UBS: Does this small-cap 2.0 rally have legs?
The U.S. equity market witnessed a swift rotation into small caps following the cooling June CPI print last week, mirroring the trend seen during the Federal Reserve’s pivot in November-December 2023.
According to UBS strategists, factors such as the stronger likelihood of a goldilocks environment, the repricing of rate cuts mitigating potential growth slowdowns, and the resurgence of the Trump 2.0 trade have led to a rally in small caps and other lower-quality segments.
This comes following a notable year-to-date underperformance in the Russell 2000 (RTY) compared to major index peers, particularly the Nasdaq 100 (NDX).
“Our US Equity Strategy team suggests the rotation into small caps could continue, predicated on slowing megacap Tech earnings,” UBS strategists said in a note.
“News regarding potential curbing of chip exports supporting the recent rotation out of Growth. While the momentum trade has started to roll over, we do not see evidence of a full-on momentum unwind just yet."
For the rotation to be real and sustainable, certain macroeconomic conditions need to be met, UBS pointed out.
Nonfarm payrolls (NFPs) need to sustain modest growth, economic growth should align similarly, and CPI cooling must continue, although a slight uptick is expected in the fall.
Rate cuts repriced post-June CPI should remain, as the early-year exuberance in RTY faded when the anticipated Fed pivot was quickly dismissed following data suggesting 'higher for longer' rates. Moreover, a peak in AI-centric earnings and clear evidence of investors reallocating capital to small caps, similar to the post-COVID era, are needed.
Despite the sharp rally in lower quality market segments due to risk-on sentiment, small caps still exhibit several fundamental weaknesses.
Over one-third of RTY companies remain unprofitable, and earnings forecast momentum for RTY has slowed compared to the S&P 500 (SPX), UBS notes.
Equity risk premia for RTY are near all-time lows, and RTY companies are more leveraged with a declining ability to service debt. Also, a significant portion of RTY corporate debt is floating rate, which could benefit from lower interest rates in the latter half of the year.
"Despite these undesirable characteristics, we think there is room for the rotation into low quality to persist if rate cuts remain priced and the Trump 2.0 trade carries on ahead of US elections. We would just want to see the boxes noted above checked off first, so to speak,” UBS concluded.
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