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Small Cap Perspectives: Russell 2000 Index 4Q2016 Analysis


The Trump Bump?

In 1864 Congress, under the direction of Treasury Secretary Salmon Chase and President Abraham Lincoln, passed the National Banking Act. The bill established a federally supported system of banks and a common currency—all needed at the time to provide an additional financing apparatus to fund the Civil War. 1 Fast forward 114 years—to 1978—and a Supreme Court case entitled Marquette vs. First of Omaha interpreted the National Banking Act as allowing for banks to charge variable interest rates as allowed by their “home” state. This meant fewer restrictions on credit card and other bank rates and ushered in a new era of deregulation and growth within financial services. Its also the reason most of the credit card solicitations in your mail originate from South Dakota or Delaware — states that give banks the most latitude.

The fourth quarter reaction of the Russell 2000® Index’s Financial Services Sector to Donald Trump’s election as President of the United States suggests that the market is anticipating another such period of enhanced profitability, particularly for banks. The “Trump Bump” was the highest return (14.3%) for the Russell 2000 Index of any presidential election period since its inception in 1979. George W. Bush’s (Bush 43) election in 2004 sparked the second highest return (+11.9%), followed by Clinton in 1992 (+11.4%). Bush 43’s election in 2000 and Obama’s election in 2008 had the lowest returns, but occurred during challenging economic times that likely overwhelmed any positive presidential sentiment.

Of this apparent post-election bounce for the market, the Russell 2000 Index’s Financial Services and Energy sectors had the highest performance. Financial Services finished the fourth quarter with a 17% return, the highest of any sector in the Russell 2000 Index. That quarterly return was the largest for the sector since the third quarter of 2009 as financial companies left for dead began to revive. If we isolate just the November and December time period around the election, we can see that returns across sectors jump and the Energy sector rises to the top with a +25.9% return.

Whether or not the market’s expectations are realized as the Trump administration takes power remains to be seen, but it seems clear that political risk—for better or worse—will help to drive the markets as we enter 2017. But, as reported at the end of last year [See the Small Cap Perspectives, December 31, 2015 report], long-term returns are more likely to be influenced by the Fed, oil prices, and international events.  The Trump presidency could, however, carry an outsized influence on the economy—small caps in particular—depending on the policies pursued.

Trump takes office as the Fed begins what it anticipates is a slow and winding march towards a historically normal range for the federal funds rate (FFR). In December the Fed’s Open Market Committee voted to raise the FFR a quarter point to 0.5–0.75%. This was just the second rate hike by the Fed since December, 2015, as it laboriously tightens monetary policy. Across recent cycles of rate increases by the Fed, beginning with moves made in 1994, the 12-month gap (December 2015 to December 2016) between the first and second rate hikes was the longest such span. In the Fed’s estimation the US labor market continues to trend positively, and inflation remains below 2%; thus achieving both of its stated primary goals and setting the stage for further increases in 2017.

It’s worth pausing here to remember that the Russell 2000 Index has historically proven a uniquely sensitive gauge of the health of the US economy. With that in mind, it is perhaps fair to question how much of the “Trump Bump” is attributable to the currently robust US economy — something difficult to parse. Recent research by FTSE Russell has discovered a pattern of small cap returns around the peaks of past economic cycles that behaves differently than the market overall [See FTSE Russell Blog, Sunny with a chance of recession: Weathering the business cycle, January 3, 2017]. If this behavior holds in the future, it could provide a guide as to where we were in the business cycle when Trump was elected, and what kindof boost Trump and his administration’s policies provided, if any. Small caps, as measured by the Russell 2000 Index, have finished better under every presidential term except for Bush 43’s second term, which began in 2004. The first Clinton term starting in 1992 saw small caps post their best 48-month performance of any four-year term evaluated. The second Reagan term beginning in 1984 saw the largest drawdown of the Russell 2000 Index during any presidency, falling close to 35.6% following the market selloff in October 1987. The first term for Clinton was also the only full 48-month period where the performance of small caps did not fall below their starting value.

 

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