In this episode of William Blair Thinking Presents, macro analyst Richard de Chazal touches on inflation’s continued downward trajectory, the recent market rotation toward small-cap stocks, and June’s strong retail sales report.

Podcast Transcript

00:21
Chris
Hi, everybody. It's Wednesday, July 24th. We are in the dog days of summer here in the US. I'm joined by William Blair macro analyst Richard de Chazal for another episode of Monthly Macro. Richard, per usual, there's a lot to talk about so I figured to ease ourselves in, we could maybe first touch on this month's headline CPI, which was once again better than expected and then we can go from there. But this is the third consecutive month of good data, which, as you mentioned in a recent report, helps confirm that inflation is firmly back on a downward trajectory. Do you want to point out some of the key data points that help to illustrate this point and why you think it may help put a September rate cut into sights?

00:57
Richard
Hi, Chris. Good to be back in and definitely in the height of summer. I think the CPI was a pretty big one that came out on the 11th of July. I think going into it the market was still a little bit on edge, kind of maybe bracing for some bad news here. So when it actually came in, better than expected, there was definitely this sigh of relief that that was the case. In case you don't remember the headline came in at -0.1%, where were one tenth of a percent positive had been expected. And the core rate, which again excludes food and energy, that rose 0.1%. And again, it was below the 0.2% expected, which might not sound like a lot, but it is actually an important difference, you know, particularly when you're talking about year over year rates of change. And both of those came down to 3% on the headline rate and 3.3% on the core, which, you know, the Fed's target is 2% on the on the PCE index of the personal consumption expenditure index, not the consumer price index. So the equivalent on the CPI is about 2.5%.

So I think, you know we're getting closer to that and that was definitely encouraging. And I think importantly, if you kind of look under the hood of the report, the guts of the thing were actually pretty good as well. I think highlight was really the shelter component. And that's been, and I think we talked about this in the past, one of the stickiest is components in the CPI and it accounts for over 35% of the basket. So it's important. And I think what we saw there was rental prices and owner equivalent rent coming down on a month over month basis to basically the readings that we saw from sort of 2015 to 2019. So those pre-COVID kind of low inflation readings. So that was really encouraging.

You know, we also saw a bit of declines in new and used car prices, airline fares, all that kind of thing. So we've seen some recent reports from the car dealers saying that they're giving out a lot of incentives now to kind of clear their lot. There had been a fear earlier that goods prices, which had kind of been in deflation, would start to move back up into positive territory again. And that really hasn't happened. So that kind of goods, price, continued deflation has been encouraging. So we're kind of back on track. And I think it helped to sort of alleviate these fears that we would be in this sort of 4 to 5% camp for, you know, the longer term and I think for the market and then for the Fed, you know, that was encouraging this was, as you say, the third consecutive lower inflation print.

Why that matters, I think, is because Chair Powell has basically told us for a while now that the fed is not going to wait till inflation gets back to 2% before it starts cutting rates. It's going to start cutting rates as long as it knows that inflation is on a trajectory back to that 2% and what they felt they needed to see to believe that that was the case, was sort of 3 or 4 lower inflationary prints. And that's basically what we got with this one, the third lower inflationary print after having kind of this bump in the road through the first quarter where inflation was higher. So I think, the Fed's perspective and from the market's perspective, that's kind of what they need to see. I think for rate cuts July is probably still a little bit too early. And I think what the market has done is really now pricing in a September rate cut. So, you know, they still will have two more inflation reports under their belt by the time that the September FOMC meeting rolls around. But I think we're pretty much there on that. You know, if you look at the futures market, the odds of a rate cut went from 61% at the start of the month in September to 99% today. So basically fully priced in.

5:24
Chris
So I assume this is one of the reasons why I've seen this rapid rotation towards small cap stocks lately. A trend that I know you and our Director of Research, John Kreger, called out, especially the gap in performance and valuation between larger and smaller cap stocks as historically unusual. Can you talk a bit about where specifically we are seeing the markets recent rotation and then what else might be driving it? And then the arguments for whether this shift has any staying power?

5:47
Richard
Good question. And I think, you know, what we've definitely have seen has been this pretty powerful or the press is reporting it violent, rotation.

05:57
Chris
Violent rotation. Yeah, a little dramatic but sure.

