Better-than-expected inflation numbers paved the way for interest rate cuts later this year, prompting a rotation in the stock market away from mega-cap tech and into other market segments that have lagged in the rally.
The June consumer price index inflation data was the most significant economic release of the year. Disinflation was broad-based, core goods prices and non-housing services fell, and rents slowed significantly. The report solidifies that inflation is on track to meet the Fed’s 2% target with sufficient confidence, a criteria that needed to be met before the Federal Reserve eases interest rates. The inflation data and the ongoing weakening of the labor market should set the stage for the first rate cut in September.
Climbing odds of a September rate cut have served as a tipping point for markets: yield curves are steepening and rates-sensitive equity market sectors are rallying. A major equity market rotation was triggered, with the move likely to continue in the coming weeks as portfolio managers adjust to the reality of peak rates and seek to rebalance exposure away from the trades that performed well in the “higher for longer” camp.
Many trading themes had multiple standard deviation moves after the CPI report; most revolved around unwinding the melt-up in mega-cap technology companies. These companies have dominated the performance of the broad indexes over the last 18 months, and many portfolio managers and allocators have capitulated into owning this narrow set of the market to avoid repeated underperformance despite lofty valuations. The near certainty of a Fed rate cut is a great excuse to sell and rebalance risk.
Apple, Nvidia, and Microsoft are each bigger than the entire market cap of the Russell 2000, so selling in these stocks to diversify into small caps, for example, will have a massive impact on the market. IWM, an ETF that tracks the Russell 2000 Index, beat the Nasdaq 100 by 5.8% on Thursday and is trading close to its two-year high. It was the highest outperformance of small caps versus the Nasdaq since November 2020 and the fourth-biggest relative return on record.
Another notable move was the improvement in breadth in the S&P 500, even though the index fell almost 1% on the day of the CPI release. Roughly 400 stocks closed higher in a down market. As a result, the S&P 500 Equal Weight index outperformed the S&P 500 by more than 2%, the largest margin in almost four years.
The broadening out of the rally and the stock rotation out of large-cap tech and momentum into the rest of the market can continue, but it will depend on a few factors.
Economic data over the next couple of months need to confirm the trend in inflation and unemployment. Inflation does not have to fall any further. It just needs to avoid an upside surprise like we saw in Q1 of this year. The same can be said for the labor market; the unemployment rate does not need to spike to trigger the Fed to ease. It only needs to drift along its current path of modest increases.
Interest rates also need to hold current levels. Bond yields have fallen more than 0.5% in the last two months, with more than half of that drop coming last week after Fed Chair Jerome Powell’s dovish testimony to Congress and the weak inflation data. Lower rates support the rally in smaller companies that tend to carry more debt on their balance sheets. Lower rates also help interest-rate-sensitive stock market sectors, such as homebuilders, which rallied nearly 7% on Thursday.
Finally, the Q2 earnings season is underway, and investors need to see more broadening out than last quarter. Large-cap technology stocks drove most of the earnings in Q1. Sustained improvement in the narrow market breadth witnessed in the first half of the year requires more evenly distributed earnings growth, which can come from a deceleration in profits from the tech giants and an acceleration in earnings from the rest of the market.
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