80% of earnings are running ahead of forecast. The consensus is for a 10% earnings rise, year on year, for the three months from April to June.

The big question for investors is whether a broadening out of the market rally can prevent an overall market fall if the more expensive big growth stocks start to underperform. Their big market weighting dragged the market higher as they were re-rated, but investors worry that a de-rating of these stocks could pull the market lower again.

Biden bows out

Not unexpected, but still a dramatic turn of events in politics, is the decision at the weekend by Joe Biden not to contest the November presidential election. His withdrawal had been speculated about for weeks since a faltering TV debate performance cast doubt on his ability to handle the most high-pressure job in global politics at the age of 81.

The market impact of this seismic political event is unclear. Biden quickly endorsed his vice-president, Kamala Harris, but her popularity is low and it is not yet a given that she will receive the backing of the Democratic party at its convention next month. Even if she does, she faces an uphill struggle to keep Republican rival Donald Trump out of the White House for a second term.

That ‘Trump trade’ is starting to show up in financial markets, mainly in the bond market where investors are betting on a Trump policy platform being inflationary on the back of tariffs, lower immigration and possible tax cuts. That argues for higher yields on longer-dated bonds as investors demand greater compensation for the risk that the value of their fixed income investments is eroded by inflation. At the same time, shorter term interest rates might be under downward pressure from a President known to favour lower borrowing costs, despite the official independence of the Federal Reserve.

China chips rates

While US interest rates remain in the future, China is already starting to ease its own policy backdrop in a bid to shore up its faltering economy. At the beginning of this week, the People’s Bank of China cut a series of interest rates including the 5-year prime loan rate which heavily influences mortgage rates. That’s seen as key to supporting the country’s struggling property market which saw a 4.5% fall in the price of new homes last month, further eroding already weak consumer confidence.

The Chinese stock market has rallied in the first six months of 2024 but remains 40% below its 2021 high as investors have lost interest in an economy that failed to bounce back from Covid lockdowns and remains under the shadow of a massive overhang of unsold properties.

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