July Market Update 2024

Posted by bedrock on 31st July 2024

July Market Update 28.06.2024

 
“Everything in life is luck.”

— Donald Trump

Summary

• There has been a vigorous rotation out of mega-cap tech stocks and into formerly lagging market segments, notably small-caps and ‘value’ stocks. There was no clear trigger, but rallies often are their own worst enemies as higher expectations become harder to meet.
• Investors have also started to voice concerns about the magnitude of CAPEX necessary to build advanced AI and the likely impact of AI development on margins. If this narrative takes hold, we could see a broader reappraisal of valuations for Big Tech. We remain underweight mega-cap US tech and overweight US small-caps and value.
• The release of the US CPI report for June on 11 July showed headline inflation falling for the first time in four years thanks to cheaper gasoline and progress on ‘sticky’ housing cost inflation. This reinforced expectations for US rate cuts to begin in September.
• Following September’s cut, we anticipate one more 25bps cut in November or December. But our base case is that this will be all the Fed does in 2024 given the risks of acting too quickly when growth remains strong and commodity supply chains are vulnerable to fresh, inflationary shocks due to the ongoing wars in Ukraine and the Middle East. We continue to manage portfolios close to benchmark duration.
• A lot happened in US politics in July with the attempt to assassinate former President Trump, President Biden’s decision to quit the race for the White House, and Harris’ likely nomination in Biden’s stead. Recent polls suggest that she has made a meaningful dent in Trump’s lead, but the honeymoon may not last. All is still to play for in November.

From laggards to leaders…

The biggest equity story of July – with one trading day to go – has been the vigorous rotation out of US mega-cap tech stocks and into formerly lagging market segments, most notably small-caps and slower growing, but ostensibly cheaper and more defensive ‘value’ stocks. Given their high concentration in the S&P 500 and NASDAQ Composite, the sudden reversal of fortunes for Big Tech has led to large losses on both major US equity indices since the middle of July. Indeed, on Wednesday last week, they each experienced their largest single-day drops since December and October 2022, respectively. Meanwhile, the Russell 2000 Index of US small-caps is soaring: up almost +10% for the month, and having enjoyed its best ever 5-day streak in the week ending July 12^th. But does recent price action signal the start of a meaningful correction for mega-cap tech or simply a bump in the road to ever-higher highs?

“The biggest equity story of July – with one trading day to go – has been the vigorous rotation out of US mega-cap tech stocks and into formerly lagging market segments.”

The rotation began mid-month following two weeks of characteristically strong gains for Big Tech. There was no clear trigger for the moves when they came, although a softer US CPI print (which would indicate that rate cuts are near-certain after the summer) has been held up as one possible cause. Indeed, most of the ‘Magnificent Seven’ that dominate the AI arms race, retail investors’ portfolios, and, increasingly, the global economy – i.e., NVIDIA, Meta, Microsoft, Tesla, Alphabet, Amazon, and Apple – had only just published impressive quarterly earnings. Moreover, although many small caps are high growth companies whose stocks ought to benefit disproportionately from rate cuts due to the high share of their purported value dependent on uncertain, discounted future earnings, so too are most of the Magnificent Seven.

Nevertheless, risk-on equity rallies very often are their own worst enemies: as momentum builds, higher and higher expectations become harder and harder to meet, and a trickle of profit-takers can suddenly become a flood. This is what appears to have happened in the past fortnight to the Magnificent Seven. To be sure, the negative price momentum was compounded last week when Alphabet released its quarterly results which revealed an advertising-growth slowdown. But the report also showed Q2 earnings and revenues outstripping analyst forecasts… That a relatively ‘positive’ release could trigger such a large drop in Alphabet’s stock (-5.0% on 24^th July alone) indicates underlying apprehension about current valuations – and suggests that the drawdown may have further to run.

In recent months, a small but growing number of investors have also started to voice concerns about the magnitude of CAPEX necessary to build advanced AI models and the likely impact of the pivot to AI development on Big Tech margins. If this narrative (of narrowing margins to fund uncertain, if promising, new revenue streams) takes hold, we could see a broader reappraisal of valuations for Big Tech companies in the coming months. We have been underweight US mega-cap tech because their valuations compare poorly to what is on offer elsewhere. AI is plainly a transformative technology, but the winners and losers of the AI arms race are rather less clear-cut. For now, therefore, we plan to stay put.

