Fade small caps, turn to midcaps and industrials: Strategist

As the market (^DJI,^GSPC, ^IXIC) reacts to the Federal Reserve’s first rate cut in four years, John Hancock investment management co-chief investment strategist Emily Roland joins Brad Smith and Seana Smith on Morning Brief to take a closer look at navigating the market amid changing sentiment.

“It's six straight days of gains leading markets higher [and] riskier assets are really celebrating this idea that the Fed can stave off a hard landing, prevent a contraction from happening, do it proactively before we see more weakness here in the labor market,” Roland tells Yahoo Finance.

The strategist says there are three key signs that a soft landing can be achieved. “The first one is that you need to see no real further cracks in the labor market.” Secondly, Roland is watching credit market conditions. “The final thing is the fed actually has to deliver on what the bond market is pricing in.” Roland indicates the bond market has priced in another 50 basis points cut this year, and another 100 points cut in 2025, which is consistent with the Fed’s dot plot.

“You're seeing the riskiest parts of the market, the most cyclical areas, small caps really being a poster child for that really taking off amidst this dovish turn from the Fed, but at the end of the day, there's not a lot of fundamental support for it.”

Roland believes a lot of the upside is already priced into small caps. “When you look at the outperformance of small caps, they're up 8% [to] 9% quarter to date. While the S&P 500 is up about 3%. You're seeing some profit taking in large-cap names and a rotation into small caps. We really see that as a sentiment-driven rally.”

“Of [small caps’] 8% return this quarter, it's been entirely driven by multiple expansion, not earnings growth. In fact, in the second quarter, the S&P 500 saw double-digit positive earnings growth. Small cap equities saw 15% negative year-over-year earnings growth for the second quarter,” Roland says, adding that analysts expect this “muted earnings growth” to persist in the third quarter.

Believing the upside is already priced into small caps, Roland says “we continue to overweight the quality factor. So these are companies with great balance sheets, tons of cash, good free cash flow, the ability to maintain margins in an environment where margins pressure is happening and playing out right now. So the poster child for high quality is going to be megacap tech.”

For more expert insight and the latest market action, click here to watch this full episode of Morning Brief.

This post was written by Naomi Buchanan.

Video Transcript

It's great to see you here.

So we certainly see this risk on sentiment back in the market ever since the Fed cut by 50 basis points or even really before that, I Is there enough to believe that some of this momentum that we've seen in the latter half of the week is enough to continue?

Yeah.

I mean, right now it looks like the soft landing scenario is very much still in the cards.

And you're seeing that reflected in a lot of optimism across markets we're watching in particular small cap equities seeing I think it's six straight days of gains.

Uh, leading markets higher.

Riskier assets are really celebrating this idea that the Fed can stave off a hard landing, prevent a contraction from having and do it proactively.

Um, before we see more weakness here in the labour market.

And so where were that?

Where would that early kind of evidence of weakness really begin?

To transpire from your perspective and and what you're watching within the, uh, labour data that we've been continuing to track here because unemployment, right, right now, still sitting at about 4.2%.

Yeah.

I mean, there's really three key things that we're watching about to look for signs that a soft landing can be achieved.

The first one is that you need to see no real further cracks in the labour market.

We look at things like initial jobless claims as being one of the most timely reads of the labour market on Thursday mornings and those are still sitting in the very low 200,000.

I think any increase there above say, 300,000 would be a bit of cost for concern.

We're also watching credit market conditions.

So right now for lower quality players, borrowing costs are low.

High yield bonds are now yielding just over 7%.

That's the lowest level since 2022.

If you do start to see more concern among investors that maybe a contraction is gonna take place, you're likely going to see high yield bonds spread widen, which could cause broader issues from the market for a volatility perspective.

And then the final thing is the Fed actually has to deliver on what the bond market is pricing in, so markets are pricing in significant cuts to the tune of another 50 basis points this year, another 100 basis points next year.

Bond market pretty much in line with what the fed dot plot told us.

But if the Fed doesn't cut by that much, in essence, they're tightening, which could create tighter financial conditions and also challenge, uh, markets here.

But so far so good, none of those three things are happening.

Um, but I think you could continue to see some momentum here across risk assets.

And let's talk about some of that momentum because small caps certainly have been an outperformer here so far this quarter.

When you talk about the fact that the Fed has begun its rate cutting cycle, what does that tell us?

Just about further upside that we could potentially see or is much of that already priced in?

I think, John, a lot of it's priced in, and I think you know when you look at the out performance of small caps are up 8 9% quarter today, while the S and P 500 is up about 3%.

So you're seeing some profit taking and large cap names and a rotation into small caps.

We really see that as a sentiment driven rally, so you're seeing the riskiest parts of the market, the most cyclical areas, small caps, really being a poster child for that really taking off amidst this dovish turn from the Fed.

But at the end of the day, there's not a lot of fundamental support for it.

So of that 8% return this quarter, it's been entirely driven by multiple expansion, not earnings growth.

In fact, in the second quarter, the S and P 500 saw double digit positive earnings growth.

Small cap equity saw 15% negative year over year earnings growth for the second quarter.

And likewise, analysts are pencilling in much more muted, uh, earnings growth for small caps going into the third quarter so we would actually be fading.

The rally here and lower quality small caps.

45% of the Russell 2000 index is comprised of companies that don't make money.

Their interest burdens are high.

We would wait to overweight small caps, uh, until an early cycle environment, we're just not there yet.

So if the trade is to to fade small caps at this juncture, is that just, uh, a reversion back into what's worked, which is mega caps, which is the A I thesis and all of the kind of picks and shovels around that trade that have been off into the races.

Yeah.

I mean, we continue to overweight the quality factor.

So these are companies with great balance sheets, tonnes of cash, good free cash flow, the ability to maintain margins in an environment where margins pressure is is happening and playing out right now.

So the poster child for high quality is going to be me.

Mega cap tech.

We've been there, but we have a little bit of a problem here as far as valuations go.

In fact, the tech the tech sector is bumping up on 30 times forward earnings.

It's come down a little bit over the last several weeks, but still expensive.

So we want to do is rotate into quality at a reasonable price.

Um, we're finding that in areas like health care stocks on the value side, which are trading at a 10% discount to the broad market and then another area that we're emphasising are US mid cap stocks.

Just think about the relative sector composition.

There, you're gonna get a big overweight to industrials industrials right now are benefiting from a manufacturing renaissance that's happening in the United States on shoring activity, fiscal spending around things like the Chips Act and the Infrastructure and Jobs Act.

We're spending like crazy in the US, and a lot of it's being funnelled into these projects.

Uh, as you mentioned pick and shovel type projects.

So we're looking to play that more secular trend through a, um through exposure to US, mid caps in the industrial sector in particular.

Emily Roland, John Hancock Investment Management Co chief investment strategist.

Emily Always a pleasure to grab some time with you.

Thanks for joining us ahead of the opening cross.

Thanks.