Have you seen the horse?

With better inflation data and near-100% presumptions of a September Fed cut, we’re finally seeing serious broadening of the market, as investors rotate out of mega cap tech and into unloved value and small caps. Through July 9 the Russell 2000 rose a mere 1% this year, but it’s gone up 8% since then. By contrast, the S&P 500 is up about 17% year to date but marginally lower since July 9. This brief period featured the second-biggest w/w outperformance of small cap relative to large on record, a 99th percentile move. Just a short-covering trade, or is it more? Wall Street technicians are torn on the matter. A move like this coming on the heels of long-term underperformance often means the start of something big, and forward returns from such a condition are, historically, well above average. Can a bull built on the Mag 7 really acquire a new identity? And the economic news of late has been mostly bad, not the setup that would prompt a durable run in small caps. Though anticipation of Fed cuts has lit the fire, small caps don’t always rise during easing cycles—indeed, for the years 1980-2019, they fell 7% on average in such periods. It depends on whether a recession is in the offing or not (as in 1995). At the moment, the risk of recession is low, and a slew of Fed governors have sounded dovish of late. Thus, a historically powerful rotation. But what about earnings season?!

A slowdown, yes, but the Atlanta Fed’s GDPNow upwardly revised the Q2 real GDP estimate from 2.0% to 2.5% following this week’s surprisingly strong retail sales report (more below). The economy has demonstrated remarkable resilience in the face of sustained high real interest rates. But this may be reaching a limit: Citigroup’s global economic surprise index has been negative for several weeks now, indicating momentum is slowing and surprises have been to the downside. This is true not just in the US but also in the eurozone and China. Inflation has been falling while unemployment is rising. With the labor force coming into balance and rents softening (Q2 new tenant rents had their first contraction in 14 years), inflation should continue moderating through year end. It had better do so since base effects will likely keep core PCE from falling much further on a 12-month basis. Services inflation finally looks to be coming under control. Unfortunately, goods prices may now be ticking back up thanks to rising transportation costs and business spending.

What a week, huh? After the assassination attempt on Trump, investors quickly priced an increased probability of a Trump win this fall, animal spirits and all. We’ll see whether the prospect of a new Democratic ticket changes that calculation. I thought 16 weeks was a “lifetime in politics.” The S&P 500 has enjoyed more than 350 trading days without a single -2% down day. In 97 years of data, this puts it in the top 10 such runs, with the longest being the 949 days leading up to February 2007. Speaking of that era, the only fed funds peak that lasted longer than the present one was in the lead-up to the Global Financial Crisis. Hmm. Also, for the first time in 35 years, the S&P 500 has risen 28 of the last 37 weeks, fourth-best since 1928. An interesting setup, as we are heading into, traditionally, the two weakest months of the year, August and September. Tech has become so heavily weighted in the index itself that a correction there would likely bring the S&P 500 down with it. The rotation began earlier this month on a day that saw the most S&P 500 stocks ever to go up (396) on a trading session that was down (-0.88%). Earnings season has only just begun (!) and politics promises to be very interesting in the weeks ahead. Perhaps it’s time to take a break. I mean, a cart without a horse necessarily takes a break.

Positives

• A consumer with a job goes shopping! Retail sales came in unchanged in June, versus expectations of a 0.3% m/m decline, with non-store retailers particularly robust. Strength in this category is likely to continue this month, given Amazon’s Prime Day in July. We enter Q3 with the consumer on firmer footing than was thought, which may keep GDP firm. On a real basis though, retail sales are only slightly positive for the year.
• Factories are busy Following May’s 0.9% spike, industrial production continued strong, rising 0.6% in June, better than the 0.3% forecast. Manufacturing production rose 0.4%, versus expectations of a 0.1% increase, and capacity utilization ticked higher. Light vehicle assemblies rose to a near-record of 13.1 million units SAAR. Admittedly, though, vehicles were a weak spot in the otherwise-strong retail sales report. 
• Regional Feds are sunny The Philadelphia Fed’s general business conditions index rose to 13.9 in July from 1.3 the month before. On an ISM-weighted basis, the composite showed expansion for the first time since August 2022. Also, the leading components were favorable, and the expectations index jumped too. The New York Fed’s Empire Manufacturing Index dropped to -6.6, but this was better than the expected -8.0, while new orders, shipments and employment improved a bit over the month.  

Negatives

• Housing still in a trough Single-family housing permits and starts fell in June, though an increase in the more volatile multifamily segment lifted total starts. The NAHB/Wells Fargo housing market index decreased to 42 in July, from 43 previously. Mortgage rates dropped to 6.87%, but this was more an occasion for homeowners to refinance (up 15.2% over the previous week) than to initiate purchases. 
• Is bad news bad or good? The Fed’s Beige Book report points to an economy that is slowing down, with the labor market weakening. While most Federal Reserve districts showed “slight to modest” growth, an increasing number said activity was stable or declining, and the growth outlook for the balance of 2024 looked pessimistic. 
• Europe still weak ZEW’s Investor Expectations survey of the eurozone dropped 7.6 points to 43.7 points even as current conditions increased 2.5 points to -36.1. In Germany, the expectations index fell to 41.8 and the current conditions index rose to a still-weak -68.9.

 What Else

Defensive names have been catching a bid lately Consumer Staples, Health Care and Utilities struggled in the months before the tech bubble burst in March 2000. In the final months of that year, though, those sectors rallied 25-35% while the broader market declined.

Inflation worries moving to the back burner? Gas prices were on everyone’s mind at inflation’s peak. Not so much nowadays. Prices are down 6 cents a gallon from a year ago. Supply levels are at the 5-year average. As for oil, it’s about 15% cheaper than when Russia invaded Ukraine.

Trump has had a good week, although In the wake of his attempted assassination in 1981, President Reagan’s approval ratings went up 8%. While the situation is still fluid, Trump has yet to hit a new high, perhaps a reflection of the polarized electorate and a ceiling on his approval.