What next for US monetary policy?

Arguably the most important macroeconomic news of the month was the release of the US CPI report for June on 11 July. The report showed headline inflation down -0.1% MoM (+3.0% YoY) and core inflation up just +0.1% MoM (+3.3% YoY). This means that June was the first month in four years in which headline prices fell! Cheaper gasoline was an important contributor to the positive news. But, crucially, so was progress on housing cost inflation. Rising rents have been among the most persistent drivers of above-target inflation since the COVID-19 pandemic, and so evidence of a meaningful easing in housing cost pressure was welcome news. Indeed, the release helped to reinforce expectations for rate cuts to begin in September: a 25bps cut to the Fed Funds was fully priced in by the end of the day (vs. 70% at the start) and today carries a 110% probability (i.e., the market attaches a 10% probability to a 50bps initial cut). This catalysed a strong Treasury rally during the month, particularly at the shorter end where we are meaningfully exposed.

“June was the first month in four years in which headline prices fell.”

Looking forward, we anticipate a 25bps cut in September and one more 25bps cut in November or December. But our base case is that this will be all the Fed does in 2024. To be sure, unemployment is creeping up – from a low of 3.5% in July 2023 to +4.1% in June 2024 – and so are defaults (albeit from a low base). But US growth and consumer spending are remarkably robust. GDP expanded +2.8% annualised in Q2 (beating almost all estimates); and, while the flash manufacturing sector PMI survey for July stands at a contractionary 49.5 (growth is signalled by a reading >50), the (much larger) services sector flash PMI estimate is a respectable 56. The Fed is not going to want to cut rates too early, stimulate demand, and risk feeding inflation when the economy is doing perfectly well on its own. Therefore, unless there is a sudden downturn in economic activity, the easing process is likely to involve a gradual glide to a lower level of policy rates. Moreover, with conflicts in Ukraine and the Middle East threatening to expand, commodity supply chains are vulnerable to fresh, inflationary shocks. This will be in the back of Powell’s mind when he weighs the arguments for easing policy.

“Unless there is a sudden downturn in economic activity, the easing process is likely to involve a gradual glide to a lower level of policy rates.”

Outside the US, July also saw action at the Bank of Japan (‘BoJ’) – but in the opposite direction to the Fed as the BoJ lifted its benchmark rate from 0-10bps to 25bps (the highest level since 2008). The BoJ also announced plans to halve bond purchases. Although core inflation is running above the 2% target in Japan (and has been for 27 consecutive months), the BoJ has not seen this as a serious problem. Indeed, central bank officials have actively sought to boost inflation and inflation expectations for years and fear too much monetary tightening too soon will choke of the ‘normalisation’ of the Japanese macroeconomy post-COVID. As Churchill said, never let a good crisis go to waste…

Biden passes the baton…

A lot happened in US politics in July. Firstly, on July 13^th Donald Trump was almost assassinated while making a stump speech in Pennsylvania. The bullet fired by his would-be assassin grazed the former President’s ear – and it would have claimed his life had he not moved his head at the last second. The Presidential election would surely have been upended if Trump had been killed. As it is, Trump’s candidacy has surely benefited from the outrage felt by the general public at this attempt to kill him. But, remarkably, the events already feels like a distant memory in the fast-moving race for the White House. This is because President Biden finally decided to quit and to endorse his VP Kamala Harris for President. Most Democrats are relieved: Biden’s senility was obvious to all but his most diehard Biden supporters at the end; and Harris is enjoying something of a political honeymoon. Recent polls suggest that she has made a meaningful dent in Trump’s lead. How long that momentum will last is unknown. She was not popular before the Democrats rallied around and threw money at her. But while the odds were long for Biden, they look a little shorter for Harris. Given the clear blue water between the two presidential candidates on policy, November’s vote matters. What other wild cards will be played before then?

If you have any questions about the themes discussed in this article, please do not hesitate to get in contact with us: info@bedrockgroup.ch