Investors pour real money into CNI Mid-Small Cap. Is the US stock market switching styles with a high profile?

The latest economic data has strongly reinforced the bet that the Federal Reserve will cut interest rates in September, with the benchmark stock index in the United States—the S&P 500 Index—recording another weekly gain, while prices of U.S. government bonds across all maturities have recovered all their losses for the year.

About 80% of the components of the S&P 500 Index rose on Friday, with the index rebounding above the key level of 5,600 points after a decline in the previous trading day. The most significant trading momentum this week undoubtedly lies in the performance of U.S. mid-cap stocks, which outperformed large-cap stocks represented by the S&P 500 Index on Friday after doing so on Thursday. Among them, the small-cap benchmark—the Russell 2000 Index—achieved its best weekly gain since 2024, especially as mid-cap stocks outperformed the seven tech giants that have led the entire U.S. stock market since 2023.

In the final 30 minutes of trading on Wall Street, the stock market gave back some of its gains. As the U.S. earnings season begins, bank stocks were generally impacted, with reports from Wells Fargo (WFC.US), JP Morgan (JPM.US), and Citigroup (C.US) failing to drive growth in the financial industry.

U.S. traders seemed to ignore the weak consumer confidence data, instead focusing on the prospect of rate cuts that could ultimately benefit small and medium-sized U.S. enterprises. Inflation data released on Thursday showed that the consumer price index (CPI) growth rate in June fell to its lowest level in three years, which, combined with Powell's slightly dovish remarks and last week's soft non-farm payroll data, propelled a significant rebound in U.S. stock and bond prices this week.

It is understood that this week, Powell told lawmakers that Federal Reserve officials are becoming increasingly vigilant about potential risks in the labor market, while waiting for more evidence of slowing inflation. Powell emphasized to Congress that the Fed has made significant progress in combating inflation and may not need to wait for the inflation rate to drop to 2% before starting to cut rates. Powell has been avoiding sending any strong signals on interest rates, but he stressed that policymakers face the risk of acting too quickly or too slowly.

Market Fully Digests Expectations of Fed Rate Cut in September

Interest rate swap trading shows that following the latest CPI and consumer confidence index releases, interest rate traders have almost fully digested the expectation of a 25 basis point rate cut by the Fed in September, and have nearly fully digested the expectation of a rate cut in December, with the probability of a rate cut in November also steadily increasing. On Friday, economists from Barclays Bank adjusted their forecasts for Fed policy, expecting a second rate cut in December following the announcement of a rate cut in September Mark Haefele from UBS Global Wealth Management stated: "We still expect the Fed to join the global rate cut cycle in September, with a total of 50 basis points cut this year."

The S&P 500 index ended around 5,615 points on Friday, with 10 out of the past 12 weeks closing with weekly gains. Nvidia (NVDA.US) led the tech stocks in a significant sell-off on Thursday, but did not recover the market value loss from Thursday. Tesla (TSLA.US) rebounded after falling over 8% on Thursday, Microsoft (MSFT.US) slightly declined, while Apple (AAPL.US) rose over 1% and continued to be the world's highest market cap listed company.

Wall Street banks faced market sell-offs after announcing their earnings, mainly due to their generally flawed performance, failing to fully meet the high expectations set by the market. Although JPMorgan reported record profits, it did not meet market expectations on key indicators such as net interest income. Citigroup stated that costs for this year may be at the high end of the range provided earlier. Bank of New York Mellon surged due to better-than-expected net interest income.

The prices of various ten-year US Treasury bonds have surged this week, helping the Bloomberg US Treasury Index to erase all price declines from 2024, pushing the index's return to 0.3%, and even completely erasing the once high 3.4% decline in April this year.

Jose Torres from Interactive Brokers stated: "However, a very critical risk is the stock market wealth effect brought about by the early relaxation of financial environment pricing - this development has already prompted our real-time tracking indicators to show that overall and core inflation rates in July may be 0.3% month-on-month." "My basic assumption is that if these developments continue, it may prevent the Fed from cutting rates for the first time in September."

Is the US Stock Market Style Switching to High Profile?

Small and mid-cap stocks outperformed the Magnificent 7 tech giants that have led the entire US stock market since 2023 on Thursday and Friday, signaling to some investors favoring small and mid-cap stocks that a market style switch may have begun.

