Key Points
- ROTATION – Virtually all major asset classes saw gains in July, but the big story was a significant rotation in market leadership. Small cap stocks outperformed large cap stocks, and value stocks outperformed growth stocks at magnitudes not seen on a monthly basis in decades.
- RECESSION SCARE – Despite the healthy gains in July, the early days of August saw a sudden shift to recession fears following poor back-to-back manufacturing and employment reports. Investors suddenly feared the Fed had waited too long to cut rates, and the economy may be facing a recession rather than a soft landing.
- ROUGH TRANSITION – The sudden U.S. recession scare combined with a crash in Japanese equity markets roiled markets worldwide in the first few days of August. A massive “carry trade” in the Japanese yen was disrupted and led to particularly heavy and forced selling in U.S. tech and small stocks.
- RECESSION CONCERNS QUICKLY REFUTED – But just as quickly as recession fears jumped to the forefront of the market narrative, U.S. services sector reports came in better than expected and helped stabilize markets. A relief rally stopped three straight days of market selling and may help provide support as August progresses.
- RINSE & REPEAT? – Pullbacks driven by technical market undercurrents like the yen carry trade tend to be more benign than a crash resulting from deeper economic problems. That doesn’t mean the markets are in the clear because history shows volatility spikes are not typically one-and-done events. Still, the analysis shows that such rapid selloffs tend to be followed by strongly positive returns in the subsequent weeks and months.
Market Summary
Asset Class Total Returns
Source: Bloomberg, as of July 31, 2024. Performance figures are index total returns: US Bonds (Barclays US Aggregate Bond TR), US High Yield (Barclays US HY 2% Issuer-Capped TR), International Bonds (Barclays Global Aggregate ex USD TR), Large Caps (S&P 500 TR), Small Caps (Russell 2000 TR), Developed Markets (MSCI EAFE NR USD), Emerging Markets (MSCI EM NR USD), Real Estate (FTSE NAREIT All Equity REITS TR).
Virtually all broad global asset classes were up in July. More importantly, it was a broad-based advance as opposed to the very narrow gains that characterized most of the second quarter. However, that broadening in the markets didn’t come without some volatility. Economic data through the month was quite mixed and mostly missed Wall Street consensus expectations. For a good part of the month, investors treated that bad news (economic data weaker than expected) as good news, reassuring them that the Federal Reserve (Fed) will soon be cutting rates. In particular, a weaker than expected U.S. Consumer Price Index (CPI) reading early in the month, combined with weaker U.S. nonfarm payrolls growth, helped drive the rate cut optimism. That mentality held for much of the month and fueled a market rotation to asset classes more sensitive to interest rate. Ultimately, the Fed left rates unchanged at its July 31 FOMC meeting, awaiting greater confidence that core inflation is on a sustainable path toward the 2% target, but did basically project a cut in September.
With that backdrop, small cap stocks were the top performing broad asset class, with a +10.2% total return for July. Real Estate took the number two spot with a +7.2% return. And U.S. bonds were up +2.3%, while non-U.S. bonds rallied +3.2%, the best monthly performance for both since December 2023. Like with equities, the rally in bonds was broad-based, with declines across the yield curve (bond prices move opposite bond yields) as inflation data moderated and expectations for rate cuts rose. Both the 10-year and 2-year Treasury yields declined (-24 and -46 basis points, respectively) to the lowest level in nearly six months. The spread between the yield on the 10-Year and 2-Year treasury notes has been inverted (10-Year yield lower than 2-Year yield) for a record 500+ trading days, but on Friday, August 2, the spread closed at just -0.09, which is its least inverted level since July 12, 2022, when the streak was just six days old.
As impressive as the move in bonds was, most of the attention on the markets turned to the rotation that occurred in U.S. Stocks. Seasonally, July has been a good month for U.S. stocks, and 2024 was the 10th consecutive year that the headline S&P 500 Index was positive for July. It also marked its third consecutive monthly gain, albeit with a modest +1.2% return. But it was the small cap Russell 2000 Index that stole the show in July, posting a +10.1% total return for the month, its best month since December 2023. That was a welcome reversal from being down (-1%) in June and -3.3% for the second quarter. July was the widest margin of monthly outperformance for the Russell versus the S&P (+8.9%) since 2000. Small caps generally benefit more from declining interest rates and have a sizable valuation advantage to their large cap counterparts. In addition, earnings growth is expected to turn higher for small caps in coming quarters, while large cap earnings are forecast to see their rate of growth slow.
