Perspectives

Large cap equities are still on a roll, posting their sixth gain in the last seven quarters. While higher-for-longer interest rates created a market headwind in the quarter, it was more than offset by the favorable impact of AI-driven growth, slowing inflation, a decent economy and solid earnings.

Market Narrowness

The S&P 500 posted a 4.3% return in the quarter, pushing its first half return to 15.3%. However, this continued strength in the equity Index hides the underlying narrowness of the market, as most of the gain came from the Magnificent 7, with AI leader Nvidia’s stellar returns leading the pack. On an equal-weighted basis, stocks in the S&P 500 posted a loss of -3.0% for the quarter. As one might thus expect, the Magnificent 7-heavy Information Technology and Communication Services sectors posted the strongest returns, followed by the defensive Utilities sector. On the flip side, the more cyclical and interest-rate sensitive Industrials, Materials, Energy, Financials, and Real Estate sectors lagged. The Russell 2000 Index of small cap stocks, lacking the power of the Magnificent 7, posted a -3.3% quarterly decline, lagging large caps by over 7%. The first-half return remains modestly positive at 1.7%. Small cap performance trailed large caps by over 13 percentage points, its widest first half deficit in over 50 years. Only the defensive Consumer Staples and Utilities sectors posted gains in the quarter, while Consumer Discretionary and Industrials lagged on economic slowdown concerns.

Market Caps and Styles

Given the strength of the high-growth Magnificent 7 stocks, large cap Growth maintained a sizable 10.5% performance advantage over Value in the quarter, stretching the year’s lead to 14.1%. Among small caps, Growth maintained a more modest advantage over Value of 0.7% for the quarter and 5.3% for the year. Even among small caps, year-to-date performance was quite narrow, driven by AI beneficiary Super Micro Computer and bitcoin play MicroStrategy, although both stocks took a breather in the second quarter. With the Russell rebalance at quarter end, these “small cap” names have now graduated from Russell’s smaller cap benchmarks. As it was last quarter, market performance had a slight quality bias, with factors such as larger size, high ROE, and low beta outperforming.

Outlook

The Fed still seems to be doing its part in successfully managing the economy to a soft landing, with inflation cooling, a steady economy, and positive corporate earnings growth. While the Fed seems in no hurry to start reducing rates given the somewhat stubborn drop in inflation, the question remains when, rather than if, rates will be cut. Markets now anticipate one rate cut this year, with four more likely in 2025. Several factors remain supportive of this favorable economic and inflation outlook, including better PCE, PPI, and CPI inflation readings, still solid jobs reports, positive GDP, and favorable personal income growth.

Still, there is a growing list of economic clouds on the horizon that might still push us into recession, which would not be unheard of given the typical lagged effect of the Fed’s tightening cycle and the inverted yield curve. In particular, lower income consumers are struggling with higher interest rates, inflation, and exhausted savings, as retail sales are showing signs of stress and loan default rates are trending up. In addition, several industries within the Industrials sector are struggling with weaker demand and pressure on profitability, confirmed by weakness in the ISM Manufacturing survey. And then there are the many imponderables out there, including war in Ukraine and the Middle East, political dysfunction in the US, and the rising influence of far-right parties in several European countries.

Yet, corporate balance sheets remain quite resilient, giving support to equity markets in the form of share buybacks, dividends, and acquisition activity. However, equities have gotten quite expensive, with the average large cap stock now selling at almost 23x earnings.

Read GW&K’s full Quarterly Investment Review for the second quarter here.

With contributions from members of our Domestic Equities Team