Market Navigator – August 2024 edition

Shifting narratives

The market began July with the continued leadership of mega cap tech and the underperformance of almost everything else. With a whiff of softer inflation reported on July 11, everything changed, as the market fully embraced the increasing likelihood of a Federal Reserve (Fed) rate cut in September and beyond, which would help small caps and more interest-rate sensitive areas hurt by higher rates.

The market’s motto moved to rotation, rotation, rotation. Small caps went on to gain more than 10% over 5 days, one of the stronger streaks in their history, and the S&P 500 Equal Weight Index, a proxy for the average stock, outperformed the traditional market-cap weighted S&P 500 by a wide margin, and several of the beloved growth names had sharp corrections in excess of 10%.

By the end of the month, we did see tech bounce back briefly on the back of solid earnings. Yet, as the calendar turned into August, investors sold into the rebound likely looking to reduce outsized positions.

Moreover, on the heels of weak manufacturing data in the early days of August and cooling employment data, stocks pulled back more broadly on economic growth concerns and the possibility that the Fed could be waiting too long to cut interest rates. This led the 10-year U.S. Treasury yield to dip below 4% for the first time since February.

And if this hasn’t been enough for investors to digest, tensions in the Middle East have heated up, former President Trump was nearly assassinated, President Biden dropped out of the presidential race, and Vice President Kamala Harris moved in as the presumptive Democratic presidential nominee. The election is set to only become more in focus with less than 100 days to go to the November elections.

Where we stand

With the economic backdrop cooling, our view is the Fed needs to start moving. The July employment report was certainly soft, though one month does not make a trend.

Over the past three months, jobs gains have averaged 170k, which is right in line with the 3-year pre-pandemic average of 177k. Second quarter GDP growth clocked in at 2.8%, and the Atlanta GDPNow model is currently tracking growth above 2% for the current quarter.

At the same time, the Fed’s preferred core inflation measure recently clocked in at 2.6% year-over-year, approaching its target of 2%. Importantly, the stock market has typically risen in the 6- to 12-month period following the first rate cut, as long as the economy avoids a recession (still our base case).

The bull market still deserves the benefit of the doubt. Yet, heading into July, we anticipated choppier waters and expect that to continue as we enter the historically more challenging period of August to September. Indeed, with the market, it’s often two steps forward, one step back.

Notably, the S&P 500’s 14% rebound from late April into the July peak was not that far off from the typical post-correction rebound of 18% that we have seen since 2009, suggesting a more mixed near-term risk/reward.

Moreover, even though the S&P 500 historically has tended to add to gains by year end following strong first halves (average +9% additional), there have often been hiccups along the way. Indeed, the market has averaged a maximum peak-to-trough pullback of 9% at some point in the second half following strong first halves.

While always uncomfortable and typically accompanied by bad news, pullbacks are the admission price to the stock market. This is what provides the potential for higher longer-term returns relative to most other asset classes.

Positioning

We are maintaining our long-standing bias to the U.S. While we expect choppier waters to persist, the economy and earnings still appear to be on better footing relative to the rest of the globe.

We downgraded the tech sector in late June, after its strongest two month outperformance since 2002. We remain positive on the sector longer term, but it became too crowded and expectations too high. The correction has relieved some of that excess, though the sector is not yet as oversold as we have seen around recent bottoms. Still, our view is investors will eventually come back to this sector given its superior growth prospects and secular tailwinds in an environment of cooling economic growth.

As for small caps, we remain neutral. Their rebound has occurred following one of the most extreme underperformance periods of the past 30 years and from attractive relative valuation levels. Given more than 25% of small cap debt is floating rate compared to just 7% for the S&P 500, these smaller companies tend to benefit more from lower interest rates. Moreover, extreme buying momentum, such as what we saw last month, tends to be positive looking out over the next 12 months.

The timing of this strength is odd, however, insofar as small caps tend to be “early out of the gate” assets and benefit early in the cycle as the economy accelerates coming out of a downturn. This time, the economy appears to be cooling, which has historically not been ideal for small caps, and earning trends remain weak.

Stay underweight international markets: Given the rotation over the past month into the more economically-sensitive areas of the U.S. markets, it was telling that we did not see more vigor from the international markets.

• In these markets, we are seeing weakening manufacturing trends and mixed results out of the banks (a key component for European stock market performance).
• The Bank of Japan continues to tighten monetary policy, which is leading to a rebound in the yen (and the unwinding of a popular carry trade for global markets), which has tended to be a negative for stocks.
• China’s markets have also been lackluster as policymakers’ stimulus efforts disappoint.

At the end of July, we downgraded our view of bond duration from more attractive to neutral following the sharp decline in intermediate- and longer-term rates. We had previously upgraded our view of duration in late April when the 10-year U.S. Treasury yield was at 4.6%. However, with the 10-year now below 4.0%, our work suggests the tactical duration opportunity has been largely realized.

Finally, with rising geopolitical risks, we still see value in holding modest positions in gold—which just traded to a record high—and commodities to diversify portfolios.

As always, we will continue to track the data and keep you informed as our views evolve.