Krishna Guha from Evercore stated that the latest PPI data used to calculate the core PCE index confirms that inflation measured by the core PCE, favored by the Fed, will show a very mild month-on-month inflation rate in June, indicating that Fed officials may firmly embark on the path of rate cuts in September He also said, "The new phase of Fed rate cuts may maintain the rotational rise of the U.S. stock market."

He pointed out: "We are now entering a new phase, with preemptive rate cuts (compared to passive rate cuts due to a sharp rise in the unemployment rate leading to a recession), which can reduce the risk to future growth prospects." "As long as the Fed's actions are not too slow to contain potential economic weakness, the reduction in the risk to future economic growth prospects is beneficial to market breadth and cyclical industries."

Dan Wantrobski from Janney Montgomery Scott stated that one of the biggest issues in the market trend on the previous trading day is whether this is a reversal of the trend over the past year and a half or just a test.

He said, "We will initially say that, from a technical perspective, we cannot confirm that yesterday's action is the beginning of a sustainable long-term trend." "However, from the perspective of trading trends, we do believe that we may continue to see further rotation of trading themes to mid-small caps in the short term, as technical charts still show the possibility of mean reversion."

The seven major tech giants in the S&P 500 index, known as the "Magnificent 7", include: Apple, Microsoft, Google, Tesla, NVIDIA, Amazon, and Meta Platforms. Global investors have been flocking to the Magnificent 7 throughout 2023 and the first half of 2024, betting on the frenzy of generating AI investments by global corporations. Due to the massive market size and financial strength of tech giants like Apple and Google, they are in the best position to leverage AI technology to expand revenue.

Looking at the entire U.S. stock market, the core logic behind the comprehensive outperformance of the seven major tech giants over value large-cap stocks and broad mid-small cap stocks since 2023 lies in the global AI frenzy background, the uncertain Fed rate cut expectations, occasional major retreats in rate cut expectations, the not-too-strong but not too weak trend of U.S. economic growth, and the absence of a recession. In this trading scenario, with the unmatched scale of AI revenue generation, rock-solid fundamentals, incredibly strong free cash flow reserves, and continuously expanding stock buyback programs, the seven major tech giants have become a "safe haven" for global funds facing uncertain rate cut expectations and slowing economic growth.

If the Fed rate cuts are imminent and the U.S. economy remains resilient without falling into an economic recession, the uptrend in U.S. stocks is very likely to rotate to mid-small cap stocks that have suffered long-term price declines since 2022. These stock targets are extremely sensitive to interest rate expectations, and even a slight rate cut is expected to boost their battered stock prices. **With the extremely strong expectation of the Fed about to start cutting interest rates, the performance of mid-small cap stocks may far exceed the seven major tech giants in the US. The main logic lies in the fact that mid-small cap stocks are often very sensitive to the benchmark interest rates set by the Fed. They heavily rely on floating rate loans, so under the background of rate cuts, it means that the long-standing debt pressure on them will be significantly reduced, thereby potentially increasing profit margins.

Therefore, with the interest rate futures market almost 100% pricing in rate cuts by the Fed in September and December, the classic rotation rally of mid-small cap stocks or the trend of profit recovery of mid-small cap stocks may completely emerge. This will then drive funds to shift towards some mid-small cap stocks that benefit from the rate cut cycle and have very cheap stock prices, rather than the tech giants whose valuations are historically high. Investors will become "comparative shoppers" in a general sense, commonly known as "comparing three products."

Matt Maley from Miller Tabak pointed out that it is important to remember that a "rotation" in the market does not equate to an "expansion in gains." He stated: "We believe that the 'rotation' trend will be completely opposite to the situation when investors heavily entered tech stocks over the past 20 months: it may drag down the entire market—just like how the tech giants with high weightings have been dragging the market higher since the fall of 2022."

Quincy Krosby from LPL Financial mentioned that the Russell 2000 index is considered a key barometer of potential interest rate easing, as well as an indicator of economic conditions.

After analyzing data since 1950, Jefferies, a major Wall Street firm, found that after the Fed's first rate cut, the performance of mid-small cap stocks outperformed large cap stocks. Especially after the first rate cut by the Fed, small cap stocks saw increases of 11%, 15%, and 28% at 3, 6, and 12 months respectively, higher than the 5%, 10%, and 15% increases of large cap stocks.

Mark Hackett from Nationwide stated: "The bulls withstood the impact of a series of economic data this week." "The market momentum remains strong. Several key obstacles have been cleared, and earnings reports, especially those of the tech giants, may become the next core factor determining the market."