US small and mid-sized stocks will rally if President Donald Trump pursues protectionist trade policies, says Hermes Investment Management – but only in the short term.
US stocks have rallied since the election of Trump, in the expectation his policies would mean increased infrastructure spending, deregulation and reduction in corporate tax in the US. The S&P 500 has repeatedly broke through past all-time highs, and Russell Midcap index, which measures performance of small-cap US stocks, has gone up 11.5% since the election result in November.
“Protectionism will be a short term positive for US small and mid-cap with the imposition of import tariffs making domestic producers more competitive,” said Mark Sherlock, lead portfolio manager of Hermes US Small & Mid Cap Equity fund, which holds a Neutral Morningstar Analyst Rating.
Speaking at a roundtable event in London, Sherlock underlined the benefits of Trump’s proposed deregulation measures and corporate tax cut to small and mid-cap businesses.
“There was a big spike in small business sentiment towards the end of 2016 compared to the past five years when companies have felt overburdened by regulation. What really got small businesses feeling optimistic was the prospect of Trump reducing regulation, making businesses cheaper, simpler and faster to run, especially in financial and energy sectors,” Sherlock said.
Small and mid-cap businesses, which have high level of domestic exposure, will also benefit from any reduction of corporate tax cut more than their large counterparts, Sherlock argued.
“If you think about big firms like Apple (AAPL) and Google (GOOGL) – they have been benefited from lower tax rates in other countries like Ireland as part of their business has located there. However this is not happening in majority of small and mid-cap businesses as they have higher domestic exposure. So a tax rate reduction in the US benefits small and mid-cap companies,” he said.
A Strong Economy Before Trump
The Russell mid-cap index companies have around 80% of exposure to the domestic economy while S&P 500 has around 55%. This suggests that small and mid-cap businesses are more highly correlated to the US economy growth.
Before Trump became the President, the US economy had already recovered from the global recession, and looked in good shape with a pick-up in wage growth, a low unemployment rate and rising consumer confidence.
“There was a good backdrop before Trump came to power,” said Sherlock. “As the economy improves, interest rates will rise, and that will be beneficial to US small and mid-cap as they are the backbone of the US economy. So I believe as interest rates start rising, small cap will outperform large cap for the first few years.”
Data provided by Hermes showed from 1963 through 2012, when interest rates rose, small-company stocks gain 13% on average while large-company stocks gained 8.1%. When interest rates fell, small-company stocks gained 19% versus large-company stock gains of 15%.
Last week shortly after data showed US inflation rose by the most in four years, Federal Reserve Chair Janet Yellen repeated that policy makers are prepared to raise interest rates in the near term.
This week one Fed governor suggested that a rate increase was on the table in March, a sentiment echoed by another Fed governor earlier in the week.
Robert Johnson, Morningstar’s director of economic analysis warned: “Before the Fed's March meeting is adjourned, a new round of inflation and employment data will be available. Year-over-year inflation is likely to accelerate with the next release, while the month-to-month number for February will look much less worrisome than the January data. However, if we are wrong and inflation accelerates in February, the Fed's hand may be forced.”
Protectionism is a Threat Long Term
While Hermes is bullish on small and mid caps under Trump rule short ter, Sherlock admitted that the benefits of protectionism will not last. He said Trump’s measures will likely erode the competitiveness of small and mid-sized businesses over the long term.
“My views are that are a few good years ahead, but then the rally will be killed off, and we might be faced with another recession,” said Sherlock.
