For those in search of safe havens amid the ongoing escalations in the global trade conflict (Steve Mnuchin would really appreciate it if you didn’t call it a “war”, because that sounds bad, ok?), the Russell 2000 and the Nasdaq have been something of a safe harbor.
Despite myriad stumbling blocks including a truly harrowing stretch in late March precipitated by acute regulatory concerns and exacerbated by Donald Trump’s Twitter attacks on Amazon, tech continues to shoulder the burden when it comes to keeping U.S. equities from suffering the same fate as their Chinese counterparts (and it’s not just the Shanghai Composite, EM equities in general are struggling, as are European financials and automakers).
When I say “shoulder the burden” I mean that literally – and then some. Just 10 stocks accounted from more than 100% of the S&P’s H1 gains:
Chalk some of that up to Howard Marks’s “perpetual motion machine” dynamic and attribute the rest to the fact that tech is where the top and bottom line growth is.
Of course, “buyer beware” – FAANG is the most crowded trade on planet Earth:
As far as small caps are concerned, their “safe haven” status is down to the assumption that they’re less exposed to the trade friction. I spent a good bit of time talking about this over the weekend and some folks seem to think the rally in the Russell lacks fundamental support.
“Small cap issues haven’t been resolved,” SocGen recently wrote, before reminding you that while they’ve outperformed “on the back of accruing benefits from the tax reform and relative safety amid trade war fears, the Fed is still raising rates, which is likely to increase pressure on the bottom lines of highly levered negative-cash-flow-generating companies.”
In a separate piece out two Mondays ago, the bank’s Andrew Lapthorne said the following:
We are not keen on the Russell 2000 as corporate leverage is high and profits are struggling. So seeing the index fly up like that must have been painful for investors who were outright short. However, such a strong performance does mean implied volatility on the Russell 2000 (RVX) has been relatively subdued versus its bigger cousins (VIX). If the ‘Trade War’ fades, then a reversal of this relationship could be on the cards.
I echoed those sentiments in a weekend post as follows:
On small caps, I’d be careful there. The investment case seems to be predicated almost entirely on assumed insulation from the trade conflict, which means you could get underperformance if trade tensions fade, and if they don’t (i.e., if trade frictions get worse), you could discover that whatever safety goes along with being in U.S. small caps was already priced in.
Here’s what “America first” looks like:
With that as the backdrop, it’s worth noting that Morgan Stanley has cut both tech and small caps, with the former downgraded from overweight to equal-weight and the latter from equal-weight to underweight.
Here are some excerpts from their call:
The bastions of safety in 2018 have remained the old stalwarts of this post financial crisis bull market — the S&P 500 at the regional level and growth stocks at the sector and stock level — most notably, US tech stocks. More recently, US small caps have been the safe haven of choice over the S&P 500 as investors view them as less vulnerable to rising trade tensions. While this makes sense intuitively, we are skeptical that US-centric small cap companies would be immune to a major escalation in trade tensions, which would ultimately be a significant drag on the US economy, too. With the dramatic 800bp of outperformance in US small caps versus large caps over the past three months, we are downgrading our view on US small caps today from overweight to equal-weight.
Similarly, we think the risk is rising that US tech and growth stocks will get wet. While we are not worried about an economic recession as the catalyst for underperformance in these market leaders like it was back in early 2016, we do think that 2Q earnings season will bring an inevitable acknowledgement from companies that trade tensions increase the risk to forward earnings estimates, even if managements don’t formally lower the bar. Throw in the fact that these stocks have rarely, if ever, been so over-loved and over-owned, and the risk of a proper rain storm in this zip code increases significantly.
Also worth keeping in mind is the fact that, as alluded to above in the quote from Andrew Lapthorne, the Russell VIX has remained stubbornly suppressed relative to its historical relationship with the “regular” VIX (i.e., the difference between the two has been persistently bumping around between 1 and 2 standard deviations below its five-year mean).
While it’s entirely possible that is just the lingering effect of the February VIX explosion (i.e., a symptom of the ongoing distortion in the vol. complex), it’s also possible that it reflects investors’ effectively pricing out Russell underperformance in light of trade concerns. If that relationship mean reverts, it could easily derail stretched small caps.
In any event, Morgan’s call is a “the first shall be last” type of deal. Take it for what it’s worth and in this case, I actually think it’s worth more than most of these calls.