The euphoria surrounding the “Trump trades” appears to have waned just weeks after completion of the U.S. presidential election. Initially, these trades dominated the investment landscape, driving U.S. stock markets to record highs, pushing Treasury yields upward, and strengthening the dollar amid expectations of tax cuts, increased government spending and tariffs. Among these dynamics, two emerging themes have stood out: a bearish outlook for crude oil markets and the rotation from large-cap to small-cap equities.
Trump’s pro-fossil fuel stance has undeniably bolstered investor confidence in the crude oil market. His emphasis on domestic energy production, coupled with expectations of deregulation and tax incentives for oil producers, suggests a supportive policy environment for the industry. However, this optimism is tempered by structural challenges in the market, notably oversupply and weak demand. While OPEC+ is anticipated to delay its planned output increases, U.S. crude oil production hit a record high in October, adding to the supply glut. Even the prospect of reinstating stringent sanctions on Iranian oil is unlikely to offset the oversupply. Additionally, geopolitical risks that typically support oil prices have eased, with the recent ceasefire between Israel and Hezbollah diminishing tensions in the Middle East.
Compounding these challenges, President-elect Trump announced last Monday new tariffs targeting the top three sources of U.S. imports: an additional 10% tariff on goods from China and 25% on products from Mexico and Canada. Although these tariffs are politically tied to issues like curbing illegal immigration and drug trafficking, their economic impact is undeniable. Even if the tariffs are not implemented, the mere threat of trade restrictions is likely to stifle global trade, eroding confidence in global economic activity. Against the backdrop of waning demand from China, these developments cast further doubt on the outlook for crude oil. As a USD-denominated commodity, crude oil prices also face downward pressure from the strengthening dollar.
Since the start of 2024, we have explored the potential for a rotation from large-cap to small-cap equities. This shift comes after years of consistent large-cap outperformance, amplified recently by the AI-driven rally. With Trump’s emphasis on “America First” policies, small-cap companies are now better positioned to benefit compared to their larger-cap counterparts. Key drivers of this shift include tax reforms, particularly corporate tax cuts, which are expected to provide significant relief to small-cap firms; many of which face higher effective tax rates than large multinationals. Additionally, infrastructure spending, a cornerstone of Trump’s agenda, is set to boost the growth of industrial and materials sectors that are heavily represented within the Russell 2000.
Deregulatory measures, especially in sectors like financials and energy, could further ease compliance burdens and unlock growth opportunities for smaller businesses. Unlike large multinationals that derive substantial revenue from global markets, small-cap firms are more insulated from disruptions in global trade, such as those caused by tariffs or geopolitical tensions.
While a stronger dollar and higher interest rates are traditionally headwinds for small-cap companies, the anticipated fiscal stimulus and deregulation under Trump’s administration could outweigh these challenges. Moreover, Trump’s preference for a low-interest-rate environment may prompt the Federal Reserve to ease rates more aggressively, providing additional support for the small-cap segment. Taken together, these pro-growth, domestically focused policies, alongside the relative underperformance of small caps over the past five years, make a compelling case for a dramatic capital rotation from large caps to small caps in the months ahead. A spread trade, such as long Russell 2000 and short Nasdaq, allows the capitalization on the expected relative outperformance of small caps over large caps while mitigating broader market risks. By offsetting exposure to large-cap declines with small-cap gains, this strategy provides a balanced way to seize opportunities arising from the capital rotation while reducing vulnerability to factors that could affect equities as a whole.
