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The Rotation Continues in Markets and Politics in 2024
Dr. Mahnoosh Mirghaemi
July 28, 2024
6 min read
In recent weeks, notable shifts have occurred in both equity markets and the political landscape. Mega-cap technology stocks, once investor favorites, have underperformed, while value and cyclical stocks, including small- and mid-cap sectors, have shown stronger performance. This trend is expected to continue, albeit with some fluctuations, as the market broadens its leadership across various sectors in the latter half of the year.
Politically, President Biden's unexpected decision to withdraw from the presidential race has dramatically changed the election dynamics. Vice President Kamala Harris, now the Democratic nominee, has narrowed the gap with former President Donald Trump. This shift introduces uncertainty, potentially increasing market volatility ahead of the November election. Historically, such volatility tends to settle after the election.
Overall, we see a favorable environment for equity investors. Economic growth remains positive, inflation is easing, and the Federal Reserve is likely to cut interest rates in the second half of the year. Investors can use market and political volatility as opportunities to diversify or enhance their portfolios.
The recent rotation in equity markets, with small-cap stocks and value sectors outperforming mega-cap technology and growth sectors, has caught many by surprise. This shift comes after an extended period of dominance by large-cap growth sectors and the "Magnificent 7." What are the driving forces behind this sudden change?
Easing Inflation: The rotation gained momentum following the July 11 CPI report, which showed lower-than-expected inflation for the second consecutive month, bringing the headline inflation rate to 3.0% year-over-year. The disinflation trend is expected to continue, driven by decreasing shelter and rent prices and softer wage increases. Markets are now pricing in multiple Fed rate cuts by year-end, supported by the CME FedWatch tool. We anticipate two to three rate cuts, which should bolster broader market leadership.
Earnings Growth: As 41% of S&P 500 companies have reported, second-quarter earnings are on track to grow by 9.7% year-over-year, exceeding expectations. Sectors like financials, energy, and healthcare are leading this growth, rather than technology and growth sectors. Fourth-quarter earnings are projected to grow by over 16%, with significant contributions from value and cyclical sectors. This broadening of earnings growth supports the ongoing market rotation and leadership expansion.
Valuation Adjustments: The valuation gap between mega-cap technology stocks and the rest of the market had become too wide. For instance, the Nasdaq's forward P/E ratio was about 35 times, compared to 16.5 times for the S&P 500 equal-weight index. After recent rallies, investors are seeking investments with greater valuation expansion potential and catalysts like lower interest rates. This shift in valuations supports the broader market rotation.
However, current market conditions echo the "I Know What You Did Last Summer" scenario, reminiscent of a correction that began around this time last year. The S&P 500 recently experienced a significant decline, ending a long streak without a 2%-plus drop, signaling a potential risk unwind amid weakening technical and sentiment indicators, disappointing earnings, and deteriorating macro conditions.
"We warned that investors were becoming complacent, suggesting a market top could occur at any time. It seems that signal has now emerged," says DaybyDay strategist Valerie Gastaldy. "Negative factors are accumulating."
President Biden's decision to exit the presidential race and endorse Vice President Kamala Harris has reshaped the election landscape. Harris, now leading the Democratic delegates, has narrowed the gap with former President Trump. This political shift adds uncertainty to the election outcome, potentially increasing market volatility. Historically, market volatility rises before elections but subsides afterward as uncertainty diminishes. From an investment perspective, this political shift hasn't changed the macroeconomic backdrop but has introduced uncertainty, which markets typically dislike. We may see increased volatility, but this is typical in election years. After the election, markets usually refocus on new opportunities, reducing volatility.
Wednesday’s decline in the Nasdaq 100 Index, following a 50% rally, highlights declining risk sentiment. The correction’s speed is faster than last year, partly due to increased crowdedness in the tech and mega-cap trade. Systematic investors are also contributing to downside pressure. With spiking realized volatility and breaking trend lines, CTAs, risk-control managers, and technical chartists are likely selling. The VIX is rising from low levels, and both the TDEX Index and VVIX are moving higher, indicating increased volatility expectations.
The broader picture of earnings in the US and Europe shows a challenging environment. Weak earnings reports and continued struggles in China are weighing on stocks. Disappointing results from sectors like travel, cars, consumer goods, and luxury indicate weakening demand and price sensitivity among customers. Rate cuts might be needed to sustain the bull market. Meanwhile, European stocks face risks around economic growth, geopolitics, and corporate earnings, with strategists forecasting limited upside for the Stoxx Europe 600 Index.
Next week promises to be eventful with several key events on the horizon. The Federal Reserve's meeting will be closely watched, with markets anticipating signals on future rate cuts. Investors will also focus on the Bank of Japan and the Bank of England, both of which have meetings that could influence global markets.
Additionally, major tech companies like Amazon, Apple, Meta, and Microsoft are set to release their earnings reports. These will provide insights into corporate health and sector performance.
Key economic data, including the July ISM manufacturing index and employment reports, will also shape market expectations and sentiment.
The S&P 500 managed to pare its weekly decline to around 0.8%, with all sectors rallying on Friday, led by real estate and industrials. Expectations for a September Federal Reserve interest-rate cut fueled a rally in Treasuries, with ten-year US yields dropping five basis points to 4.19%, the biggest retreat in over a week.
Despite recent market and political volatility, the fundamentals supporting equity expansion remain intact. The economy remains resilient, with second-quarter GDP growth exceeding expectations at 2.8%, driven by healthy consumption growth. While economic growth is expected to cool, it should remain positive, around 1.5%-2.0%.
