Guotai Junan Securities: Can the uptrend of US mid-small cap stocks continue?

According to the Zhitong Finance and Economics APP, Guotai Junan Securities released a research report stating that since May 2024, the Russell 2000 Index has shown strong consistency with the Fed's interest rate cut expectations. Therefore, as the trend of the Fed's policy interest rates changes, the correlation between US small-cap stocks and interest rate cut expectations will gradually strengthen. The enhancement of Fed interest rate cut expectations and the further clarity of the US election results are important factors driving the upward trend of US small-cap stocks. In addition, Trump's support rate has significantly increased due to TV debates and shooting incidents, making small-cap stocks a direct beneficiary of the "Trump trade". It is worth mentioning that the shift in extreme positions may also be an important factor driving the rise in small-cap stock prices.

Recently, US small-cap stocks have shown strong performance, with the Russell 2000 Index rising rapidly. Since July 9, 2024, the cumulative increase has exceeded 10.5% at one point. At the same time, the relative volatility of the weekly returns of the Russell 2000 and the Nasdaq Index has rapidly expanded. Although Tesla (TSLA.US) and Alphabet (GOOG.US) had bright spots in the second quarter financial reports, concerns in the market arose due to the lack of profitability in the artificial intelligence business. Driven by risk aversion, funds have started to flow into small-cap stocks.

The momentum of the continuous rise in the US stock market since 2023 mainly comes from the significant increase in the stock prices of seven large technology companies. However, most US companies have not shown significant gains, and entering 2024, they have even continued to contribute to reverse drag, with the performance of small-cap stocks also not being ideal.

Since May 2024, the Russell 2000 Index has shown strong consistency with the Fed's interest rate cut expectations. The high-interest rate policy of the Fed does not have a significant impact on tech giants. In terms of company growth cycles, they have already passed the stage of relying on financing for business expansion and have excellent "self-sufficiency" capabilities, which is the best proof of their industry status. In contrast, small and medium-sized enterprises in the US are more significantly affected by high-interest rates. Long-term high-interest rates mean high operating costs for companies, and they do not have the ability to fully pass on costs to consumers. Therefore, as the trend of the Fed's policy interest rates changes, the correlation between US small-cap stocks and interest rate cut expectations will gradually strengthen.

The expectation of a Fed rate cut and further clarity on the results of the US presidential election are important factors driving the upward trend of US small and mid-cap stocks. After the release of the US CPI data for June, the market fully traded on the expectation that the Fed would cut rates in September, easing pressure on small and mid-cap stocks as interest rates decline. To some extent, the June inflation data in the US has significant milestone significance, with the year-on-year growth rate of the June CPI recording 3%, lower than the market's expected value of 3.1%. More importantly, the June CPI month-on-month was -0.1%, the first negative turn since 2020. Subsequently, Fed Chairman Powell also stated that there is no need to wait for the inflation rate to drop to 2% before starting to cut rates. As the path of rate cuts becomes clearer, the pressure on US small and mid-cap stocks begins to ease, with the Russell 2000 index surging significantly in the short term.

In addition, Trump's support has significantly increased due to TV debates and shooting incidents, making small and mid-cap stocks a direct beneficiary of the "Trump trade". Increasing tariffs is one of Trump's core policies, with large companies being direct victims of high tariffs. In contrast, small and mid-sized companies typically have more business within the US, with a smaller direct impact from high tariffs. At the same time, Trump plans to relax regulations on businesses, with the financial industry being a direct beneficiary sector, and financial companies accounting for a relatively high proportion in small and mid-cap stocks. A relaxed regulatory environment will drive mergers and acquisitions, which is undoubtedly a positive for small and mid-cap stocks.

It is worth noting that the shift in extreme positions may also be an important factor driving the upward movement of small and mid-cap stock prices. Data from the Commodity Futures Trading Commission (CFTC) shows that before the release of the June CPI data, asset management companies' net positions in the Russell 2000 were relatively stable for the year, while hedge funds continued to increase their short positions. Starting in July, asset management companies and hedge funds quickly adjusted their position strategies, both significantly increasing their long positions in the Russell 2000. On July 16, the long positions of asset management companies and hedge funds were 59% and 41% respectively, a significant increase from July 2 (55% and 28%).

Looking ahead, the US economy's better-than-expected growth and the imminent Fed rate cut are expected to continue to alleviate pressure on US small and mid-cap stocks. Driven by consumer spending and growth in equipment and inventory by businesses, the US real GDP for the second quarter recorded an annualized quarter-on-quarter growth rate of 2.8%, higher than the first quarter's 1.4% and well above the market's expected value of 2.1%. This means that even if inflation spikes leading to rapid rate hikes by the Fed in two years, the US economy's foundation remains solid. Meanwhile, despite the better-than-expected economic growth, the market's expectation of the Fed's first rate cut in September remains unaffected. In this scenario, the pressure on both the numerator and denominator ends of US small and mid-cap stocks is expected to continue to recover