by Alex Harding, CFA
Vice President
Equity Research and Portfolio Management
Since the release of the Consumer Price Index (CPI) on July 11, the stock market has experienced a noticeable shift in leadership as the inflation rate continues to move toward the Fed’s target of 2%. Investors have been moving away from technology stocks, which have been the darlings of the market this year, towards small-cap and value stocks. Small-cap stocks, measured by the Russell 2000 index, surged 9%, enjoying their best five-day stretch of outperformance in decades, while the technology-heavy, large-cap S&P 500 index declined 1%.
Several key factors are driving this rotation. The most immediate catalyst was the inflation report, which saw its largest monthly decline since May 2020. Because of this, the market’s expectation of a rate cut by the Fed in September has jumped from ~50% two weeks ago to nearly 100% with the belief that the Fed does not have to be as “restrictive.” Historically, when the Fed cuts interest rates, it’s because the economy is in a recession. Today, it’s a much different backdrop. The Fed looks to have achieved the rare occurrence of an economic soft landing and avoided recession, a testament to the resilience of the economy. If this continues, the recent rally in small-cap stocks may have more room as these companies use more leverage and variable-rate loans on their balance sheets than their large-cap peers.
Source: FactSet
Another significant factor driving the rotation out of tech stocks this week was the news report on Wednesday that the Biden administration is considering stricter trade restrictions on China. The new restrictions aim to curb China’s access to advanced semiconductor technology. In response, the semiconductor industry sold off more than 6% on the day.
Second Quarter Earnings Season
The second quarter earnings season began late last week. As is customary, banks kicked things off by providing a glimpse into the health of American consumers and corporations. The takeaway is that higher interest rates have become a headwind to revenue growth and consumers’ ability to service their debt. In conjunction with muted loan growth, the higher cost of attracting and retaining deposits is squeezing lending margins for banks. While credit remains well-contained overall, auto and credit card delinquencies are now above pre-pandemic levels. Fortunately, they remain well short of the delinquency rates seen during the Global Financial Crisis and banks appear to have sufficient capital to absorb losses.
For global banks, such as JPMorgan Chase and Citigroup, the investment banking businesses offset the challenges faced in traditional lending this quarter. After two years of sluggish activity, the improving economic landscape and more stable interest rate environment give corporate executives the confidence to issue debt and acquire companies. Despite profitability headwinds and credit normalization, the soft-landing narrative and prospect of interest rate cuts on the near horizon has put a bid into bank stocks, which comprise a large portion of the Russell 2000 index, this month.
Takeaways for the Week
Starting on July 11, small-cap stocks enjoyed their best five-day stretch in decades against large-cap stocks, outperforming by 10%
Second quarter earnings season has begun – expectations are for 5% sales growth and 8% earnings growth compared to last year
Earnings season heats up next week with >30% of market cap and 140 companies reporting