Is the rotation for real?

That’s one key question for equity investors going forward.

As discussed here last week, the post-CPI trade in the US saw small-caps outperform big-tech and the equal-weighted S&P outperform the cap-weighted benchmark by huge margins.

Although the S&P did rise for the week, it underperformed the egalitarian index by the most since November of 2020.

The thesis is straightforward. America’s corporate “have-nots” struggled as the Fed raised rates. Now that rate-relief’s on the horizon, small-caps and the “average” company can outperform the mega-caps in a “catch up” trade.

The problem with that idea is as straightforward as the thesis itself. These are companies which’ll struggle if growth decelerates and pricing power fades further. Fed cuts tend to presage slower growth and cooling inflation points to less in the way of pricing power.

In his latest, Morgan Stanley’s Mike Wilson cast doubt on the sustainability of the rotation. “We are not of the view that last week’s brief rotation to lower quality cyclicals persists in a durable manner,” he said.

It’s not so much that Wilson thinks all cyclicals are bad, it’s that he harbors doubts about any rebound in low-quality names. The Fed, he wrote, begins cutting when nominal growth decelerates, “historically a time when the market pays up for quality and secular growth attributes as… the initial string of rate cuts has a limited impact in terms of reviving pricing and operating leverage for lower quality areas.”

The figure above shows relative performance for quality growth versus low-quality cyclicals plotted with the front-end.

Wilson doubts this time’s different. “We believe the historical precedent holds and pricing power fades for low quality cyclicals,” he said, reiterating a bias for big-caps with growth and quality attributes. If you’re determined to dabble in small-caps, Wilson said stick with small-cap growth over value.

If you ask SocGen’s Andrew Lapthorne, last week’s post-CPI trade (i.e., the big reversal on July 11 documented in the linked article above) might’ve been a kind of Fata Morgana in the first place — a positioning-driven move, not a carefully considered fundamental rotation.

“[I]t seems the logic to the move is that lower interest rates put less pressure on those business that are suffering the most, i.e. small-caps,” Lapthorne wrote, before noting that “the uniform strength of the move highlights that positioning could also be behind it as well.”