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RBC Capital Markets sees slowing economic growth as a roadblock for a sustainable rotation out of high-flying growth and large-cap stocks into other areas of the stock market.
The Russell 200 (RTY)(IWM) rally late last week while the S&P 500 (SP500)(SPY) slumped following the June CPI inflation report spurred speculation that investors were ready to shift away from mega-tech stocks to seek out small-caps, value stocks and other lagging pockets of the market. While valuations and positioning for a while have set up a rotation to new leadership, fundamentals need to cooperate for the market to overcome false starts, Lori Calvasina, head of U.S. equity strategy at RBC, said in a note Monday.
Among its observations, large (XLF) and small-cap financial stocks tend to trade closely, in terms of relative performance versus the broader market, with consumer sentiment. Last week, the widely watched University of Michigan’s Consumer Sentiment Index fell to an eight-month low in July in a preliminary reading.
“Financials is a key component of the Value trade, and these challenges give us some pause in getting fully on board with the idea that the market is ready to embark on a sustainable leadership transition from Growth to Value within the Large Cap segment,” Calvasina said.
The strategy team also said small caps and value stocks in recent years seem to catch a tailwind when GDP growth is trending above average. “With GDP expected to dip into below-average territory in coming quarters, and concerns about the consumer increasing, we’ve been a little wary of the idea that now is the precise time to look for the rotation trade to finally get underway in a sustainable way,” Calvasina said.
But RBC said it grew “more comfortable nibbling on Small Caps” after the cooler-than-expected June CPI inflation, which bolstered confidence that the Federal Reserve will start rate cuts soon.
While small caps were starting to make a case for themselves over large caps from an earnings perspective, that case isn’t as clear in Value relative to Growth, RBC said.