Fundamentals Drive Markets in the Absence of Fed Action

Executive Summary 

Last week, stocks were up and bonds prices traded down/yield up. The MSCI Emerging Markets Index outperformed both the MSCI EAFE Index and the S&P 500. The best-performing sectors in the S&P 500 were consumer discretionary, communication services, and consumer staples. Across U.S. Russell style and market-cap indices, large-cap value performed best, but the quality factor led more broadly. 

Earnings growth expectations for the calendar year, which normally decline once the year have climbed sharply, going from 15.2% market consensus expected growth at the start of the year to over 20% as of the end of July. The S&P 500 first half 10.2% total return has been driven by strong fundamentals rather than multiple expansion.  Second quarter earnings season continues to be strong, and economic data is mostly beating expectations globally. The S&P 500 earnings season is now more than halfway complete, with several mega-cap companies reporting results last week. The numbers are impressive, with earnings growth tracking at 47% year over year. Over the last 30 plus years, this type of earnings growth has only occurred following periods of negative earnings growth, such as 2008 and 2020.   

As for fixed income last week, the 10-year Treasury yield rose to 4.71% over the week, and the 2year / 10year Treasury yield spread steepened to +44 bps. The best-performing parts of the bond market were preferreds, TIPS, and high yield. High-yield bond spreads were unchanged at 279 bps and remain well below the 2025 high of 453 bps.  Why are the 30 year long rates at the highest level in 20 years? 1) Inflation, 2) Fiscal problems, 3) Hyperscaler issuance. The bottom line is that we're not going back to the 2010s, and this broadly good news for everyone cutting coupons in high-quality fixed income. 

The market response to earnings has been uneven which the Investment Office believes is a healthy sign investors are critically evaluating results and guidance rather than have a blind eye to “risk on”. Some companies reported strong results, yet their stocks struggled due to capex guidance. Others may have already had strong growth expectations baked into their valuations. However, some previously underperforming stocks rallied significantly on better-than-expected results.  

Over the course of last week, the U.S. dollar declined, resulting in a risk-on impulse across markets. The Fed meeting served as the initial catalyst for the dollar's decline. Economic data in Europe improved in July, with both GDP and sentiment coming in better than expected this past week.  The Eurozone Economic Surprise Index has gone from meaningfully negative to positive in relatively short order. 

What Are We Evaluating? 

The backdrop shifted once again in July, the third major shift this year, following March and April. The AI and semiconductor trade that led all year reversed sharply in July, with the group entering a bear market as investors flipped from rewarding capital spending to scrutinizing it. The U.S.-Iran conflict re-escalated, which reopened the oil > inflation > Fed policy channel. Major equity indices pulled back from record highs, the VIX drifted toward 20, and the Fed has turned more hawkish, but the damage has been relatively concentrated.  

While AI stocks have entered correction territory, credit spreads remain near cycle lows and market breadth has improved. It’s the mirror image of early Q2. Our base case is that market volatility remains elevated, with wide dispersion and continual rotations as the market works through two open questions: (1) whether the AI pullback is the first crack or a healthy mid-cycle reset, and (2) whether the oil-inflation-Fed risk builds or fades. In our view, the setup continues to carry wide tails in both directions, and we are intentionally positioned to capture the durable long term AI trends with selective value allocations domestically and abroad as the range of outcomes resolves.  We believe there are opportunities in certain asset backed lending strategies to help diversify and amplify fixed income returns in what continues to be a resilient “no hire/no fire” job market.