The Month At-A-Glance
- U.S. stocks and global equities continued their winning ways in July. The S&P 500 gained 3.2%, developed international stocks were up 3.2%, emerging markets returned 6.2%, and the Russell 2000 gained 6.1%.
- Hope grew for an economic “soft landing” as U.S. inflation continued to fall while economic growth (Q2 GDP) was stronger than expected.
- Investor sentiment in the U.S. is now extremely optimistic. At extremes, this is a contrary indicator for future market returns.
- While the recent growth and inflation news is encouraging, we remain concerned about the elevated risk of an economic and earnings recession within the next year, which is not adequately discounted in the S&P 500 at current levels.
Market Recap
Global equity markets rallied in July, with emerging markets leading the way. The MSCI EM Index gained 6.2%, propelled by an 11% gain in Chinese stocks. Both the S&P 500 and MSCI EAFE indexes gained around 3.2%. In a sign of a broadening market rally – i.e., beyond the Magnificent Seven mega-cap U.S. tech/AI stocks – the small-cap Russell 2000 Index outperformed the S&P 500, returning 6.1% for the month.
The S&P 500 hit a 15-month high at month-end and is up 21% for the year. All 11 S&P 500 sectors rose in July, led by Energy. However, as the table below shows, the divergence in returns across sectors for the year to date has been extreme. The top three sectors – Information Technology (top holdings: Apple, Microsoft, Nvidia), Communication Services (Alphabet, Meta) and Consumer Discretionary (Amazon, Tesla) – have returned 36% to 47%. Meanwhile, the bottom three sectors – Utilities, Health Care and Energy – have been negative or barely positive.
In the bond markets, U.S. interest rates inched higher in July as the Fed hiked the Fed funds rate another 25bps. The 10-year Treasury yield ended the month at 3.95%, breaching 4.0% early in the month (and again in early August). The Bloomberg U.S. Aggregate Bond Index was flat for the month. Riskier credit performed well, with the US High Yield market gaining 1.4% in July.
The Treasury yield curve remains deeply inverted—with short rates meaningfully higher than those at the long end— historically a key recessionary indicator.
Notable Events
A key driver of the strong equity market in July was good economic news on both the growth and inflation fronts, which continues to positively surprise market participants. Many investors have been positioned for a recession this year as the Fed has aggressively tightened monetary policy in order to bring core inflation down to its 2% target. But the economy and labor market have remained resilient in the face of 525 basis points (5.25%) of Fed rate hikes since last March. The economic data in July continued to support the soft-landing narrative: that the Fed can bring inflation down to target without pushing the economy and corporate earnings into a sharp recession.
As U.S. stocks have surged off of their October 2022 lows, investor sentiment has turned from extreme pessimism to extreme optimism, e.g., as seen in the NDR Crowd Sentiment Poll chart below. This type of market/sentiment momentum can drive markets higher in the short-run, i.e., it is self-reinforcing as more investors jump on the bull-market bandwagon. But over the medium- to long-run (5-10+ years), it is underlying company fundamentals (earnings growth, dividends) and valuations that drive equity market returns. And when sentiment reaches extreme levels of greed (or fear), markets are susceptible to a reversal as expectations become detached from fundamentals.
Turning to fundamentals, so far this year, S&P 500 earnings growth has not been impressive, although it has been better than analysts’ beaten-down expectations coming into the year. As such, almost all of the market’s return this year has been due to P/E multiple expansion – valuation expansion – rather than earnings growth. The S&P 500’s 12-month-forward P/E has risen from 17x at the start of the year to nearly 20x now – an 18% increase.
Looking forward over the shorter term, barring an unexpected macro shock, the key for the U.S. stock market is whether or not earnings growth rebounds into year-end and 2024. Based on the economic backdrop and several leading indicators of recession, we still see an uncomfortably high risk that it won’t happen and that the current bullish sentiment will disappoint.
However, along with most everyone else in the market, we are impressed (and surprised) with the resilience of the U.S. economy in the face of this Fed tightening. And we don’t dismiss the soft landing scenario in our analysis and portfolio positioning, which explains why we have not been more underweight global stocks this year, given our recessionary base case.
Investment Takeaways
We did not make any tactical portfolio allocation changes in July. It is encouraging to see the market rally broaden out beyond the “Magnificent Seven” mega-cap tech/AI stocks. This reflects the better-than-expected macroeconomic news, giving investors hope the economy can avoid a recession and boosting more cyclically sensitive areas of the markets (e.g., EM stocks, small-cap stocks, financials, industrials). Absolute valuations for these “non-Tech” segments still look reasonable to attractive, and they look very attractive relative to mega-cap U.S. tech stocks. (For example, the forward P/E of the Magnificent Seven is around 32x, while the rest of the S&P 500 is selling at roughly 17x.) As such, among other things, we are evaluating whether to tactically shift some of our U.S. large-cap growth stock/S&P 500 allocations into other cheaper areas of the U.S. market. Stay tuned.
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