July 22, 2024 – Investment Commentary

What’s happening

Equities: Last week, the rotation and broadening of the market from the previous week continued, though this week, the S&P 500 eventually returned -1.9% as mega cap stocks (the Magnificent 7) fell ~5% even as the average stock in the index was mostly flat. Early in the week, the S&P 500 hit its 38th record high of the year. However, selling out of the mega cap stocks continued through the week, particularly impacted on Wednesday, along with chipmakers, amid concerns about additional US restrictions on chip sales to China. Small cap stocks continued to outperform large caps, rising 1.7% for the week. Energy (+2.1%) and real estate (+1.3%) were the best performing sectors in the S&P500; technology (-5.1%) and communication services (-2.9%) were the laggards. EAFE markets returned -2.4%, led lower by Europe (-2.9%), while EM returned -3.0%, led lower by China (-4.8%), where the Communist Party’s Third Plenum offered little in policy initiatives to support the flagging economy.

Fixed Income: Investment grade fixed income sectors were mixed as rates rose across the curve. Municipals returned +0.1%, while US AGG returned -0.3% and US IG returned -0.4%. HY bonds returned 0.3% as spreads compressed slightly, while bank loans returned 0.2%. EM debt returned -0.6% as the US dollar rose 0.3%.

Rates: Rates rose across the curve, and the yield curve steepened as the market began to price in the implications of another Trump presidency with potentially higher tariffs and deficits. The recession-watch 3M10Y spread widened 6bps and closed the week at -110. The 2Y-10Y spread compressed 1bp and is now -28. Rates were generally flat in other developed economies. The BTP-Bund spread is at 1.31%. 5-year and 10- year breakeven inflation expectations rose slightly and now sit at 2.19% and 2.30%, respectively; the 10Y real yield was flat at 1.94%. The market now expects the Fed to cut between two and three times in 2024, with the first cut now expected in September (93% probability) vs the Fed’s guidance of one cut. At year-end 2024, the market expects the Fed Funds rate to be 4.70%.

Currencies/Commodities: The dollar rose 0.3%. The commodities complex fell as energy prices fell 3.1% for the week. Brent prices fell to $83/bbl. US natural gas fell 6.8% as unusually high temperatures cooled somewhat, while European gas rose 1.2%.

Market monitors: Volatility rose for equities and bonds (VIX = 17, MOVE = 94); the 10-year average for each is VIX=18, MOVE = 77. Market sentiment remains high at +29, showing investors remain highly optimistic.

What we are watching

Election implications: The reaction to the news that President Biden will not seek re-election was quite subdued Monday morning, in contrast to the previous weekend where interest rates jumped with the rising odds of a Republican sweep. As such, traders are waiting to see who the Democratic nominee will be before assessing potential implications for the economy and markets.

Earnings: Earnings season is in full swing this week, with 2 companies from the Magnificent 7 (Alphabet and Tesla) due to report on Tuesday. Earnings growth from these mega cap companies is expected to slow from mid-40% in the last two quarters to ~30% in the current quarter. Earnings for S&P 500 companies outside of Magnificent 7 are expected to be positive year-over-year for time in 5 quarters. For the AI-hyper scalers, markets will particularly be looking for forward guidance on revenues generated (and expected) from the massive capital expenditures done to date (and expected over the next several years) on AI infrastructure.

Inflation: The Fed’s preferred inflation gauge, the Personal Consumption Expenditure (PCE) index for June, will be reported on Friday. Markets will look to assess whether inflation continues to moderate and the potential implications for when the Fed will start to cut interest rates. As explained above, markets are currently pricing in a 90%+ probability of a rate cut in September.

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. 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.