Highlights

• Rotation Out of Large into Small?
• Cracks forming in the Job Market?
• Rate Cuts in September?

US Markets

In July, we saw a notable shift towards small-cap equity stocks, which tend to be more responsive to interest rate changes. This trend resulted in the Russell 2000 outperforming the Nasdaq Composite by the largest margin in over two decades. For Q2 2024, with 75% of S&P 500 companies having reported actual results, 78% have reported a positive EPS surprise, and 59% have reported a positive revenue surprise.

S&P 500 and Russell 2000 Performance Following Fed Rate Cuts

At the beginning of the third quarter of 2024, Tesla, which had lagged in the first half of the year, significantly outperformed other members of the “Magnificent Seven" as the company valuation became more appealing. Tesla did report a 45% drop in profits for Q2 earnings while sales came in above analyst expectations. Investors focused on the higher-than-anticipated capital expenditure figures following the earnings reports of Google, which intensified concerns about escalating AI-related spending without a clear timeline for returns on these investments. Alphabet’s management noted that the risk of underinvesting was greater than the risk of higher spending, potentially exacerbating market apprehensions.

In July, possibly driven by optimism around rate cuts, the Real Estate sector exhibited robust performance, securing an impressive 8.28% gain and turning positive year-to-date. Conversely, the Technology sector was the only one to experience a decline, posting a notable 4.01% drop. Notably, all 11 sectors in the S&P 500 are now positive for the year.

US Economy

Unemployment has been on the rise for the past three months, approaching a level that triggers a recession warning according to the Sahm Rule. Developed by former Federal Reserve economist Claudia Sahm, this rule has a flawless track record over the last 50 years for predicting recessions. Specifically, the Sahm Rule signals a potential recession when the three-month moving average of the unemployment rate increases by 0.5 percentage points from its low over the previous 12 months.

Currently, the Sahm Rule is indicating increased caution regarding a cooling labor market. While this warning is significant and merits attention, it’s important to note that the signal is quite pronounced at this moment. This heightened alert underscores the need for vigilance but does not necessarily guarantee an imminent recession¹.

In the second quarter of 2024, real gross domestic product (GDP), which reflects the total value of goods and services produced in the economy, grew at an annualized rate of 2.8% after adjusting for seasonality and inflation. This follows a strong start to the year and tempered expectations for an early rate cut.

Consumer prices have been trending towards the Federal Reserve's 2% target, with the Consumer Price Index (CPI) showing a 0.1% decline on a seasonally adjusted basis in June, following no change in May. This decline is significant for the Federal Open Market Committee (FOMC) as it indicates easing price pressures, particularly in persistent inflation areas like non-housing and housing services.

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Global Markets

In the UK, stronger-than-expected GDP growth in the second quarter, combined with persistent services inflation, suggests that interest rate cuts may be more gradual compared to the US and Europe. Chinese equity markets faced challenges, with declines reflecting ongoing difficulties in the real estate sector and its broader economic impact. In response, Chinese authorities have implemented measures to bolster liquidity, including cuts to the reverse repo rate and the benchmark loan prime rate. These steps are designed to stimulate lending and support economic growth amidst persistent market headwinds.

Fixed Income Markets

In the US, June’s softer CPI reading and a weakening labor market have significantly increased investor expectations for Federal Reserve rate cuts in 2024 and 2025. This shift in outlook has supported long-end US Treasuries, which saw a 5.45% gain over the month. The rally in short-term bonds has also contributed to a steeper yield curve, with the spread between the 10-year and 2-year US Treasury yields narrowing to -21 basis points, the smallest difference since January 2024. The Federal Reserve has signaled that the time to begin cutting interest rates is nearing, although they have not yet taken action. In their July 31 decision, the Fed kept the federal funds target rate unchanged. However, market expectations of a 72.5% probability towards a quarter-percentage-point rate cut at the upcoming September 18 meeting, with another cut likely by the end of the year during the December 18 meeting. Quarterly rate cuts are anticipated to continue into 2025.

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