6:00
Richard
A little dramatic, I think, but sure. So this rotation is taking place, under the surface of the equity market. So, if you look at the S&P 500 as a whole over the last couple of weeks, the market has basically been flat to slightly down since that inflation report. So if you look at, something like the tech sector, however, that's been down about 3.5%. But what you have seen has been a rotation in sectors. So, you've seen some of the cyclicals starting to perform better. So industrials, materials and particularly financials. But I think this rotation has been more about size than sector. So what we've really seen has been a size rotation where investors are now moving away from those larger cap mag seven type stocks. And now starting to look at S&P 600 small cap index or Russell 2000 or these sorts of things, which are both really up over 8% over this period, which is actually a pretty big move.

So I think, as you say, John Kreger, our Director of Research, he basically said, you know, if this is something that is going to continue, maybe it would be worth highlighting some of the quality names we cover at William Blair, some of those quality smaller cap names. So the truth is not so much in the S&P 600, where they are kind of filtered out. But in the Russell 2000 you do have a lot of lower quality companies that are not making profits in there. So we definitely focus on the on the quality end of the small cap area. And I think, what we want to know is, is this rotation going to continue?

That's obviously the big question, you know, is this just, a small jump in volatility from a series of undervalued and under owned, companies? Or does it have legs? And I think for investors, the difficulty is that they've seen these kind of head fakes before. Like back in December, I don't know if you remember December when Powell did his sort of pivot about cutting rates, small caps took off again. And then he had kind of sort of backtracked when inflation proved to be a little bit more consistent, and you had that big selloff in small caps once again.

I think, this seems to be the little bit more durable, and I'll give you some reasons why. I think one is that the market itself had become very undiversified with just those mag seven or fabulous five. So very, very tight concentration and valuations had got really, really stretched. And I think what's causing or what prompted this is clearly by far has been the good news on inflation.

So the rotation started on July 11th when that inflation report was released and I think that's important for a couple of reasons. One is because smaller cap stocks tend to be more adversely impacted by higher inflation these days. Generally, they tend to be more price takers than price setters. So they've been kind of, more adversely impacted recently by the higher input cost and then less able to pass that along, or even increase prices at the other end to their end consumers. So their profits have been more squeezed than, say, the larger caps, who have more economies of scale, they have more pricing power, all that kind of thing. So lower inflation, definitely helpful for them, or at least more stable inflation. And the other thing there is, is that obviously with inflation coming down, rates, interest rates are going to come down as well. And remember for smaller caps, these companies are far more sensitive to interest rates because they're more reliant on shorter term, shorter duration debt bank loans, this kind of thing. So your larger cap can go out and sort of tap equity markets. Tap debt markets. They have savings. So they're much less sensitive to changes in interest rates than are the small caps.

So the fact that this lower inflation, you know, brings with it a good chance at rates are going to come down. That's definitely helped. Questions I was getting - But what about what about the Trump trade? You know, Trump was soaring in the polls. We had that disastrous Biden debate on June 27th. Then we had the attempted assassination of Trump, which kind of saw his numbers in the polls increasing. You know, how much has that been a big driver of what we've seen? I think, you know, maybe it's added to it a little bit but I don't think it's been the main driver. I mean, Trump's very sort of pro-growth platform of lower taxes, more fiscal stimulus, a weaker dollar, more deregulation. That does seem to be kind of helpful for growth. But I think there's a lot of ambiguity there as well, in the sense that this could also tilt much more inflationary. And, you know, while it could be good for growth in the near term, over the medium term that might end up getting more inflation and higher interest rates, and maybe that's less positive for the smaller cap.

So put a little bit of hesitancy, you know, assigning too much weight to the Trump trade on that. Though a couple of other things, so at the same time or just shortly after that inflation report, we did get some good news on retail sales. So that put a little bit more weight into the sort of the soft-landing narrative that the economy isn't necessarily tipping into recession. That's good for smaller caps over the near term. But I think what ultimately you need for this to be a really durable rotation is to see these, you know, are there longer-term support structure in place? And I think there is I think there probably four main pillars I’d pin.

