Weekly market wrap

The rotation continues: In both markets and politics

Key Takeaways:

• In recent weeks, we have seen rotations in both equity markets and politics. In stock markets, the mega-cap technology names, which had been darlings of investors for most of this year, have lagged more recently. Value and cyclical parts of the market, including small- and mid-cap stocks, have outperformed in recent weeks. We believe this rotation has legs, perhaps not without bumps along the way. And more broadly, we see the theme of the broadening of market leadership (in both tech and nontech sectors) continuing in the back half of the year.
• In politics, the historic announcement of President Biden to exit the race has shifted the election dynamics. Vice President Kamala Harris, who is poised to become the Democratic nominee, has narrowed the gap between her and frontrunner former President Donald Trump. While it is early days still, this rotation has added uncertainty to the election outcome, and we may see market volatility in the weeks ahead of the November election. However, history has showed us that volatility ahead of election day is common and tends to subside after the election is over. 
• More broadly, we continue to see a favorable backdrop for equity investors. Economic growth is cooling but positive, inflation is easing, and the Fed looks poised to lower interest rates in the back half of the year. In this environment, we believe investors can use volatility, whether from market or political rotations, as an opportunity to diversify or add to investment portfolios.

Stock-market rotation continues – but can it last?

Equity markets continued the rotation that began earlier this month, with small-cap stocks and value and cyclical sectors all outperforming mega-cap technology and growth sectors. After more than 1.5 years of large-cap growth sectors and the "Magnificent 7"* leading the market, what has caused this somewhat sudden rotation away from the tech darlings? In our view, there are now a few key elements that have fallen into place to support the rotation. We highlight three of these below.

1. Inflation has surprised to the downside: The rotation perhaps truly picked up after the July 11 consumer price index (CPI) inflation came in cooler than expected for the second month in a row, with headline inflation now at 3.0% year-over-year.¹ In our view, the disinflation trend looks poised to continue, though perhaps not in a straight line lower, driven by areas like lower shelter and rent pricing and softer wage gains ahead. Markets now more meaningfully believe in Fed interest-rate cuts in the back half of the year, with the CME FedWatch tool indicating markets are pricing in three rate cuts: at the September, November and December Fed meetings. Given the better inflation trends and some softening in the labor market, we believe two to three rate cuts by year-end is a reasonable scenario and should be supportive of market leadership broadening.
2. Earnings growth likely to broaden: We are in the midst of second-quarter earnings season, and with about 41% of S&P 500 companies having reported thus far, earnings are on track to grow 9.7% year-over-year, above expectations for 9% growth at the end of the first quarter.¹ The largest upside earnings surprises are coming from sectors like financials, energy, and health care, more so than technology and growth sectors. In addition, as we head toward fourth-quarter earnings, not only is earnings growth expected to be above 16%, but also the value and cyclical sectors are expected to contribute more to this growth than the artificial intelligence (AI) and technology sectors. This broadening of earnings growth, in our view, is supportive of the market rotation and the broadening of market leadership as well.
3. Valuation rotation underway: Finally, one key driver of the rotation may be that valuation differentials between the mega-cap technology space and the rest of the market (e.g., the S&P 500 equal-weight index) had moved too far too fast. For example, the forward price-to-earnings ratio of the technology-heavy Nasdaq index at the beginning of July was about 35 times, versus just 16.5 times for the S&P 500 equal-weight index. After a nice rally in markets, investors may be seeking investments that have more scope for valuation expansion and may also benefit from catalysts like lower interest rates. And this valuation rotation would be supportive of the broader market rotation we've been seeing.

With the factors above in place, we believe the broadening of market leadership has legs, although likely not without volatility or bumps along the way. Perhaps one consideration to counter the rotation narrative is that the U.S. economy is not in an early expansion stage, which is typically when areas like small-caps and cyclical sectors show sustained leadership. In fact, economic growth seems poised to soften a bit over the next few quarters. Nonetheless, with inflation cooling and the Fed likely cutting interest rates, markets may be anticipating a pickup in consumption and growth down the road. And if economic growth remains positive, we believe the "soft landing" narrative remains intact, which also supports the broadening of leadership.

Also, keep in mind that large-cap technology companies continue to have solid earnings growth and strong balance sheets, and may also benefit from lower rates and better consumption. In our view, while tech sectors may have experienced stretched valuations and seem due for a correction, investors could gravitate toward both growth and cyclical/value sectors (a true broadening of leadership) in the months ahead. If the theme for markets over the last few quarters was narrow leadership, we believe a key theme and investment approach going forward will be portfolio diversification.

Political rotations – what do they mean for portfolios?

Last week, President Biden made a historic decision to drop out of the presidential election late in the race, and he endorsed Vice President Kamala Harris for the job. Since then, Harris has received the support of a majority of Democratic delegates to become the party's nominee. It's early days still, and we have yet to learn full policy agendas on both sides of the aisle, but this political rotation has led to somewhat of a shift in the race.

The betting odds and early polling have shown that it is a much closer race between VP Harris and former President Trump than with President Biden as the candidate. Former President Trump still maintains a lead overall, but the gap has narrowed. This, of course, may change over the next few weeks, as we await several key events, including Harris choosing a running mate, the start of the Democratic National Convention, which is set for August 19-22, and potentially the next presidential debate, which will likely occur in mid-September.

From a market perspective, while these moves have not altered the macroeconomic backdrop, they have increased uncertainty around the election outcome – and we know markets tend not to like uncertainty. We may see a pickup in market volatility in the weeks ahead, but this is not uncommon in election years. In fact, history shows us that market volatility tends to increase ahead of election day, and then subside afterwards, regardless of who is in power. This could be in part because some uncertainty is lifted after the election is over, and markets can again focus on opportunities ahead.

Bottom line: Despite the rotations, fundamentals remain supportive

Overall, despite market and political volatility in recent weeks, we continue to focus on the fundamentals, which we believe remain supportive of the ongoing equity expansion. The economy, as we learned last week, remains resilient. Second-quarter GDP growth exceeded expectations, coming in at 2.8% versus forecasts of 2.0%, largely driven by healthy consumption growth of 2.3%.² While we would expect economic growth to cool in coming quarters, we believe it will remain positive and near its trend of 1.5% - 2.0%.

This backdrop of cooling but positive economic growth, easing inflation, and a Fed poised to cut rates continues to remain supportive of equity markets broadly, in our view. We would use volatility in coming weeks, whether related to market or political rotations, to diversify, rebalance, and add quality investments at better prices. We continue to favor large-cap and mid-cap U.S. equities, and we see sectors like industrials and utilities participating more in the broadening of market leadership. We would also be mindful of remaining too exposed to cash-like instruments, including CDs and money-market funds, as interest rates are poised to head lower. The next few months could provide interesting opportunities to dollar cost average into strategic allocations in equities and bonds, in line with individual risk and reward preferences, to ensure that you remain on track to meet long-term financial goals.

Mona Mahajan
Investment Strategist

^{Source: 1. FactSet 2. Bloomberg
*Magnificent 7 represented by Apple, Microsoft, Amazon, Meta Platforms, Alphabet, Tesla and NVIDIA.}

Weekly market stats

^{Source: FactSet, 7/26/2024. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *4-day performance ending on Thursday.}

The week ahead

Important economic releases this week include the FOMC meeting and nonfarm payrolls report for July.

Review last week's weekly market update.