Small cap stocks is 'a spot we like relative to inflation,' UBS analyst says

Stuart Kaiser, the head of equity derivatives research for UBS, joins Yahoo Finance Live to forecast where investors should be looking as inflation highs loom, particularly noting the promise of small cap stocks.

Video transcript

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BRIAN SOZZI: How to trade inflation is one of the biggest conversations on Wall Street trading desks at the moment. Let's bring in UBS head of Equity Derivatives Research, Stuart Kaiser for more on this. Stuart, good to see you, as always. I think you gave me the best trade in the break. I mean, buy one of these inflationary turkeys, stick it in my freezer, and maybe sell it two weeks from now.

But look, if one does not want to buy turkeys, how should you be trading these hot inflation prints that we continue to get?

STUART KAISER: Hey. Good morning, Brian. I think it's a great question. I think directionally, you have two choices. I think if you believe the markets are going to kind of power through higher inflation over the medium term, then I think you want to be long things like the commodity sectors within US equity markets, potentially small cap equities, or some exposure to potential metals and mining and things of that nature.

I think if you're more worried that inflation could trip up the rally, then you're looking at downside trades. And I think most investors we've spoken to are really focused on the tech sector for that, whether that's NASDAQ, semis, large cap S&P tech, and things of that nature.

So I think it really depends. If you're trying to trade tactically around the short-term risks, I think most people have sort of gravitated towards tech. And if you're just generally bullish, then I just think you want exposure to parts of the market that tend to benefit from that higher inflation. And again, that would be sort of commodities, capital goods, small cap, and more cyclical parts of the market, I guess.

JULIE HYMAN: You know, Stuart, the sort of transitory argument has faded into the background a little bit as inflation has been more persistent. But how is the market treating it right now? Because I have seen some commentary that inflation is at or near peak. Are we seeing any of that reflected in the trades that you're watching?

STUART KAISER: It's a great question. Our UBS view is that you're not going to have inflation peak until probably late in the first quarter of next year. So you still have a period of time here where inflation will probably continue to pressure the markets. Our inflation strategists are actually above consensus for prints into year end.

So we do think there, over the short term, are some kind of risks to inflation continuing to surprise to the upside. And I think what you've seen there is you've seen the market start to add some hikes into 2022 because they're worried the Fed may kind of come under pressure from that.

And then on the equity side, again, I think we saw a period of tech put buying. More recently though, we've just seen a tremendous amount of activity in upside in the energy sector and even in emerging markets, which doesn't seem like it'd be a good inflation trade. But I think it has sort of cyclicality and kind of a growth exposure that people have been attracted to.

But I think the two most popular trades we've seen to the upside would be small cap and energy. And hedging, sort of more tactically, would be in tech. But I don't think this is going to go away. It's probably late in the first quarter of next year with inflation in the high 6%s or low 7%s. And that should continue to pressure the market. So I think this is a conversation that's going to be on our plate for a while, actually.

BRIAN SOZZI: Yeah, Stuart, I'm starting to see a lot more folks chatter about on rate hikes by summer of next year, which means the Fed would signal that some part in the first half of next year. Do you think that signal-- and it's likely coming-- is that correction-worthy for the markets?

STUART KAISER: It's a great question. The Fed has sort of created this window for themselves, right? They've said, we're not going to finish tapering until June. And in the interim, we're going to evaluate inflation here and then decide what we need to do from there.

I think your question revolves around when would the Fed discuss it or, maybe more importantly, when would the data and the market kind of begin to pressure the Fed to make that decision and have that discussion?

Whether it's correction-worthy, I think potentially. If inflation were to get to a level where it looked like the Fed needed to react more strongly and more quickly, i.e. the Fed was behind the curve, I think that could definitely cause a pullback.

The fact is, we haven't really seen that this year though. When inflation was released in May, we had kind of a one-day pullback. We obviously had a bit of a hiccup in September. The market down about 5% when the Fed started to talk about tapering and things of that nature. So I think there is precedent that you could get a 3% to 5% pullback.

