Market Matters 29 July 2024

It was another volatile week for the equity markets despite some encouraging economic data out of the US and UK. The rotation trade out of the US mega caps and into small-cap and sector laggards continued, as the Russell 2000 topped the table for the second week. Other regions were whipsawed to some extent by the US gyrations. There were also signs of an unwinding of the Yen ‘carry trade’, with the currency moving back from 162 against the USD to finish around 154. The currency appreciation hit Japanese equities hard. Even another rate cut in China failed to ease the sell-off in Asian markets, and both the Hang Seng and MSCI China are now showing losses over the last 12-month period. Oil dropped sharply at the beginning of the week and staged a muted recovery on the back of the strong US GDP numbers before heading down to week lows. Bonds traded sideways despite all the macro noise, and Gold, having set new highs intra-week, settled back down below $2400.

Before taking a closer look at the sector rotation underway in the American market, we got some excellent economic data releases last week, precisely the type supporting the Goldilocks narrative.
First, we got confirmation that the US economy is in good health, with Q2 real GDP jumping 2.8% q/q and 3.1% y/y. Business investment boomed 8.4% q/q, up from 4.4%, driven by capital equipment and intellectual property spending. As goods spending rebounded, personal consumption expenditures rose 2.3% q/q, up from 1.5%. Then, on Friday, we got the Fed’s preferred measure of underlying US inflation. The core personal consumption expenditures (PCE) price index rose by 0.2% in June from the previous month and 2.6% year-over-year.

This moderate increase and healthy consumer spending suggest that inflation is cooling without significantly impacting the economy and increases the likelihood of a September rate cut. Had investors been in a different mood, I expected both these releases to have been greeted by a much stronger positive reaction from the markets, but we appear to be in a twilight zone at the moment. The old narrative of Big Tech dominance and passive inflows driving the winners higher – at the expense of smaller, cheaper and unloved stocks – seems to be reversing. Investors are now grappling with the conundrum: will the rotation continue or reverse?

For this upward market movement in equities since Oct 22 to be confirmed as a proper, healthy, sustainable bull market, we expect to see increased market breadth. For it to continue, we would then need a pickup in economic growth and confirmation of corporate health with a steady increase in corporate earnings across different industries, not just tech.

Well, we just might be able to tick all those boxes.

Despite the S&P 500’s 0.8% drop last week, over 300 of its stocks ended the week positively, and small-cap stocks recorded another week of strong gains. That’s the sign of a healthy market. Remember, in normal market cycles over time, you would expect small-cap and the median-cap to outperform large-cap.


The shift had already begun at the beginning of the month, but Tesla’s earnings miss and worries over Alphabet’s planned spending on AI triggered concern that Big Tech is spending too much money on AI infrastructure.


To be fair to Alphabet, it still beat earnings expectations even with the high spending, and as their CEO explained why they are pumping so much into AI;

‘the risk of underinvesting is dramatically greater than the risk of overinvesting for us here. Even in scenarios where if it turns out we are overinvesting, these are widely useful infrastructures for us, they have long useful lives, and we can apply it across, and we can work through that.’

The share price reaction was painful, with nearly a 10% fall last week from Google, an excessive amount, given that their results were still a ‘beat’. But the pressure on big tech to deliver has never been greater, and if they are spending so much on AI, that might hamper the earnings growth investors want to see to justify the valuations. Perhaps the blind love affair investors have had with the Mag 7 is ending? Extending that argument one step further could herald a new period where passive trackers (that unthinkingly follow capitalisation-weighted indexes) underperform. There is finally appetite from retail and institutional investors to invest in the next wave of market winners, and they have begun hunting in areas such as small-cap, consumer stocks, real estate, industrials, financials and health care. Maybe it’s the turn of Active managers to start outperforming again; after all, it would appear to be cyclical, as the following chart argues…

But before we write off big tech, let’s remember that their earnings growth is still likely to be significantly above that of the average company in this results season and for the foreseeable future. Yes, they are expensive, but this premium has repeatedly proved to be justified. In the next six months, if we were to see a slowdown in the growth rates of the US economy, investors will go back to what was working, the perceived safety trade – the Magnificent Seven and other growth-oriented companies tied to the AI theme. That’s not my base case. I expect economic growth to prove resilient but don’t forget that would also be good news for big tech. I don’t see so much correction from this segment, but it is more likely a period of consolidation. However, for the first time in a long time, there are arguably better opportunities elsewhere and the beginnings of an appetite from investors.

Another of my pillars for a sustainable bull market, corporate earnings growth, is in place. With 41% of the companies in the S&P 500 now reporting for Q2 2024, 78% have come in with earnings per share above estimates. The blended (combines actual results for companies that have reported and estimated results for companies that have yet to report) earnings growth rate for the second quarter is 9.8%, which is on course to mark the highest year-over-year earnings growth rate reported by the index since Q4 2021.

Looking into the future, analysts are optimistic about the (year-over-year) earnings growth rates, projecting 6.8% for Q3 2024 and a substantial 16.7% for Q4 2024. The recent market fluctuations have also led to a slight decrease in valuations, with the forward 12-month P/E ratio now at 20.6. While this is still higher than the 5-year average of 19.3, it can be justified by the potential rate cuts on the horizon.

Almost lost in all the drama in the US, we got some good PMI data out of the UK last week, and companies reported a surge in confidence, hiring and new orders after Labour’s landslide election victory. New business grew fastest in 15 months, while hiring was the strongest in over a year. After stumbling last month, confidence rebounded in July and is now close to a two-year high reached earlier in the year. That’s unequivocally good news for the economy, but might it inadvertently cause the BOE to stay their hand regarding rate cuts? We shall find out this week…

But, the first post-election business survey paints a welcoming picture for the new government, with companies operating across manufacturing and services, having gained optimism about the future, reporting a renewed surge in demand and taking on staff in greater numbers. The domestic rotation in the US may also lead their institutional investors to start looking further afield for value opportunities, and perhaps the UK, with its shiny new pro-European Govt, will finally begin to feature; we live in hope!


Indeed, the surge in UK M&A suggests that companies can see the value; we need the money managers to follow suit. All eyes will be on the BOE next week as we get their decision on interest rates and hear from Andrew Bailey and the BOE on their economic outlook. Will they or won’t they cut? At the moment, market expectations are they won’t cut (60%), but that’s a slim margin and reading the tea leaves, I think they may well cut, which could be a pleasant surprise for both bonds and equities; we shall see. My logic could be flawed, but given that we only get a press conference and hear from Andrew Bailey every three months, I think he would want to coincide a rate cut with the chance to talk about it, and they probably don’t want to wait till November when we will be lost in US electioneering.

In contrast to the UK, Euro-area private-sector activity barely grew this month as its top economy unexpectedly slumped. According to data published Wednesday, S&P Global’s composite Purchasing Managers’ Index fell to 50.1 in July. While that’s above the 50 level that signals growth, it’s the worst reading since February and worse than economists had predicted in a Bloomberg survey, which saw the measure holding steady at last month’s 50.9.

That shortfall can be attributed to Germany, which surprisingly contracted, dropping below the vital threshold for the first time since March. France also failed to grow, though its 49.5 reading outpaced all but one estimate in a survey of 11 economists.


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