Episode Details

Our CIO and Chief US Equity Strategist explains that in the event of a Republican sweep in this fall’s U.S. elections, investors should not expect a repeat of 2016 given the different business environment.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley’s CIO and Chief US Equity  Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about  why investors should fade the recent rally in small caps and other pro cyclical trades. 

It's Monday, July 22nd at 11:30am in New York.  

So let’s get after it.

With Donald Trump’s odds of winning a second Presidency rising substantially over the past few weeks, we’ve fielded many questions on how to position for this outcome. In general, there is an increasing view that growth and interest rates could be higher given Trump's focus on business-friendly policies, de-regulation, higher tariffs, less immigration and additional tax cuts.  

While the S&P 500 has risen alongside Trump's presidential odds this year, several of the perceived  industry outperformers under this political scenario have only just recently started to show relative outperformance. One could argue a Trump win in conjunction with a Republican sweep could be  particularly beneficial for Banks, Small Caps, Energy Infrastructure and perhaps Industrials. Although, the  Democrats' heavy fiscal spending and subsidies for the Inflation Reduction Act, Chips Act and other infrastructure projects suggest Industrial stocks may not see as much of an incremental benefit relative to the past four years. The  perceived industry underperformers are alternative energy stocks and companies likely to be affected  the most by increased tariffs. Consumer stocks stand out in terms of this latter point, and they have underperformed recently. However, macro factors are likely affecting this dynamic as well. For example, concerns around slowing services demand and an increasingly value-focused consumer have risen, too. 

It's interesting to note that while these cyclical areas that are perceived to outperform under a Trump Presidency did work in 2016 and through part of 2017, they did even better during Biden's first year. Our rationale on this front is that the cycle plays a larger role in how stocks trade broadly and at the sector level than who is in the White House. As a comparison, we laid out a bullish case at the end of 2016 and in early 2017 when many were less constructive on pro cyclical risk assets than we were post the 2016 election. It’s worth pointing out that the global economy was coming out of a commodity and  manufacturing recession at that time, and growth was just starting to reaccelerate, led by another China boom. Today, we face a much different macro landscape. More specifically, several of the cyclical trades mentioned above typically show their best performance in the early cycle phase of an economic  expansion like 2020-2021. They show strong, but often not quite as strong performance in mid cycle  periods like 2016-17. They tend to show less strong returns later in the cycle like today. Our late cycle view is further supported by the persistent fall in long term interest rates and inverted yield curve.  

We believe the recent outperformance of lower quality, small cap stocks has been driven mainly by a combination of softer inflation data and hopes for an earlier Fed cut combined with dealer demand and short covering from investors on the back of Trump’s improved odds. For those looking to the 2016 playbook, we would point out that relative earnings revisions for small cap cyclicals are much weaker today than they were during that period.   

Back in December when small caps saw a similar squeeze higher, we explored the combination of factors  that would likely need to be in place for small cap equities to see a durable, multi-month period of  outperformance. O