To be sure, it wasn’t just a rotation from large cap versus small cap that characterized the month of July. The sector composition of the S&P 500 witnessed a notable change as well. Nine of the 11 S&P sectors were positive, reinforcing the broad-based nature of the July rally. However, the change in leadership was stark. The Technology and Communication Services sectors, dominated by the Magnificent 7 (Mag 7) giant cap tech-related stocks – Apple, Amazon, Alphabet (Google), Meta (Facebook), Netflix, Nvidia, and Tesla – fell -2.1% and -4.1% respectively. Of course, they had massive performance leads on all other sectors going into July, but it nonetheless shows the widening participation of the stock market and a change in leadership, even if only for the short-term thus far. Interest rate sensitive sectors like Real Estate, Utilities, and Financials were the leading sectors (up +7.1%, +6.7%, and +6.3%, respectively), having been the beneficiaries of interest rate declines. On the other hand, four of the Mag 7 stocks came under pressure after investors appeared underwhelmed by their second-quarter earnings releases near the end of the month.
With the rotation to defensive sectors like Utilities and away from Technology and Communication Services, the disparity between growth and value styles also saw a big reversal. The Russell 3000 Growth Index was down -1.3% in July, while the Russell 3000 Value Index rallied +5.5%. The +6.7% outperformance of value over growth was the largest for any month since March 2001. Of course, over that period, growth has trounced value by over 300%, so value was long overdue and has a lot of making up to do.
It wouldn’t be right to leave the July market review without addressing the rough transition from the month of July over to August (at least for the first few days of August as we went to publication). The back half of July saw increased volatility, and on July 24, the S&P 500 suffered its first daily decline of at least -2% in 365 trading days. The proximate cause was underwhelming earnings reports from Tesla and Alphabet (Google) that sent the Mag 7 down -5.9%, its worst one-day return since September 13, 2022. That set a negative tone going into the final week of the month, and then for the first three days of August, the S&P 500 was negative, culminating in a 3-day drop of -6.1%. The Mag 7 sank -9.0% over those first three days, and the Russell 2000 fell -9.5%. The markets were already jittery entering August from the subpar Mag 7 earnings but then had to grapple with sudden recession fears after an unexpectedly weak ISM Manufacturing report as well as a poor July employment report that was far short of job growth expectations and saw the unemployment rate rise to 4.3%, its highest level since October 21. Then, over the weekend, news circulated that legendary investor Warren Buffet’s investment company, Berkshire Hathaway, sold nearly half its massive stake in Apple. And investors awoke Monday morning to news that the Japanese stock market fell -12% overnight and more than -20% over three days after the Bank of Japan made a surprise +0.2% rate hike. That only brought their policy rate to +0.25%, but after nearly two decades at zero and negative rates, the increase was enough to blow up a massive carry trade in the Yen. It is estimated that $4 trillion or more was in the Yen carry trade, in which large institutional investors borrowed Yen at near zero interest rates and used the borrowing to fund purchases of the AI, tech, and growth stock complex.
Where does that leave us after four days into August? Well, for starters, the Bank of Japan received a swift lecture from the rest of the world and, on August 6, assured the world there wouldn’t be any other surprise rate hikes. That helped stabilize global markets on Tuesday, August 6. Early August also brought some upside surprise economic news to counter the prior week’s poor manufacturing and jobs data. The ISM Services PMI was stronger than expected and bank lending was unexpectedly more robust than forecast. Combined, they helped ease the recession concerns from a week earlier. Rate cuts from the Bank of England and the central bank of the Czech Republic in early August also helped encourage investors overseas. Even after the sudden declines in August, the major U.S. equity indexes are up by double digits for the year. Moreover, despite some more turbulent seasonality in August and September, markets typically rally nicely in the fourth quarter, especially when they are up more than 10% going into the second half of the year.
Source: Bloomberg. Data as of July 31, 2024.
