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Unfortunately, politics matters

Unfortunately, politics matters

While some may dismiss politics as a bunch of rhetoric with few accomplishments, it can have a real impact on our financial markets.

If we look at the trading pattern of the small-cap market since the election, it appears volatile. The equity markets were initially hopeful that the U.S. presidential agenda would be able to lift the U.S. economy out of the subpar growth pattern of 2% that we’ve witnessed over the last several years. From the election to Inauguration Day (see Chart 1), the small-cap market was euphoric with the prospect of tax cuts, deregulation, repatriation of foreign earnings, healthcare reform and the view that growth would finally accelerate to 3% or more.

Chart 1: Equity returns from Election Day through Inauguration Day

Source: Bloomberg, August 21, 2017. For illustrative purposes only . PAST PERFORMANCE IS NOT AN INDICATOR OF FUTURE RESULTS. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

This was reflected in the small-cap sector outperforming the large-cap sector by 6.80%. And why not? After all, the Republican Party controlled all three branches of government. However, it seemed unlikely that this agenda would sail through Congress as easily as the market had expected; rather, it was more likely that it would be more of an uneven path toward reform than was priced into markets at the time.

It now appears that the pendulum has swung from this euphoric state of optimism to complete pessimism with regard to the presidential agenda. This was highlighted by the failure of the “repeal and replace of Obamacare” legislation in late July (see Chart 2) and then followed by the disaster of the president’s press conference on August 15 regarding the Charlottesville riot over the removal of a Confederate statue. Sentiment appears to be at a low point.

Chart 2: Equity returns since Inauguration Day

Source: Bloomberg, August 21, 2017. illustrative purposes only. PAST PERFORMANCE IS NOT AN INDICATOR OF FUTURE RESULTS.

We now believe you can make a good argument to be a “contrarian” and become a bit more optimistic about the presidential agenda.

We now believe you can make a good argument to be a “contrarian” and become a bit more optimistic about the presidential agenda. The sentiment has swung so far toward the negative side that any potential to “get something done” would be a significant surprise for smaller companies.

In addition, the Trump administration made the huge mistake of attempting to tackle healthcare first, which seems to be the most difficult agenda item. Other initiatives such as tax reform or infrastructure spending should garner more support and, more importantly, the Senate and the House appear to be more aligned with these two legislative items, unlike healthcare.

We can also gain some insight when looking at the sectors within the small-cap space and further observe some of these dramatic swings in performance in this pre- and post-election period. For example, energy has had a swing in performance of more than 60% (see Table 1). At the same time, other sectors that witnessed dramatic moves in performance, such as industrials, materials and financial services, were equally reliant on this improved macroeconomic backdrop. These sectors also appear to indicate that pessimism has shifted dramatically to the downside.

Table 1: Equity returns

PAST PERFORMANCE IS NOT AN INDICATOR OF FUTURE RESULTS.

Despite the poor performance of the small-cap sector over the last several months, small businesses still appear to be quite optimistic about the outlook going forward, despite the minor decline we saw recently. Chart 3 shows the outlook that small companies have about their prospects going forward.

Chart 3: NFIB Small Business Optimism Index

Source: Bloomberg, July 31, 2017. For illustrative purposes only.

Given this view that we could now see some movement on the easier legislative items, the small-cap sector appears poised to represent good value given where valuations are today (see Chart 4).

Chart 4: Small-cap vs. large-cap forward price-to-earnings (P/E) ratio

Source: FactSet, Aberdeen Asset Management, July 31, 2017. Note: Excludes negative earnings. For illustrative purposes only.

The small-cap market has historically traded anywhere from a 10% discount to the S&P 500 Index to a 20% premium based on the one-year forward price-to-earnings (P/E) multiple. As of this writing, the small-cap market is trading at a 5% discount to the long-term premium between these two markets. All of this suggests that it may be time for another look at small caps.

Important Information

Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.

Indexes are unmanaged and are included for illustrative purposes only. You cannot invest directly in an index.

ID: US-300817-43358-1





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