What will happen next in a market dominated by "rate cut trades" and "Trump trades"?

Recently, the U.S. stock market is being dominated by two forces: the "rate cut trade" driven by rate cut expectations, and the "Trump trade" driven by the probability of Trump's re-election.

Under the influence of these two forces, the style of the U.S. stock market has changed. The momentum of tech stocks led by the "Mag 7" has paused, while small-cap stocks led by the Russell 2000 Index have rebounded strongly.

However, in the past few days, as large-cap tech stocks continue to struggle, small-cap stocks have started to give back some of their gains. Even the commodity market has experienced a broad-based pullback, leading the market to question: can the rally in small-cap stocks continue? How will the election and the Fed's decisions further impact the U.S. stock market?

Analysts believe that against the backdrop of rate cut expectations and gradually improving earnings, small-cap stocks are still favored, and the improvement in market concentration will provide support for the market rally; considering other factors such as the economy and corporate earnings that may also disrupt the market, the "Trump trade" is still uncertain.

Rate Cut Expectations Expected to Continue Boosting Small-Cap Stocks

Generally, smaller companies tend to have higher leverage and are more likely to finance through floating rate debt, making small-cap stocks more sensitive to interest rates compared to large-cap stocks.

With last week's unexpected drop in inflation data, rate cut expectations have intensified. Market data shows that the Russell 2000 Index saw a cumulative increase of 11.5% in the past five trading days, but then retraced slightly, with a 1.68% increase for the week.

However, despite the strong rebound in small-cap stocks, there is still a gap compared to the gains in large-cap stocks. Year-to-date, the S&P 500 has risen by over 15%, while the Russell 2000 has only recorded a 7.8% increase.

Liz Young Thomas, Chief Investment Strategist at SoFi, believes that although strong earnings from tech stocks have helped large-cap stocks outperform small-cap stocks in recent quarters, considering the overvaluation of these tech companies, with the gradual recovery of small-cap earnings in the second half of the year and the continued boost from rate cut expectations, small-cap stocks are still favored.

In addition, as sectors in the U.S. stock market rotate, analysts Ed Clissold and Thanh Nguyen from Ned Davis Research found that market breadth indicators have significantly improved in the past week.

Kevin Dempter, an analyst at Renaissance Macro Research, pointed out that this is a positive signal:

"The outlook for the next 3-6 months is bullish, as breadth should extend the duration of the bull market."

"After a momentum signal, there is usually a short-term pause, but with the easing of overbought conditions, the bullish trend should resume."

Uncertainty Surrounding the "Trump Trade"

With some time remaining until the final election vote, the outlook for the presidential election remains uncertain.

Larry Adam, Chief Investment Officer at Raymond James, stated that according to data from the betting market, the likelihood of Trump winning has reached a "cyclical high" of 70%Under the "Trump Trade", the market generally expects that its loose fiscal policy and loose monetary policy tendencies will bring stronger fundamental support, especially benefiting the energy, financial, and healthcare industries.

The latest development in the election is that reports suggest Biden is facing pressure from senior Democrats to withdraw, leading to a market correction in the past two days.

However, Adam also pointed out that there are still too many variables in the market, making it difficult for investors to clearly bet on the "Trump Trade" — economic, corporate profit growth, and Federal Reserve policy often play a more crucial role in determining industry performance than political factors.

Adam commented:

"What seems to be the obvious driving force in the short term may not have a long-term impact, as other factors often overshadow the political influence on asset prices."

"Given the unpredictability of this election cycle, anything could happen in the next 109 days."

Furthermore, considering that if Trump wins, his combination of domestic tax cuts, foreign tariffs, and immigration restrictions may increase inflation risks, which could conflict with the Federal Reserve's loose monetary policy path, bringing more complex implications to the stock market