Price Returns for Equity, Total Returns for Bonds.
* The term basis points (bps) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 0.01%. Bond prices and bond yields are inversely related. As the price of a bond goes up, the yield decreases.
Quick Takes
ROTATION
Since early July, markets have experienced a rotation in market leadership. Factors like weak U.S. manufacturing and labor data sparked a broad reversal of trading strategies. Decelerating inflation and slowing U.S. employment growth led markets to start pricing in higher probability of Fed rate cuts. The market-priced probability for a September rate cut moved from 58% at the beginning of July to 100% in early August, which coincided with small cap stocks outperforming large cap stocks and value stocks outperforming growth stocks, as seen in the charts below. The monthly performance shifts were the largest monthly shifts seen in decades.
July’s Rotation from Large to Small and Growth to Value
Source: Bloomberg.
RECESSION SCARE
In the first two days of August, the consensus economic concern shifted, almost overnight, from inflation to recession. A poor ISM Manufacturing report on the first day of August was quickly followed by a poor July employment report on the second day of the month. The reports triggered a sudden and significant concern that the Fed has waited too long to cut rates, and suddenly, the economy was vulnerable to a recession rather than the more palatable soft-landing scenario (a growth slowdown but without a recession). The ISM Manufacturing PMI fell for a fourth straight month in July and hit an 8-month low. The July employment report, as seen in the two charts below, showed new nonfarm payrolls came in at just 114,000 versus expectations for 175,000, while the unemployment rate unexpectedly jumped to 4.3% when it was expected to stay at the prior month’s level of 4.1%.
Jobs Growth Drops, Unemployment Rises
Source: U.S. Bureau of Labor Statistics, CNBC.
ROUGH TRANSITION
The sudden U.S. recession scare, combined with a crash in the Japanese equity markets, roiled markets worldwide and sparked a “risk-off” selling spree for the first few days of August. Again, regarding Japan, the assumption was that the Bank of Japan would keep borrowing costs permanently low and permit the mammoth “carry trade” to persist in perpetuity. For years, investors borrowed at rock-bottom Japanese rates to buy higher-yielding assets, including U.S. tech stocks. When officials in Tokyo decided last week to unexpectedly tighten Japanese monetary policy for the first time in 17 years, a global selloff ensued as the cost of carry suddenly increased. Almost all risk assets came under intense selling pressure, but it was particularly intense for the U.S. tech and small cap segments of the market, as shown below, where the Mag 7 and U.S. small caps lost more than -9% in just three days.
No Appetite for Risk in Early August
% Change, August 1 through August 5
Source: Morningstar.
RECESSION CONCERNS QUICKLY REFUTED
But just as quickly as the recession narrative jumped to the forefront of the market narrative, reports came in that the U.S. services sector expanded more than expected in July – after contracting a month earlier by the most in four years. The ISM Services PMI rose +2.6 points to 51.4. Readings above 50 indicate economic expansion, and the July figure was above the median forecast in a Bloomberg survey of economists. The details underneath the July headline number showed a rebound in services employment, new orders, and business activity that suggests the largest part of the economy is growing at a decent pace. “The rebound in the ISM services index in July is hardly consistent with the economy or labor market falling over a cliff, as many seem to fear following the weaker July employment report,” said Stephen Brown, deputy chief North America economist at Capital Economics. “Notably, there was no mention of the dreaded R-word [recession] from respondents in the accompanying press release either.”
ISM Services index counters fresh recession talk
Institute for Supply Management (ISM) Services PMI
Source: Institute for Supply Management.
RELIEF RALLY
The upside surprise in the ISM Services PMI and the assurances from Japanese monetary policy authorities calmed markets and led to a relief rally on the fourth trading session of August, which should help generate support for markets to stabilize. It is not yet known if any hedge funds or other large institutions will be taken out by the sudden pullback in markets, particularly those saddled with heavy losses from the “carry trade,” but it was encouraging to see investors willing to step in and buy beaten down stocks. If early-August panic continues to abate, the Fed cuts rates as expected in September, and the U.S. economy continues to show its resilience, a soft landing is still probable. The economic outlook remains steady, and the market’s recent reactions appear overblown in context of the broader investment backdrop.
