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Welcome to RBC’s Markets in Motion podcast, recorded November 7, 2024. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
Today in the podcast, we run through three things in focus in our conversations following the US election. First, we review the tailwinds for US equities that we’ve been highlighting from a Trump win, along with some of the headwinds to watch out for. Second, we highlight why we think Small Caps have at least a little bit more room to run and what we’re watching to help us know when it’s time to fade the trade. Third, we review our thoughts on the old economy, value-oriented sectors that did well on Wednesday.
If you’d like to hear more, here’s another five minutes.
Takeaway #1: Tailwinds and Headwinds for US Equities Broadly Heading Into Trump’s 2nd Term
On the broader US equity market, we’ve been emphasizing the following:
- First the tailwinds. At the time of this recording, a number of House races hadn’t been declared yet, but betting markets seemed confident that Republicans would take control. While both a Republican sweep and Republican White House win with a split Congress have historically been good for the stock market, average annual S&P 500 returns have been much higher, on average following a sweep (13% vs. 5%).
- Policy is generally a tailwind in a Republican sweep. Our recent survey of RBC’s equity analysts had a modestly bullish bias in a Republican sweep due to his approach to regulation and taxes, driven by optimism on the Energy and Financials sectors.
- Thinking more broadly, we have argued that global investors will see Trump’s victory as a reason to overweight US equities.
- We’ve also been pointing out that getting past the event and alleviating some of the uncertainty around the political backdrop seemed likely to get business activity moving again.
- In terms of headwinds, investors have been concerned about Trump’s approach to tariffs and their potential inflationary impacts as well as the deficit.
- There are also indirect impacts to consider. Equity valuations seem likely to eventually take a hit if 10-year yields rise too much more. Historically, sizable moves in 10 year yields bigger than 250 basis points can trip up the stock market performance as well. On a related note, historically, big appreciations in the US Dollar can have an adverse impact on earnings revisions trends for the S&P 500.
Moving on to Takeaway #2: How Much More Room Do Small Caps Have to Run?
- Ahead of the election, we pointed out that if Trump won, particularly with a sweep, hedge fund investors seemed likely to buy Small Caps, which had become aligned with Trump’s odds in betting markets in October.
- There was also a historical playbook for this trade. Small Cap positioning surged in 2016, 2017, and 2018 on economic optimism around Trump’s victory, the passage of corporate tax cuts (which benefited Small Caps more than Large Caps), and the trade war with China (where a buy the USA trade was briefly in vogue). Small Cap futures surged Tuesday night/before the open Wednesday as the results trickled out, and the Russell 2000 posted a gain of 5.8% on Wednesday.
- One of the best questions we’ve been getting is how much more room Small Caps have to run. Positioning already looks a bit stretched, with Russell 2000 futures positioning per data from CFTC already close to the 2016, 2017, and 2018 highs in last week’s update, ahead of the election.
- We think the best way to gauge how much more room this trade has to run is by looking at the Russell 2000’s market cap weighted median P/E, which was 16.7x as of Tuesday’s close, but peaked at 18.9x in 2016, 19.7x in 2017, and 17.6x in 2018. There’s not a ton of room left, but likely some even after Wednesday’s big move.
- We’ve taken a look at what happened to the Small/Large relative trade after the last two Presidential elections. Interestingly, Small Caps outperformed for a month after Trump’s 2016 victory and four months after Biden’s 2020 victory. 10-year yields moved up during those two periods of Small Cap post election outperformance as well.
Wrapping up with Takeaway #3: Which Old Economy Cyclicals Look Most Interesting Right Now?
- Old economy cyclical, Value-oriented sectors surged on Wednesday, with Financials and Energy outperforming within both the S&P 500 and Russell 2000. Industrials was also a top performer in the S&P 500, while Materials was a top performer in the Russell 2000. Growth sectors were mostly middle of the pack, while defensives lagged.
- In our discussions of the broader rotation into these old economy sectors a few thoughts emerged.
- First, Energy came into the day with the most valuation appeal at the sector level in both Large Cap and Small Cap.
- Second, Industrials came into the day with the least amount of valuation appeal in both Large Cap and Small Cap, as it has been looking highly expensive in the S&P 500 and Russell 2000 on both absolute and relative P/E.
- Third, Financials was somewhere in between. Within the S&P 500, the sector has continued to look attractive on our relative P/E work but slightly overvalued on our absolute P/E model.
- We see deeper valuation appeal for the sector in the Russell 2000, where the sector looks attractive on both metrics.
- Separately, We took a look at sector performance 3, 6, and 12 months after the 2016 and 2020 elections and found that Financials outperformed on a 12-month time frame after both elections within both Small Cap and Large Cap.
- Taking into account all of this information, we feel comfortable continuing to buy Financials (but prefer the Smaller cap names). We are also comfortable sticking with Energy for a while longer, but will be keeping a close eye on the valuations for this sector where the underlying fundamentals have felt a bit more challenged. And we would be faders of the Industrials move, given how expensive it is and since it was one of the worst performing sectors in the S&P 500 during the 2018 China trade war.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.