JPMorgan identifies a 'catch-all trade' that will profit from the biggest issues confronting investors - including a trade war

Paulo Whitaker/Reuters

• JPMorgan's equity strategists have advised clients to be overweight small-cap companies that do much of their business in the US and aren't as exposed to global trade.
• This group of stocks is a "catch-all trade" for profiting from higher economic growth and inflation while guarding against the downside of a trade war, said Dubravko Lakos-Bujas, JPMorgan's head of US equity strategy, in a note on Tuesday.
• Year-to-date, the Russell 2000 small-cap index has gained nearly 10%.

The Dow Jones industrial average on Tuesday wiped its 2018 gains on trade-war jitters, but the same couldn't be said of the Russell 2000.

This difference between the two indexes - of major companies and small-cap stocks - shows that smaller companies are benefitting more from the biggest issues on investors' minds, including trade, regulation, and inflation. The Russell 2000 has outperformed both the Dow and S&P 500 to gain nearly 10% this year.

Foreseeing this, JPMorgan's equity strategists advised clients late last year to tilt portfolios towards companies that do much of their business in the US. By being overweight small-caps, the bank said, investors were poised to benefit from favorable growth policies in the US and stronger growth. After the US announced its latest plan to escalate tariffs on Chinese goods, JPMorgan doubled down on its counsel.

"We continue to recommend small-caps as a 'catch-all trade' for its higher cyclical, reflation, and tax policy exposures, as well as lower sensitivity to ongoing risk," said Dubravko Lakos-Bujas, JPMorgan's head of US equity strategy, in a note on Tuesday.

"Importantly, domestic companies are more insulated from trade headlines and USD volatility."

Lakos-Bujas' recommendation for smaller domestic companies is pegged to the belief that stronger economic growth would benefit them more, even if it causes the inflation that some investors dread. Multinationals, he said, are exposed to negative economic revisions in the Euro area and in emerging markets.

Tax reform is another tailwind behind small-caps. The effective tax rate fell from 32% pre-tax cuts to 22% in the first quarter, Lakos Bujas said. That's almost double the benefit for large caps, where the effective rate is expected to fall from 27% to 21%, he said.

But small-cap companies don't have the all-clear. From a technical standpoint, Lakos-Bujas said the Russell 2000's outperformance over the S&P 500 is likely to slow down.

Also, sustained wage growth would hurt many of these smaller, labor-intensive companies, as would waning support for the Trump administration's economic agenda.

As it relates to trade, small-cap companies that import goods subject to tariffs could be hurt by rising costs, said Rich Sega, the global chief investment strategist at Conning, which has $122 billion in assets under management.

A trade war would also hurt companies that export products that China imposes import taxes on.

"We'd rather not have it," Sega said. "But it's not enough to offset the very strong current and, I think, potential future benefits of tax reform, regulatory reform, and fiscal stimulus."

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