Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S. (Photographer: Michael Nagle/Bloomberg)

There's More to the Small-Cap Rally Than Trade

(Bloomberg Opinion) -- Small-capitalization stocks are on fire, with the S&P SmallCap 600 Index surging 11.3 percent in 2018 to just about match its 11.7 percent gain for all of 2017. By comparison, the S&P 500 is up just 4.24 percent. The thinking is that smaller, domestically focused companies are less exposed to the fallout from a potential trade war and a rising dollar than their larger, international peers. That makes sense, but it appears there's a more fundamental reason behind this trade. 

The monthly Small Business Optimism Index released on Tuesday showed that for the first time the history of the series, which dates back to 1973, more independent business owners are reporting higher quarterly earnings than those reporting a decline. Whether you agree with President Donald Trump's politics or not, it's hard to say that his efforts to cut back unwieldy rules and regulations while reducing corporate tax rates isn't benefiting businesses. "For years, owners have continuously signaled that when taxes and regulations ease, earnings and employee compensation increase,” Juanita Duggan, president and chief executive officer of the National Federation of Independent Business, which compiles the report, said in a statement. The results of the poll also showed that positive sales trends are the highest since 1995, while expansion plans and compensation increases are the most robust in the survey's history.

There's More to the Small-Cap Rally Than Trade

Earnings in the first quarter for companies in the S&P SmallCap index, whose biggest member is hospice care provider Chemed Corp., rose about 19 percent from a year earlier, the best performance since the end of 2014. The consensus among analysts was that earnings would increase only 6.2 percent, according to Bloomberg Intelligence. To be sure, surveys such as the one produced by the NFIB are considered "soft data" and not based on actual results. Bianco Research President Jim Bianco has noted that NFIB members skew heavily Republican, suggesting they are a bit biased

WHEN AVERAGE IS OUTSTANDING 
With the Federal Reserve widely expected to raise interest again on Wednesday, this week's auctions of bonds by the U.S. Treasury Department could have easily gone off the rails. After all, the government was looking to jam through $69 billion of bond sales in three separate auctions on Monday and Tuesday to get ahead of the Fed's decision instead of spreading them out over three days. On top of that, the sales raised a net $44 billion in new cash for the government, the most since February 2013 and coming at a time when there's already a lot of hand-wringing about sky-high government borrowing. And if that wasn't enough, the Labor Department confirmed Tuesday that inflation as measured by the consumer price index is accelerating at the fastest pace in more than six years. But rather than pull back, traders stepped up and the government was able to find a home for all those new bonds without any signs of trouble. Yes, none of the auctions were outstanding, but that doesn’t matter. In the face off all the headwinds, the fact that the auctions were all in line with recent averages can be seen as a big vote of confidence in the market for fixed-income assets. Traders submitted bids for 2.38 times the $14 billion of 30-year bonds offered Tuesday, the same as the average of 2.38 for that maturity over the last 12 months.

There's More to the Small-Cap Rally Than Trade

CROWDED DOLLAR TRADES
One of the biggest surprises in global markets this year has been the dollar's strength. The Bloomberg Dollar Spot Index has risen this year, including on Tuesday, even though as recently as late April hedge funds and other large speculators had more bets on the greenback's decline than any time since early 2013. Well, traders have been steadily reversing those wagers to the point that being bullish on the dollar is now the third-most-crowded trade in markets, behind being long a basket of technology-related shares and short U.S. Treasuries, according to Bank of America Merrill Lynch's monthly survey of released Tuesday. The survey collected responses from 184 investors with combined assets of $541 billion. Since hitting its low for the year in February, the Bloomberg Dollar Spot Index has rallied more than 5 percent on speculation that U.S. economic growth would persist even with some weaker data and amid political turmoil in Europe and emerging markets, according to Bloomberg News's Lananh Nguyen. A hawkish tone out of the Fed on Wednesday could help to ratify the bullish dollar trade. Anything less could hurt the dollar and reinforce the notion that foreign-exchange traders have no idea how to value currencies. The Citi Parker Global Currency Index, which tracks nine distinct foreign-exchange investment styles, has fallen in each of the past five quarters and in each of the past three years.

There's More to the Small-Cap Rally Than Trade

WHAT TRADE WAR?
Most economists and investors are expressing concern that a growing trade dispute between the U.S., its allies and China could erupt into a full-blown trade war. That’s why a Department of Agriculture report on Tuesday shocked the commodities market. The USDA signaled that the outlook for U.S. exports of pork, dairy products and grain is rosy, sparking a rally in agriculture commodities. Pork exports this year may rise 6.4 percent, more than forecast in May, the USDA said in a monthly report, citing “continued strong shipments to a number of key markets and expectations of continued pork exports to Mexico” in 2018, according to Bloomberg News's Megan Durisin. Last week, Mexico imposed tariffs on some U.S. meat cuts and cheese in a response to American import taxes on steel and aluminum. “Continued strength” in U.S. shipments of fatty dairy products this year may counter the Mexican move, the USDA said. After Mexico announced tariffs, the National Pork Producers Council said the U.S. industry was “taking on water fast” amid trade disputes, and the U.S. Dairy Export Council said the levies might “deliver a blow” to exports. The USDA’s outlook was also positive for grain, boosting the forecast for sorghum exports on demand in China, which recently scrapped an import tariff. Wheat shipments may climb as crops shrink in rival nations, and burgeoning corn demand abroad will probably cut domestic inventory, according to the report.

There's More to the Small-Cap Rally Than Trade

INDIA'S A HAVEN
There's one high-profile standout among the carnage that is emerging-market stocks this year: India. The nation's benchmark S&P BSE Sensex Index has gained 9.50 percent from its low this year in late March, compared with a decline of 2.91 percent for the MSCI Emerging Markets Index. Money managers including Franklin Templeton and Newton Investment Management say they like the nation because it has the fastest-growing major economy in the world and enjoys relative insulation from external shocks as a booming middle class delivers enough domestic demand to counter the fallout from protectionism, according to Bloomberg News’s Selcuk Gokoluk. India is “one of those places that provides better risk-reward compared with emerging markets at large, especially China or more globally linked countries,” Gaurav Sinha, an asset-allocation strategist at WisdomTree Investments Inc., told Bloomberg News. “If I am investing in India, I am investing for the local consumption.” The firm, which manages exchange-traded funds, recommends investors allocate as much as 20 percent of their portfolios to Indian equities. India’s middle class has ballooned past 600 million, according to a study by Mumbai University. The nation will become the third-largest consumer economy, with household spending tripling to $4 trillion by 2025, according to a report by Boston Consulting Group last year.

There's More to the Small-Cap Rally Than Trade

TEA LEAVES
The Fed's interest-rate decision on Wednesday just got a lot more interesting. Although the consensus is that policy makers will boost rates for the seventh time since December 2015, markets will be focused on what they say about the outlook for inflation. What's interesting is that although the government said Tuesday that the consumer price index rose 2.2 percent in May from a year earlier, wage gains failed to keep pace. If the Fed expresses concern about a tepid pace of wage increases, it could temper expectations for how many more times investors expect the central bank to raise interest rates in the second half of the year. The pay figures are a reminder to the Fed "that you don’t need to necessarily get more aggressive in your approach because wages haven’t accelerated as much as they have in the past,” Kevin Cummins, an economist at NatWest Markets, told Bloomberg News.

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