Anything more than, that I think you'd have to be in a situation where you were genuinely concerned the Fed was behind the curve and was going to have to do some catch-up hikes. And again, that's not our base case. But I think that's the type of situation you'd need for that kind of market action.

JULIE HYMAN: And Stuart, again, I know you're more of an equity options guy than a bond market options guy. But are you seeing any kind of pricing in that there could be a change in leadership at the Fed? Do you think that the market is adequately sort of pricing in that possibility?

STUART KAISER: We've only had, I'd say, a minimal amount of conversations about that with clients. I think there was a couple articles out this morning that President Biden is evaluating Lael Brainard as well as Joe Biden-- excuse me, as well as Jerome Powell. So I think that's out there.

I haven't seen anything, any specific trades or specific moves in bond options that would be directly linked to that. I think people are much more focused on the pace of rate hikes as well as the pace of inflation. And I think both of those candidates, which seem to be the two primary candidates, seem to have a generally consistent view that you should take your time and kind of be measured in terms of how the rate hike cycle might approach itself.

So I think if you had candidates that were vastly different in terms of how they were thinking about this, maybe then the market would have to price something. But I think by and large, the view is that, in terms of monetary policy, those two potential candidates are similar enough where you haven't really seen it get priced out, at least in what we've followed.

BRIAN SOZZI: That CPI report, Stuart, late last week, I think, caught a lot of folks by surprise. It pressured the markets. This week we'll get a retail sales report. How are your clients positioned, trade-wise, into this?

STUART KAISER: Yeah, it's interesting. We were way, way above consensus for that inflation print. And I think consensus kind of moved in our direction into the inflation print. But the numbers were still surprising. So I think that's definitely the case.

We do expect a pretty strong retail sales report. You also have a fair amount of consumer staples and consumer discretionary stocks reporting between now and Black Friday. And I think, look, the focus here is going to be on discussions around wage inflation and input cost inflation.

If you rewind the clock back to the second quarter earnings period, a number of consumer staples stocks discussed that. And their stocks made very large moves on earnings. So I think what folks are trying to do is identify stocks that might be under pressure from some form of pricing power and either hedge or at least be a little careful about those stocks around earnings season.

So I think generally speaking, the view is retail sales should be pretty solid. But at least as we get into sort of what we would call the last wave of earnings season, I think the real focal point here is, do those companies discuss wage inflation, input cost inflation, or the potential for supply chain to impact their holiday spend season? So I think those would be the three major topics that investors are going to be debating over the next kind of run-up until Thanksgiving.

JULIE HYMAN: Stuart, just quickly, small caps. I want to save a word for small caps here, which I know you mentioned in some of your notes to us. As we think about going into year end and next year, if we're going to continue in this relatively high-inflation environment, maybe moderating growth environment, is small caps something that makes sense for people?

STUART KAISER: It is a spot we like quite a lot relative to inflation. Small caps should tolerate a higher rate of inflation than tech or large cap stocks. And we think that makes a lot of sense.

I think the little tripping point we've had here the last few weeks is the shape of the yield curve. We've seen the treasury curve kind of flatten out quite a bit over the last few weeks. And that flattening of the yield curve actually tends to be a little bit of a headwind for small cap and cyclical stocks.

So ideally, what we'd like to see is, if you are bullish small cap, growth and inflation remain fairly strong but the yield curve kind of steepen out a little bit. So you have two aspects here. I think you've got an inflation piece, and you've got a rates piece.

And based on our outlooks, both of those should stack up pretty well for small cap. And we do like being long small cap as sort of either an inflation exposure or an inflation hedge, depending on how you're positioned. So yeah, we're pretty positive on that part of the market.

BRIAN SOZZI: Great insights is always. Stuart Kaiser, UBS head of equity derivatives research, good to see you. Have a great rest of the week.