By Thomas O. Herrick
Chief Market Strategist, Managing Director
The market narrowness manifested in massive semiconductor outperformance during May and June began to unwind during July. As we published in Street SMARTS on June 25th, market narrowness does not portend looming losses. The data supports the opposite, a breadth catch up much more typical. Over the last 30 days we have seen such a catch up, triggered by lower-than-expected June CPI inflation data released July 11th. In addition to supporting an upcoming rate cut dynamic, better inflation data is a driver of continuing real income growth. Real income growth across all income cohorts is the prime actor supporting consumer spending, which in turn supports solid GDP growth. Most importantly, the evidence is that investors are not selling and moving to the sidelines, they are rotating. Rotation is the life blood of bull markets.
Recent trading sessions have been characterized by breakouts in small cap indexes, improved performance in equal weight S&P 500, and vast improvement in the NYSE advance-decline line. At the same time mega cap tech has struggled. All this said, no market moves in a linear fashion. The most significant short-term risk triggering a pullback is if a scenario of uninspiring second quarter earnings evolves.
No rate cuts? No problem!
Source: Carlyle Analysis; Federal Reserve, July 2024. There is no guarantee any trends will continue.
Improved inflation data feeding into future Fed funds rate policy is the macro trigger supported by improved technical trends in small cap companies and cyclical sectors. The most sizable opportunity within a rate cut dynamic is small cap equity, as those companies are most sensitive to rates with a far greater proportion of floating rate debt. The outperformer when rates are cut is the same space that suffered the most during rate increases. Further supporting small and mid-caps is the valuation dispersion relative to large caps. Forward PE ratios are trading at a discount to their 20-year average versus the bulk of large cap trading at a premium to the 20-year average. Meeting both large and small cap earnings expectations will be crucial going forward.
Market rotation tied to changed rate expectations
Source: Carlyle Analysis; Bloomberg July 2024. There is no guarantee any trends will continue.
Since the Fed began raising rates in March 2022, nonfinancial corporate net interest expense has actually dropped by 40%. Interest earned on $9 trillion of corporate cash rose more than interest paid. That said, this benefit has not been evenly distributed. Cash holdings are disproportionately held by mega cap tech. That trade favoring large cap tech looks to unwind with rate cuts just over the horizon.
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