Turnaround Tuesday brings badly needed relief rally
1-day % Change, August 1 through August 6
Source: Bloomberg.
RINSE & REPEAT?
Fortunately, the late July and early August stock-market roller coaster appears to be mostly driven by the reversal in the speculative Yen carry trade rather than the omen of economic disaster, a credit crisis, or an exogenous event (war, natural disaster, etc.). A pullback driven by technical market undercurrents is more benign than a crash resulting from a deeper systematic economic crisis. That doesn’t mean the markets are in the clear in the immediate term though. The Cboe Volatility Index, or VIX, is a measure of the expected volatility of the S&P 500, often referred to as Wall Street’s “fear gauge.” In the early morning of August 1st, the VIX hit 65.73, the third highest mark since the data began in 1992, following the 2008 global financial crisis and the 2020 Covid-19 crash. By the market close, however, the VIX had fallen back to 38.57, closer to a typical bad day. The intraday reversal lower was welcome, but the road ahead could still be bumpy because volatility often takes time to clear out from the system. On average, a volatility spike leads to a higher trading range for the VIX in the near term, and follow-on selloffs in the following 30 trading days are common. As shown in the chart to the right below, a surge in volatility is not typically a one-and-done episode. There are typically several bouts of it before a lower volatility regime is reestablished. It is important to recognize that market declines are a natural part of the investment cycle. For long-term investors, staying invested is crucial. An analysis by Bespoke Investment Group shows that such rapid selloffs are rare but tend to be followed by strongly positive returns in the subsequent weeks and months.
Volatility spikes are not usually one-and done
S&P 500, cumulative price change relative to days with a big jump in volatility
Notes: Volatility surge defined as the Cboe Volatility Index hitting an intraday high of 30 or above. Data between 1992 and 2024.
Source: Cboe, FactSet, The Wall Street Journal.
Asset Class Performance
The Importance of Diversification. Diversification mitigates the risk of relying on any single investment. It offers many long-term benefits, such as lowering portfolio volatility, improving risk-adjusted returns, and helping investments to compound more effectively.
Source: Bloomberg.
Asset‐class performance is presented by using market returns from an exchange‐traded fund (ETF) proxy that best represents its respective broad asset class. Returns shown are net of fund fees for and do not necessarily represent performance of specific mutual funds and/or exchange-traded funds recommended by The Retirement Planning Group. The performance of those funds may be substantially different from the performance of the broad asset classes and to proxy ETFs represented here. US Bonds (iShares Core US Aggregate Bond ETF); High‐Yield Bond (iShares iBoxx $ High Yield Corporate Bond ETF); Intl Bonds (SPDR® Bloomberg Barclays International Corporate Bond ETF); Large Growth (iShares Russell 1000 Growth ETF); Large Value (iShares Russell 1000 Value ETF); Mid Growth (iShares Russell Mid-Cap Growth ETF); Mid Value (iShares Russell Mid-Cap Value ETF); Small Growth (iShares Russell 2000 Growth ETF); Small Value (iShares Russell 2000 Value ETF); Intl Equity (iShares MSCI EAFE ETF); Emg Markets (iShares MSCI Emerging Markets ETF); and Real Estate (iShares US Real Estate ETF). The return displayed as “60/40 Allocation” is a weighted average of the ETF proxies shown as represented by: 30% US Bonds, 5% International Bonds, 5% High Yield Bonds, 10% Large Growth, 10% Large Value, 4% Mid Growth, 4% Mid Value, 2% Small Growth, 2% Small Value, 18% International Stock, 7% Emerging Markets, 3% Real Estate.
* The term basis points (bps) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 0.01%. Bond prices and bond yields are inversely related. As the price of a bond goes up, the yield decreases.
Chris Bouffard is CIO of The Retirement Planning Group (TRPG), a Registered Investment Adviser. He has oversight of investments for the advisory services offered through TRPG.
Disclaimer: Information provided is for educational purposes only and does not constitute investment, legal or tax advice. All examples are hypothetical and for illustrative purposes only. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed. Please contact TRPG for more complete information based on your personal circumstances and to obtain personal individual investment advice.