Small-Cap vs. Large-Cap Stock Rotation: How it can predict a slump in the US economy?
Fed Policymakers confirmed their marked shift in tone after their meeting on Wednesday, with a downward revision of inflation and GDP forecasts, as well as significant downgrade of the dot plot. Fixed-income securities rose sharply as they reached on only one increase in 2020.
Prices of US Treasury bonds posted the highest daily gain for several years as the meeting basically led to an unexpected downside revision of nominal rate and inflation outlook. At one point, bond yields fell below the effective federal funds rate.
Surprisingly, the appetite for risk assets also remains steadily high, as can be seen from the returns of the S&P500, confidently targeting the historical peak of 2900 on Thursday.
The demand for stocks and bonds reflects a diametrically opposite attitude to risk. This is due to a differing degree of certainty in future cash flows. Theoretically, it’s also due to the fact that the growth of stocks is accompanied by a decrease in the value of bonds, and vice versa. However, this is not always the case.
Since the beginning of 2019, both the stock market and bonds have risen, which raises the question of an unobservable factor breaking the correlation. Either the stock market knows something more than the fixed income market, or vice versa. The latter option is more likely, as disturbing movements in bonds are known for their predictive potential.
The yield on 10-year securities went down to 2.539% on Friday, which was last observed in January 2019 when rumors began to circulate about the end of the recovery phase and the imminent transition to recession. In particular because of the “error” in the Fed policy.
More recently there are also examples where stocks and bonds have been growing simultaneously. For example, in February 2016, the yield on 10-year Treasury bonds decreased from 2.32 to 1.36% over six months. In the same period, the stock market grew by 17%.
The boost for both stocks and bonds came largely from the Fed who announced a pause in tightening until almost the end of the year, and only then resumed rate hikes.
The current situation is very similar to one back in 2016. A study of the causes of concern back then in the fixed-income market, in particular the two leading indicators, could make it possible to understand what considerations investors in bonds are guided by today.
Firstly, it’s worth noting that in 2016 the Chinese economy failed, as can be seen from the slump of export orders for the country’s manufacturing sector. As China’s main trade partner is the United States, the fall in Chinese export orders is largely a reflection of the decline in demand for imports to the US. This is a mechanism for transmitting a fall in economic activity from a leader in production to a leader in consumption. Now, when one of the worst times in Chinese history has come for their manufacturing sector, we can expect a sluggish increase in import prices in the US (which also determines the dynamics of consumer inflation in the US). As a consequence, we can also expect a fall in compensation for inflation in US bonds. The chart below shows how closely China’s export orders and US bond yields are.
Export orders are the leading indicator that predict consumption of imported goods in the US.
It’s also prudent to mention that when trying to predict economic fluctuations, it’s useful to take our attention to stock “rotation” in the US. There is value vs. growth rotation as well as small-cap vs. large-cap rotation happening, depending on underlying economic trend. Small-cap stocks are usually more vulnerable to cyclical factors as their number prevails in cyclical sectors of the economy. For example, in sectors like retail, real estate, raw materials processing, production of some non-sophisticated goods and the restaurant and hotel industry. Such concentration in sectors is logically related to the level of their capital intensity.
If managers expect negative cyclical factors to take effect, then plans for output and investment will be adjusted accordingly. Investor expectations will also be lowered. Accordingly, the dynamics of the shares of small vs. large capitalization can be expressed by a simple ratio of the corresponding indices for example: Russell 2000 and the S&P500.
If we compare the joint dynamics of this relationship and the yield of 10-year securities, it can be seen that the flow from small companies subject to cyclicality, to large-cap companies is accompanied by a drop in bond yield. This is logical if the economy is going to slow down.
These indicators shed light on the near future of economic activity in the US, which may soon go into a slowdown phase. The question remains however: what contributes to, and for how long will the US stock market growth last?
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Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.