The end of the Omnitrade

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Good morning. Markets were unfazed yesterday by the change in the Democratic ticket. Stocks ended higher and yields rose slightly across the curve. Ho-hum. But there is some exciting news: Unhedged has added a new team member. Aiden Reiter was until recently the Samuel Brittan fellow in economics at the Financial Times headquarters in London. Before that, he worked in consulting and as a political organiser. He graduated from the Wharton School at the University of Pennsylvania. He seems likely to join the long tradition of people Rob has hired who turn out to be smarter than he is. Email praise to me and complaints to him: robert.armstrong@ft.com and aiden.reiter@ft.com.

Small-caps, the flight from quality, and ETFs

One might wonder why I am writing about the small cap rally again, given that it ended in the middle of last week and may be reversing itself (tech had a big day yesterday; small cap indices were up, but trailed big caps). The reason is this: we have been in an omnitrade market, where a single theme and a handful of companies have dragged the whole market along. This is a strange regime, and any hint of how it might end is important. Every crack in the facade deserves attention, and the wild small cap rally was a pretty big crack.

To sum up what we said yesterday, the primary reason for the rally was the lowering of inflation and rate expectations following the CPI inflation report. Short covering reinforced the effect. Another angle was the topic of a Bloomberg story yesterday: hedge funds taking gains in big tech stocks and redeploying the proceeds.

Hedge funds spent last week selling their winners at the fastest pace since the meme stock craze in January 2021 . . . The cohort “aggressively unwound risk across their long and short books” for the week ending July 19, according to Goldman Sachs Group Inc.’s prime brokerage desk . . . Investors also extended their rotation into small caps as bets on interest-rate cuts increase

Have we only seen the first leg of a larger rotation — perhaps away from growth stocks more broadly, and towards value? And will small cap earnings trends support such a move?

Haydn O’Brien of Maunby Investment Management emailed to make a point that is relevant to answering those questions:

Focus on value vs growth misses an essential factor in this rally — the quality of the underlying companies. It would seem that the rises in the S&P 600 and the Russell 2000 are more of the ‘scum to the top’ variety than of hidden gold being rediscovered

This idea fits neatly with, but is not identical to, the point about short covering. And I had a look at the S&P 600 small cap index and found some confirmation for it. The 60 companies in the index that appreciated the most during the week-long rally have an average return on equity that is much lower than the bottom 60 performers (13 per cent versus 21 per cent), lower price/earnings ratios (14 versus 16) and have seen analysts’ estimates for 2024 earnings cut by much more over the past 12 months (12 per cent versus 4 per cent).

A data point that was a bit harder to read was earnings growth expectations. The top performers are expected to see earnings per share rise 28 per cent in 2024, double the rate of the worst performers. This is consistent with the other contrasts — if you think weaker companies have the most to gain by an improving economy and lower rates, and if you think the economy will be in a robust expansion in 2025. But I’m not sure why you would think this, or why you would think it is consistent with a return to very low rates.

Here is a different theory of the case. Amazingly, during the small capapalooza rally only 12 stocks in the S&P 600 fell. This looks less like a grab for the lowest-quality stocks than indiscriminate buying. It might be, in other words, that a lot of people realised they were underexposed to small companies and got exposure in the fastest way possible: by buying an ETF. And indeed, here is a chart of flows into the iShares Russell 2000 fund:

The size of the jump is interesting, as is the fact that it subsided so quickly. This raises yet another interesting question. Now that the violent grab for small cap exposure is over, will we see a more selective, gradual, quality- and price-sensitive move into the space by active investors? Will active small cap funds be able to raise more capital in the months to come?

Dollar devaluation

Donald Trump thinks the dollar is too strong and that this hurts the US economy. Here he is in his recent Bloomberg interview:

So we have a big currency problem because the depth of the currency now in terms of strong dollar/weak yen, weak yuan, is massive. And I used to fight them, you know, they wanted it weak all the time. They would fight it and I said, if you weaken it any more, I’m going to have to put tariffs on you . . . That’s a tremendous burden on our companies that try and sell tractors and other things to other places outside of this country.

Trump says a lot of things and not all of them translate into policy. But Robert Lighthizer, Trump’s economic adviser who could be his pick for Treasury secretary, is reportedly in favour of weakening the dollar, not just threatening countries that weaken their own. The goal would be to reduce the trade deficit: a weaker dollar would make imports more expensive for American consumers, and would make US exports cheaper for foreign consumers. It would also lower the real value of the country’s debt load.

Dollar devaluation would have serious downsides. It would be inflationary, as the price of imports would rise. And voters who have their savings in dollars don’t like it when you make those dollars worth less. This is likely why Trump talks not of devaluation of the US currency, but rather appreciation of everyone else’s — at the point of a gun, or rather the point of a tariff. But the effect on households would be much the same.

Devaluation is also hard to do. Macroeconomic and interest rate differentials are a major driver of currency movements. The current US economy’s strength and the Fed maintaining high interest rates is a recipe for a robust dollar. Fighting it would require either interest rates to fall faster in the US than other economies, or a big economic shock. Yet even the latter, as Eswar Prasad pointed out to us, may not weaken the dollar. The dollar’s status as a safe haven asset causes it to appreciate in dire economic times.

If Trump and Lighthizer nonetheless decide to weaken the dollar relative to other currencies, there are four basic ways they could do it:

1. Unilateral intervention in foreign exchange markets. The US has a facility for currency intervention, under the discretion of a Treasury secretary: the Exchange Stabilization Fund. The secretary could use it to buy foreign assets and flood the market with US dollars.

   But as we have seen in Japan, a unilateral intervention is expensive and ultimately ineffective without a change in interest rate differentials and economic fundamentals. And the ESF’s total capital, at about $200bn as of May 2024, would likely not be enough for a sustained intervention.

   Creating more money for an intervention is not something an independent Federal Reserve would undertake, given its inflationary impacts. Trump would therefore need to go to Congress to increase the ESF. But given the politics of weakening the dollar, it is unlikely he would get much support.

2. Co-ordination/coercion. The only tried and true way to intentionally devalue a currency is to co-ordinate efforts with other countries — bringing more international consensus and capital to bear, while not placing undue burden on US coffers. The US did this to some success in the 1980s, following the Plaza Accord.

   At the time of the Plaza Accord, interest rate differentials between the US and the rest of the world were more extreme. It is also unlikely that other ministries of finance would be willing to increase the values of their own currencies in the current trade environment, where Chinese overcapacity threatens everyone’s export industries.

   Trump could try the threat of tariffs. But at that point he may as well just drop the devaluation altogether. As Joseph E Gagnon of the Peterson Institute points out, both devaluation and tariffs distort trade — but tariffs at least raise revenue.

3. Spook the market. Trump could just say that he was going to pursue dollar devaluation, causing a dollar sell-off. This would be relatively “cheap” and quick, but empty threats are not a sustainable strategy.

4. Tax foreign holdings of US dollars and assets. Higher costs for holding US dollars and assets would drive capital away from the dollar. Brazil had a similar policy for a number of years that affected holders of the real, and a bipartisan bill in the US Senate has proposed something similar.

   For investors in US assets, this is the doomsday scenario. Part of the reason US assets have such high valuations relative to other countries’ is the money simply wants to get into America. Trump sees a rising stock market as a measure of his success. Taxing foreign ownership of US assets would pit his vanity against his hatred of the trade deficit.

(Aiden Reiter)

One good read

The Nobel literature prize kingmaker.

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