I think the first is that valuations are extremely attractive. So relative valuations are about as low as they have been since at least the early 1990s. You know, that's both on a relative basis and on an absolute basis using just about any metric you want. So, these are really stocks that investors have abandoned. So they're very under owned. I think the second thing is structurally, there are a number of positive big macro factors which I think could be quite helpful for them. And one of those is, you know, we're in the early innings, I think, of a major renaissance in CapEx, so a CapEx boom where companies haven't invested. The capital stock is old. You've got a tighter labor market. So there's a desire for them and a need for them to invest more. And I think either Trump or Kamala Harris are very pro pushing this kind of reshoring stuff as well. So that's kind of a tailwind at their backs as, as well. And maybe another thing that's maybe a little bit more speculative still is the whole innovation, generative AI factor. And how does that impact smaller cap stocks? Is it better for them? Worse for them? You know, it’s still early days, but it could help to maybe level the playing field between them and some larger cap companies. So for example, if you previously needed, say, a whole football pitch worth of computer programmers or coders to you know, do whatever it is, programs you were running at which the largest companies can really afford. Maybe now with ChatGPT or whatever, you just need a couple, so that helps. I think, some of these smaller companies or hopefully it does.

The last thing I think is the whole private equity boom over the last decade or so, I think it's been interesting because private equity has been kind of, a big competitor to small cap investors in the sense that these are funds with a lot of money, sort of throwing money at the market, paying ever higher multiples for assets, kind of fighting over themselves for these smaller companies. And what they've been doing is, is taking these companies off the public market or not even listing their take, buying them out before they even list. So that's sort of sucked these companies off the market. So we've seen that in the number of listed companies that have been on the market, which has continued to come down. But what's changed here, I think, is with rates now higher, I think investors are starting to question the returns that some of these private equity funds are actually generating and particularly in light of the illiquidity aspect to and investing in those. So new funding is kind of dried up. And I think there's sort of, a stasis going on in this world. And I think what you've seen as a result is investors turning their heads or companies rather turning their heads to public equity markets and saying, well, actually, you know, maybe that's a something that's more interesting. So we've had a massive surge in IPO issuance through June, and that's continued into July. And historically, that's also been consistent with better relative performance from the small cap. So let's see, I mean, I think I think it's interesting and we definitely have some big changes ahead and I think it's still early days, with this rotation in market leadership.

16:50
Chris
All right, so you mentioned this briefly, but figured we could shift the convo a bit to consumer spending, which, you know, it seems to be alive and kicking with June's advanced retail sales report coming in better than expected. What are some of the key data points there that stuck out to you in that report? And then what is it saying about the economy as a whole? Is there any worry that this may have the opposite effect on the Fed's view of a rate cut in September?

17:14
Richard
Ya I think the news up to now has still been bad news is good news and good news is bad news. So when this kind of good news comes out is always a little bit ambiguous how the market is going to take it. And I think what we saw was, and what we are seeing with the consumer, is that activity is slowing, it's moderating, but it's not collapsing. So consumers balance sheets are in really good shape. But you know, we are starting to see greater areas of stress, particularly amongst lower income consumers. We've seen delinquencies pick up. We've seen those excess savings that they had, those have been run down and consumer confidence has been quite poor, and particularly amongst lower income households. So, I think kind of heading into this retail sales report, again, market expectations were pretty low. And then you had this kind of jump in sales where again, they were much better than expected. Spending was really solid across the board. It wasn't tied to any one particular sector. I mean, the only area where you saw actual weakness was auto sales, which were down, I think about 2%. But I think the market really took it as good that, you know, that's helpful and for small caps as well. So it's kind of a soft landing goldilocks-type scenario.

I think what it did or has done for the fed is basically help to confirm that, you know, 25 basis points in September and maybe another 25 in November or December is still on the table, but I think it was strong enough to question whether a 50 basis point rate cut was actually necessary. Because I think there had been kind of this negative narrative building and more people talking about 50 basis points worth of cuts in September would be necessary. And, you know, let's see how it goes. We still have July and August data to get through, but I think the July number of retail sales was strong enough to suggest that there's still a lot of momentum there. Unemployment is still low. The consumer is still relatively decent. Let's not jump too quickly have 50 basis points worth of cuts.

19:43
Chris
All right. Well, Richard, before we jump, is there anything else we didn't touch on that you think maybe worth covering?

19:48
Richard
I think definitely next month we need to cover the elections. You know, things are heating up there. So maybe we can do a special on that one next month.

20:00
Chris
I think that'd be great. All right, well, that's all the time we have for today. Let's, do this again next month, and we'll see each other soon.

20:05
Richard
Perfect. Thanks, Chris.