July 2024: A “Great Rotation” in volatile markets

Note on recent volatility:
The market volatility that accompanied July’s leadership rotation has surged further at the start of August. We ended our July market update with the caution that fears of a deeper economic slowdown could undue not only the shift in leadership, but also cause a large drawdown across the overall stock market. Those fears, specifically that the Fed has kept rates too high for too long, took hold on August 1st and were exacerbated by a weak employment report on August 2nd. Investors may now be doubting the soft-landing scenario that has been priced into equities. It is important to note that economic conditions in the US remain relatively solid and recessionary indicators are not currently flashing red, but changes in the pace of that growth and expectations for the future trajectory are what are dragging the market down these first few days of August. Weaker economic conditions would certainly put economically sensitive segments of the market under pressure (small cap stocks have already given back much of their July gains) and AI related stocks have continued to weaken on further reconsideration of lofty valuations. On the other hand, declining interest rates have provided a further boost to fixed income returns, allowing bonds to (finally) provide some offset to falling equities.

It is likely that the markets will overshoot on the downside and that the actual weakening of the economy (and the Fed’s interest rate moves) will prove to be in line with the soft landing, but that is of course very difficult to predict. Whenever volatility surges like it has recently, the best recommendation is to maintain a diversified portfolio that is not “all in” on a single and highly uncertain economic and market scenario.

July 2024: The month at a glance

Stock and bond markets posted positive returns in July in the face of higher volatility. Continued easing in inflation and softening in the labor markets raised expectations that the Fed would begin cutting interest rates at their September meeting. The June CPI report released on July 11th had a substantial impact on both stock and bond markets. That report showed inflation falling 0.1% from the prior month and up 3% from a year earlier, down from 3.3% in May and the lowest year-over-year rate in three years.¹ The tight job market also continued to soften, with the June unemployment rate rising slightly to 4.1% from 4% in May and 3.6% a year earlier.² Investors were buoyed by Fed Chair Powell’s comments on July 30th that, if these trends continued, “a reduction in our policy rate could be on the table at our September meeting”.³ Investors will now be focussed on timing and magnitude of the expected rate cuts and whether the “higher for longer” rate policy has already put the economic soft-landing scenario at risk.

The change in interest rate expectations not only bolstered fixed income returns, but fueled a significant change in equity market leadership. Small cap and value stocks, which tend to be more sensitive to economic conditions and interest rates, rallied sharply over the month. At the same time, large cap growth stocks, dominated by the big technology firms, fell in July as Q2 earnings announcements from several bellwether companies signaled some slowing in growth expectations in a category that was priced for perfection.

• Equity markets rose during July, but market leadership shifted substantially.⁴
• Small cap and value stocks surged while technology stocks lagged.⁵
• Fixed income rallied as interest fell on building expectations for a September rate cut.^{6 7}
• Inflation continued to cool and labor markets softened.^{8 9}

Tech finally takes a breather

In a volatile month, the broad equity market ended the month slightly positive with a large shift in leadership. Increased investor confidence in coming rate cuts boosted segments of the market that have been hit hardest by the rate hikes — small caps, real estate and financials.

• The S&P 500 rose 1.22% in July and is now up 16.70% in 2024.¹⁰
• US large cap growth stocks, which dominated the first half of 2024, fell for the month, with the S&P 500 Growth and NASDAQ indices down 1.30% and 0.75%, respectively.¹¹
• Small cap and value stocks surged in July, with the S&P Small Cap 600 Value index up 11.70% after reporting negative returns in the first half of 2024.¹²
• Developed International markets fell during the month, but emerging markets posted solid gains.¹³
• Industry sector leadership rotated dramatically
  • Technology and communication services stocks were the only S&P 500 sectors to post negative returns in July.¹⁴
  • Interest rate sensitive sectors, especially real estate and financials, led the market for the month.¹⁵

Rising expectations for a September rate cut

Slowly falling inflation and weakening labor markets increased investor expectations for a Fed rate cut in September. The increased conviction pushed rates down across the yield curve with the 10 and 2-year treasury rates down 37 and 41 basis points, respectively in July.¹⁹ These moves led the yield curve to steepen, reducing the spread between the 10-year and 2-year yields to -20 basis points, its narrowest level since January 2024.²⁰

• Falling rates boosted returns across all fixed income segments in July.²¹
• Corporate bonds, both in the US and internationally, were up over 2%.²²
• High yield bonds continue to post solid gains.²³
• July also brought rotation between the first half of the year’s winners and losers:
  • Global government bonds posted the strongest returns, but remain negative year-to-date.²⁴
  • Short duration fixed income and preferred stocks reported the weakest returns during the month.²⁵

Does the “great rotation” have legs? 

