July 15, 2024 – Investment Commentary

What’s Happening

An event-filled week and weekend is impacting markets across asset classes. Last week, the core consumer price index (CPI) — which excludes food and energy costs — climbed 0.1% from May, below expectations and its slowest pace since 2021. The report bolstered the bets that the Fed would cut interest rates as soon as September, sending interest rates lower across the curve and sparking a major rotational shift in equity markets. Even as the S&P 500 index and tech-heavy NASDAQ initially fell, about 80% of stocks in the S&P 500 finished higher as investors abandoned the safety trade of mega cap technology stocks. Small cap stocks, largely left out of the equity market rally year-to-date, soared to their best weekly returns of the year and outperformed large-cap stocks by over 5% for the week. Both the S&P 500 and the NASDAQ eventually finished the week higher as the broadening in the market continued.

As world financial markets reopened after the failed assassination attempt on Donald Trump over the weekend, trades that anticipate a Republican White House and a potential congressional sweep gathered momentum. Stock futures rose while Treasuries fell (price down, yield up) as trading kicked off on Monday, with long-dated bonds leading losses on bets that Trump’s potential economic policies of extending the tax cuts in the Tax Cuts and Jobs Act, tighter immigration and trade tariffs will spur growth but also inflation. The yield on 30-year bonds rose above two-year equivalents for the first time since January. Higher tariffs in a second Trump term may also impact growth in Europe and renew a trade war with China, likely reducing the economic prospects for both geographies.

What we are watching

Bank Earnings: Bank earnings reports are often viewed as harbingers for the broader earnings season to follow and a view into the state of the economy more generally. Banks’ stocks kicked off earnings season last Friday, and they fell based on what was viewed as a tepid outlook. Commentary pointed to a solid but slowing economy, corporations cautious about adding to borrowings amid higher interest rates and broader uncertainty, and pockets of weakness in consumer spending as the labor market decelerates.

Small caps: Small cap stocks tend to outperform over large caps in environments of accelerating economic growth and underperform when growth decelerates. Further, small caps stocks remain highly vulnerable to higher interest rates due to weak balance sheets and limited profitability. Currently, ~44% of the companies in the Russell 2000 index are not profitable, vs a long-term average of 28%. For small cap stocks to continue to perform, post-election policy would have to meaningfully improve the outlook for economic and earnings growth without putting upward pressure on rates.

China: China’s growth unexpectedly slowed to the worst pace in five quarters as faltering consumer spending undermined an export boom. Gross domestic product expanded 4.7% in the second quarter from the same period a year earlier, weaker than almost all estimates. President Xi has bet on manufacturing and high-tech sectors to propel the economy as consumer spending and real estate investment drag. However, that strategy faces risks from higher tariffs in a potential second Trump term.

What to do

Fixed Income: On our mid-year outlook call in late June, we pointed to multi-year highs in bond yields as attractive levels to put cash to work. While yields are currently slightly lower, and the long end of the curve may drift higher due to the outlook for inflation and deficits (see above), we still see value in fixed income. Further, if the economy decelerates further, lower yields (higher prices) in fixed income will serve as an important portfolio ballast to potential drawdowns in equity markets.

Equities: Our equity allocations are diversified across quality growth, dividend growers, and the market index (S&P 500). While a handful of stocks have driven market performance YTD, we continue to advocate for a diversified allocation with prudent concentration.