Market Review
Softer inflation lifts most equities
Inflation had a notable impact on financial markets during the month following a weaker-than-expected U.S. Consumer Price Index (CPI) report. After the release on July 11, investors immediately pulled forward their expectations for interest rate cuts from the Federal Reserve (Fed). Early in the month, the implied probability of a September rate cut hovered around 75%. But by month end, traders were pricing in a more than 100% probability that the Fed would begin easing its policy rate in September. Given the Fed’s last rate action (a hike) came over a year ago in July 2023, this marks one of the longest Fed “pauses” in history.
For equity markets, renewed conviction in seemingly imminent rate cuts led to a significant rotation away from mega-cap stocks, particularly in the Information Technology sector, which had previously led performance. Smaller capitalization and value stocks, which had experienced a negative yearly return through July 10, suddenly found themselves back in positive territory after the release of the inflation report.
Fixed income markets also reacted favorably to the inflation report. The Bloomberg U.S. Aggregate Bond Index delivered its best monthly return of the year as interest rates declined across the curve, and the 2-year U.S. Treasury (UST) yield declined 40 basis points (bps) for the month, its largest monthly decline of the year.
Developed international and emerging market equities were far less impacted by the release of U.S. economic data, and both asset classes lagged for the month. The MSCI China Index had its worst monthly return since January, following a disappointing response by government officials at the recent Third Plenum meeting, as policymakers offered less support for economic reform than investors had sought.
Theme of the Month
What goes up, may come down…
The abrupt pivot from mega-cap growth stocks and rotation into smaller, lower-quality value stocks during the last three weeks of July was the dominant market narrative of the month. Given the second quarter experienced one of the most extreme periods of positive outperformance by large-cap growth over almost every other asset class, we were not surprised by the rotation.
The rotation began with the July 11 CPI report, which both came in below consensus expectations and marked the first negative month-over-month growth rate since May 2020 (Figure 1). When a swift market shift unfolds, we believe it is imperative to stick to our investment process to determine if a tactical asset allocation shift is warranted.
Figure 1. U.S. CPI Index Month-Over-Month (%)
Inflation falls for the first time since 2020
Source: As of 7/31/2024. Source: Bloomberg L.P.
View accessible version of this chart.
In this instance, it is important to keep in mind that inflation is a lagging indicator; when it displays signs of weakening, it typically implies other economic data is already moderating. Therefore, it may seem contradictory that weak economic data — essentially bad news for the economy — translated into good news for the stock market and sparked a rally in lower-quality stocks. In our view, however, the rally was a response to the market’s never-ending desire for stimulus, in this case, Fed rate cuts. We maintain strong conviction that while business cycles never repeat, they sometimes rhyme — even within the same cycle. For example, the July rally harkens back to what occurred late last year, when the Fed pivoted from declaring it was “on pause” to looking for an opportunity to start cutting rates. In November 2023, the CPI report had also come in below consensus expectations and similarly catapulted smaller cap and value stocks to outperform large-cap growth into year end. Likewise, investors began to expect the Fed to enact six or seven rate cuts starting as early as March 2024. Then, in early 2024, once economic data came in stronger than expected, large-cap growth resumed its market leadership.
Should the Fed cut rates in September, we believe lower-quality stocks will need a new business cycle catalyst to drive their performance higher. One possible support would be a steepening of the yield curve, or the spread between long- and short-dated UST yields. The spread between the 10- and 2-year UST has been inverted for more than two years, creating a material headwind for the Financials and Real Estate sectors, as well as high-dividend yielding stocks. Additionally, the 10-year UST to 3-month Treasury-bill curve remains inverted by more than -100 bps. All else equal, the Fed would likely need to cut interest rates multiple times to help normalize this curve, while we believe a 25-bp rate cut could propel the 2/10 yield curve to a positive slope.
While the inverted yield curve is a signal from the bond market that the Fed still has a long way to go to normalize markets, the rotation into smaller cap and value stocks implies equity investors have already incorporated material changes in Fed policy into their calculus. As a result, we believe valuations for those stocks are becoming fairly rich.
The Russell 2000® forward price-to-earnings ratio is now at the highest level since late 2021, having jumped approximately two multiple points in three weeks — an incredibly fast move. A significant factor behind the speed, is that while prices have moved significantly higher, forward earnings expectations have not followed suit with market performance (Figure 2).
Figure 2. 3-Month Net Earnings Revisions
Despite recent performance, small- and mid cap equity earnings revisions are well below large cap.
Source: As of 7/31/2024. Source: FactSet®. FactSet® is a registered trademark of FactSet Systems Inc. and its affiliates.
View accessible version of this chart.
In fact, earnings revisions have been negative for small-cap stocks. To maintain a sustainable shift in performance toward lower-quality stocks, it should coincide with an improvement in fundamentals, which has yet to materialize.
For more information, please contact your PNC advisor.
Figure 1: U.S. CPI Index Month-Over-Month (%)
Inflation falls for the first time since 2020 (view image)
Date |
U.S. CPI Index Month-Over-Month (%) |
8/2019 |
0.1 |
1/2020 |
0.1 |
6/2020 |
0.5 |
11/2020 |
0.2 |
4/2021 |
0.7 |
9/2021 |
0.4 |
2/2022 |
0.8 |
7/2022 |
0 |
12/2022 |
0.1 |
5/2023 |
0.1 |
12/2023 |
0.2 |
6/2024 |
-0.1 |
Source: As of 7/31/2024. Source: Bloomberg L.P.
Figure 2: 3-Month Net Earnings Revisions
Despite recent performance, small- and mid cap equity earnings revisions are well below large cap (view image)
Date |
S&P 500® |
S&P MidCap 400® |
Russell 2000® |
5/2021 |
40.4% |
35.1% |
16.1% |
10/2021 |
39.9% |
29.5% |
10.3% |
3/2022 |
20.4% |
12.9% |
3.5% |
8/2022 |
-6.0% |
-1.6% |
-0.3% |
1/2023 |
-11.6% |
-5.0% |
-5.1% |
6/2023 |
-1.1% |
-6.4% |
-11.8% |
1/2024 |
4.8% |
0.7% |
1.2% |
6/2024 |
4.5% |
1.1% |
-5.7% |
Source: As of 7/31/2024. FactSet®. FactSet® is a registered trademark of FactSet Systems Inc. and its affiliates..