The rally in small cap stocks, especially small cap value stocks, in July was impressive. Combined with a sell off in the AI fueled mega cap tech stocks, the “great rotation” produced spreads in performance over the month that hadn’t been seen in decades.²⁶ The Russell 2000 Index of small cap stocks outperformed the tech-heavy Nasdaq 100 index by 13.3% in July, the largest monthly performance gap since February 2001 at the end of the tech bubble deflation.^27 28 It is important to note the large and small cap stocks go through long cycles. The chart below shows how long those cycles can last. The current dominance of large cap stocks began a decade ago and the cumulative performance gap since then has reached levels last seen in the late 1990s/early 2000s tech bubble. After that bubble burst in 2000, small cap stocks went on a six year run of outperforming large cap stocks.²⁹

The drivers of the rotation in equity market leadership are important in helping to gauge whether July’s results are just a one month event or the start of a longer cycle. Some market strategists point to technical reasons for the rotation with investor rebalancing too high exposures to mega cap tech stocks, so feel July’s reversals will prove temporary and that AI enthusiasm will return the mega cap tech sector to the forefront soon.³⁰ Others suggest that the shift in leadership was long overdue and reflected gaps in valuations between large and small cap and value and growth that have become too large to ignore.³¹

Ultimately, it will be about the path of economic fundamentals. Small cap and value stocks are much more sensitive to economic conditions and interest rate cycles. They rally when investors are more confident about the prospects for economic growth. An expected downward path for interest rates can help increase that confidence. After the July 11th CPI report showed continued progress on reducing inflation, investors gained conviction that the long-awaited cuts in interest rates were getting closer. Expectations for rate cuts fueled a rally in the areas of the market that had been hit hardest by the interest rate increases of the past several years. That fueled a remarkable 16.77% gain in small cap financial stocks and an 18.5% gain in regional banks.³²  Real estate stocks also rallied with homebuilder stocks up 17.6% on expectations that  lower rates could revive the sluggish U.S. housing market.³³

The more narrow market leadership, the less likely that leadership is based on fundamentals. On that score, it is encouraging to see that 7 of the 11 small cap economic sectors posted returns above 10% in July, and all but one sector (technology) returned above 7%.³⁴ The gains among small cap stocks really were broad based. Still, the fundamental drivers of the rotation are improved expectations for economic growth (or a “soft landing”) that come from the Fed getting closer to cutting interest rates. If those expectations are reaffirmed with rate cuts in September while inflation measures improve and economic conditions remain relatively strong, then July’s rally in small cap and value stocks should indeed have legs. Any uncertainty about timing and magnitude of rate cuts or increased fears of an economic slowdown will certainly threaten the continued rotation specifically and the overall market in general.

[1] https://www.bls.gov/news.release/cpi.nr0.htm

[2] https://www.bls.gov/news.release/empsit.nr0.htm

[3] https://www.federalreserve.gov/newsevents.htm

[4] https://www.spglobal.com/spdji/en/index-family/equity/

[5] https://www.spglobal.com/spdji/en/index-family/equity/

[6] https://www.spglobal.com/spdji/en/index-family/fixed-income/

[7] https://fred.stlouisfed.org/series/DGS10

[8] https://www.bls.gov/news.release/cpi.nr0.htm

[9] https://www.bea.gov/news/2024/personal-income-and-outlays-may-2024

[10] https://www.spglobal.com/spdji/en/index-family/equity

[11] https://www.spglobal.com/spdji/en/index-family/equity

[12] https://www.spglobal.com/spdji/en/index-family/equity

[13] https://www.msci.com/end-of-day-data-search

[14] https://www.spglobal.com/spdji/en/index-family/equity

[15] https://www.spglobal.com/spdji/en/index-family/equity/us-equity/sp-sectors/#indices

[16] https://www.spglobal.com/spdji/en/index-family/equity

[17] https://www.nasdaq.com/market-activity/index/comp/historical

[18] https://www.spglobal.com/spdji/en/index-family/equity

[19] https://www.federalreserve.gov/releases/h15/

[20] https://fred.stlouisfed.org/series/T10Y2Y

[21] https://www.spglobal.com/spdji/en/index-family/fixed-income/

[22] https://www.spglobal.com/spdji/en/index-family/fixed-income/

[23] https://www.spglobal.com/spdji/en/index-family/fixed-income/

[24] https://www.spglobal.com/spdji/en/index-family/fixed-income/

[25] https://www.spglobal.com/spdji/en/index-family/fixed-income/

[26] https://www.morningstar.com/news/marketwatch/20240731357/small-caps-and-value-stocks-dominated-in-july-by-the-widest-margin-in-decades-can-the-great-rotation-continue

[27] https://indexcalculator.ftserussell.com/

[28] https://www.nasdaq.com/market-activity/index/comp/historical

[29] https://indexcalculator.ftserussell.com/

[30] https://www.marketwatch.com/story/small-caps-and-value-stocks-dominated-in-july-by-the-widest-margin-in-decades-can-the-great-rotation-continue-3c31e7cf

[31] https://www.advisorperspectives.com/commentaries/2024/07/11/value-matter-anymore-richard-bernstein?firm=richard-bernstein-advisors

[32] https://www.spglobal.com/spdji/en/index-family/equity/us-equity/sp-sectors/#indices

[33] https://www.spglobal.com/spdji/en/index-family/equity/us-equity/sp-sectors/#indices

[34] https://www.spglobal.com/spdji/en/index-family/equity/us-equity/sp-sectors/#indices

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