Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Good morning. After a somewhat alarming correction, the stock market has now posted two days of solid gains. Intel, which appointed a new CEO, is up 30 per cent in less than a week. Can a new boss make that much of a difference? Email us: robert.armstrong@ft.com and aiden.reiter@ft.com.
Don’t read too much into small caps
Remember the idea that US small-cap stocks would be the great beneficiary of Donald Trump’s economic policies? Unhedged remembers it well, because we fell for it, if only briefly. For a moment, it all seemed so logical: tax cuts and deregulation would boost the domestic economy, and small caps’ sales are much more domestic than big caps, while their earnings are much more economically sensitive. So in small caps’ autumn rally we (and others) saw the coming of a Trump boom.
Well, er, about that. We are still waiting for the tax cuts and deregulation. And the tariffs, or more precisely uncertainty about what tariff policy will be, have turned out to have a dramatic negative effect on domestic sentiment — consumer, business and investor alike. Small caps have been hit correspondingly hard. The S&P 600 is down 16 per cent from its November peak, even after rising nicely in the past two days. And the narrative has duly flipped: the small cap sell-off is now read as an omen of a Trump recession.
Over the weekend my excellent former colleague Joe Rennison wrote a piece in The New York Times entitled “This Stock Market Index Is Flashing a Clear Warning About the Economy”. It makes the central points about small caps’ higher domestic exposure, thinner and more cyclical margins, and so forth. And it quotes the strategist David Kelly of JPMorgan Asset Management summing things up: “If you want one clear signal that the market is worried about recession more than anything else, then look at the Russell,” referring to the broad small cap index.
Having been too credulous about small caps’ power of prophecy once, we won’t do it again. As Jill Carey Hall, strategist at Bank of America, pointed out in a note last week, 15 per cent declines in small cap indices are much more common than recessions. They occur, on average, once every year and a half or so, and sometimes several times in a single year. The last one was in 2023, and there were two in 2022. Her chart (the Y-axis shows the number of 15 per cent declines in a given year):
Furthermore, Hall argues, small cap indices fall twice as much in an average recession as they have this time around. There is a long way to go before we hit recession territory.
And there is another way to read the decline in small caps: as a technical byproduct of a shifting market regime. Jordan Irving, a US small- and mid- cap manager at Glenmede, argues that small caps are “underinvested but heavily traded”, meaning they are not well represented in long-term portfolios. Instead, they are heavily used as a trading “factor” — alongside other factors such as value, growth or quality. Factors are vehicles for betting on the direction of the market trend. “My sense is we see a pullback among the traders, not a capitulation among investors,” Irving says. Compounding the problem, he notes, is smaller companies’ hesitance, in the face of policy uncertainty, to give clear forward guidance with their fourth-quarter results. This leaves investors focused on the present moment, which is pretty dreary.
It is important, at this odd moment, to focus on what we know and not extrapolate too aggressively. What we know is that the chaotic policy approach of the Trump administration is having a terrible effect on sentiment. But we also know that the hard economic data remains pretty good (see next piece). So the right question is not: “Are we heading for recession?” That skips too far ahead. Instead, ask: “What are the prospects that the policy chaos will get better or worse?” More on that in days to come.
Consumer spending: bad vibes, OK data
The February retail sales report came in yesterday, bearing mixed messages. The headline number was up 0.2 per cent from the month before — far below consensus estimates of 0.6 per cent. And there was also a downward revision of January’s report from -0.9 per cent month on month to -1.2 per cent. This might suggest the US economy is slowing:
But the headline is a bit deceptive. More important is the “control group” reading — essentially “core” retail sales, excluding volatile series such as petrol, building materials and car dealers. This is the measure that feeds most directly into the consumption measure of GDP. The control reading was up 1 per cent month on month, completely offsetting the -1 per cent reading from January. It amounted to a “blowout”, according to Rosenberg Research:
So the report looks like confirmation of the “bad economic sentiment but good hard economic data” trend. But there were signs of weakness around the edges. Consumer discretionary spending was down in a few crucial categories — particularly restaurants. And stronger sales in other categories could reflect “people [continuing] to bring forward purchases of durable goods in order to avoid future tariffs-related price rises”, said Samuel Tombs, chief US economist at Pantheon Macroeconomics.
Still, the slowdown is mostly vibes. The spending data that Bank of America draws from its millions of debit and credit card customers confirms this. Household spending was up 0.3 per cent month on month in February, BofA believes, an improvement over January. But again, there was weakness in important discretionary categories, particularly travel. And spending was considerably down in the DC metro area, where Elon Musk’s helter-skelter Doge lay-offs are concentrated.
We don’t know how long bad sentiment can remain consistent with solid spending. But the answer is not “forever”.
(Reiter)
One good read
FT Unhedged podcast
Can’t get enough of Unhedged? Listen to our new podcast, for a 15-minute dive into the latest markets news and financial headlines, twice a week. Catch up on past editions of the newsletter here.
