Roaring Reopening Trade Threatened With Boom Nearing Peak

In a stimulus-crazed economy, everything goes faster.

The recovery came quicker than forecast, the rally in reopening stocks was dizzying, and now the comedown may be upon markets sooner than anyone thought, too.

Stocks that soared are starting to give the gains back in fits and starts. The small cap Russell 2000 Index -- at one point up 135% from the pandemic bottom -- is underperforming the Nasdaq 100 by roughly 4 percentage points this month, after largely dominating since the vaccine breakthroughs in November. Cyclical sectors such as financials and energy have trailed as technology powered ahead in the past month.

Morgan Stanley is warning that the economic cycle is going to be “much hotter and much faster” than normal. With consensus building that growth is going to peak this quarter, the reopening trade that powered rallies in everything from cruise operators to casinos may peaking with it.

“It’s time for investors to start moving out of many of the strategies, many of the sectors that work in that early cycle right after a recession period into things that work better when things get a little bit more mid-cycle,” Andrew Sheets, chief cross-asset strategist at Morgan Stanley, said in a Bloomberg TV interview.

To be sure, the reopening trade is not dead, as evidenced Friday when strong data sparked a 2% rally in small caps and banks jumped. But with greater frequency, investors are rotating away from companies that benefit from a surging economy and into ones that perform well under most conditions.

Exchange-traded fund flows reflect that sentiment. Quality ETFs -- which select companies based on balance-sheet strength and earnings -- have absorbed $233 million so far in April, on track for the first month of inflows since November, Bloomberg Intelligence data show. Meanwhile, large-cap equity funds have taken in $7.8 million this month versus outflows of $336 million for small-cap ETFs -- the first net withdrawal since September.

Goldman Sachs analysts expects U.S. economic growth will peak this quarter at a 10.5% annualized rate, which will then level off to 1.5% by the end of 2022. While the economy should still be growing above trend throughout the second half of the year, defensive sectors such as utilities are poised to benefit as that pace moderates, they said.

“Decelerating economic growth is also typically accompanied by sector rotations within the equity market,” Goldman strategists including Ben Snider and David Kostin wrote in a note this week. “Cyclical industries tend to lead the market in environments of positive and accelerating economic growth, but as growth peaks and decelerates more defensive industries typically outperform.”

Of course, should U.S. economic growth average 7% in the second half of 2021 as Goldman’s predicting, that’s not necessarily a death knell for value and small cap stocks. For example, financial shares -- one of the heaviest sector weightings in value benchmarks -- tend to correlate closely with the shape of the U.S. yield curve, which is generally expected to steepen through year-end.

But after a fierce rally, those reopening trades are set to cool, according to John Hancock Investment Management. The Russell 2000 has surged 38% over the past six months, nearly double the gains of the S&P 500 and the Nasdaq 100.

“We’re already at the tail end of the early part of the cycle where small-caps have ripped higher, you’re seeing value start to really do well,” Emily Roland, the firm’s co-chief investment strategist, told Bloomberg Television earlier this month. “We want to be in a position where we’re getting ready for this mid-part of the cycle where fundamentals start to matter a lot more.”