Market Commentary: June 2024

Written as of July 13, 2024.

Highlights this Month

• Even in the U.S., negative currents are becoming apparent.
• Understanding the concentration of gains among top stocks. 
• Magnificent 7 or Magnificent 1? 
• The AI boom: are market leaders sustainable?
• Navigating the debate around AI stocks. 
• Nvidia: chipmaker or market maker? 
• Technical outlook on 10-year rates. 
• The stability of credit spreads suggests no urgent action is required.  
• Economic signals are sending mixed messages. 
• Employment remains a key recession indicator. 

Executive Summary

The S&P 500 has notably led the U.S. markets, achieving a total return of +15.3% for the first half of the year, with a strong performance in Q2 and June. However, broader market enthusiasm varies; the S&P/TSX has experienced a year-to-date increase of 6.1% but has seen declines in both Q2 and June. 

This strong start for the S&P 500 is notable, yet less than a quarter of stock ETFs are surpassing its performance this year. The index's traditional capitalization-weighting structure continues to outperform its equal-weighted counterpart, which has gained only 5.1% year-to-date. The significant contribution to the S&P 500's gains has come from a small number of large-cap stocks, particularly driven by the AI boom, with Nvidia alone accounting for over 32% of the index's return. 

While earnings estimates for top performers have risen, most other stocks within the index face negative revisions, highlighting a concentration of growth among a select few companies. This trend has implications for active portfolio managers, who often lag behind passive funds in capturing these gains. 

In the credit markets, stress is evident in lower-quality bonds, but the broader impact remains limited. Economic indicators are mixed, with signs of contraction in manufacturing and services, though employment growth remains robust, evidenced by the addition of 206,000 jobs in June. Inflation trends show improvement, though disparities in inflation expectations between income groups complicate Federal Reserve policy decisions. 

Looking ahead, the Fed's potential rate cuts are uncertain in timing and scope, with increased federal debt influencing bond yields. The market's strong performance, led by a few key stocks, remains contingent on several factors, including the Fed's actions and improvements in overall market breadth. 

June in Review

As we close the books on June, the markets found themselves at the mid-year mark in relatively good shape. According to Goldman Sachs, U.S. 10-year treasuries and non-profitable tech stocks are among the few asset classes in the red year-to-date. Large-cap U.S. stocks continue to lead the way, with only India surpassing the S&P 500's impressive +15.3% total return for the first half (total return in U.S. dollars). The S&P 500 saw a gain of 4.3% in Q2 and 3.6% in June, finishing the first six months with strong momentum. Other markets, however, displayed less enthusiasm. For instance, the S&P/TSX is up 6.1% year-to-date (total return in Canadian dollars) but dipped 0.5% in Q2 and 1.4% in June. While markets may appear calm, some worrying trends are starting to emerge. 

Even in the U.S., negative currents are becoming apparent. 

On the surface, U.S. stocks have had a record start to the year. The Wall Street Journal notes that the past six months have marked the second-best start for the S&P 500 this century. According to Strategas, this strong first half usually signals a positive outlook for the remainder of the year, with the S&P 500 typically averaging a 7.5% gain in the following six months. 

Yet, there's more to the narrative. The Bear Traps Report points out that while cumulative returns for the year are above average, the average equity ETF is lagging. Bloomberg reports that less than a quarter of all stock ETFs are outperforming the S&P 500 this year. Morningstar adds that only 18.2% of actively managed mutual funds and ETFs using the S&P 500 as their benchmark are beating the index. 

Understanding the concentration of gains among top stocks. 

The S&P 500 has become a tough target to beat. The traditional capitalization-weighted index consistently outperforms the equal-weighted version, which has only gained 5.1% year-to-date and fell 2.6% in Q2 and 0.5% in June. Recent data highlighted by the Daily Chartbook reveals a troubling breadth: while the S&P 500 rises, many stocks are on the decline. Not since 2002 has the S&P 500 increased so much while so many stocks suffered over a four-week span ending June 14. Despite the S&P 500 reaching new highs, as of early July, only 56% of stocks on the New York Stock Exchange are trading above their 200-day moving average. The surface may seem calm, but beneath it lies considerable volatility. 

Magnificent 7 or Magnificent 1? 

A smaller number of large U.S. stocks are driving market gains. According to Strategas, the top 10 largest stocks in the S&P 500 accounted for over 77% of its total year-to-date return. Although these stocks represent 37% of the S&P 500's weight, their performance has been disproportionately high. In 2023, the "Magnificent 7" contributed over 62% of the S&P 500’s 26% return, with Microsoft leading at a 13% share, followed closely by Apple, Nvidia, and Amazon. In 2024, Nvidia alone has contributed over 32% of the S&P 500's return, according to Barron's. 

The AI boom: are market leaders sustainable?

The AI boom and the subsequent earnings growth of technology leaders are propelling this concentration. Apollo notes that the top 10 companies in the S&P 500 contribute 23% of earnings, lower than their 35% market cap share. Bridgewater underscores that the five largest stocks in the S&P 500 have lower earnings shares compared to their market cap shares, indicating high investor expectations for future earnings growth. For instance, Nvidia has a 4.8% market cap share but only a 2.3% earnings share, suggesting it must achieve significant future earnings growth to justify its valuation.  

JP Morgan reveals that the earnings estimates for the 20 largest S&P 500 stocks have been revised upwards by 18% over the past year, compared to just 2% for the entire S&P 500. Outside the top 20, most S&P 500 stocks have seen negative earnings revisions. For Nvidia and its peers to continue outperforming, they must maintain this earnings growth gap, which is increasingly challenging. Active portfolio managers often hold lower weights in these top performers compared to passive funds, contributing to the underperformance of active managers and ETFs. 

Navigating the debate around AI stocks. 

As is typical on Wall Street, the outlook for AI stocks like Nvidia is hotly debated. The bearish narrative centres on the law of large numbers, raising questions about how growth can persist given Nvidia’s already high revenue and earnings, along with its stock price. Bridgewater recently highlighted the difficulty market leaders face in maintaining their positions due to the ongoing process of creative destruction. According to Absolute Strategy Research, Microsoft, Meta, Amazon, and Google expect to increase total capital spending by $54 billion over the next year, while Nvidia's revenue is projected to soar by $100 billion. These four hyperscalers already account for 40% of Nvidia’s sales, and not all their capital expenditure will go to Nvidia. For Nvidia to achieve its ambitious revenue target, these tech giants will need to spend more, or Nvidia must find additional revenue streams, or its forecasts may be overly optimistic.

A crucial aspect of this debate hinges on the customers' ability to source alternative suppliers to Nvidia or even develop their own chips. How reliant are they on Nvidia’s proprietary software? While the excitement surrounding AI is palpable, the business case for such substantial capital investment remains to be convincingly demonstrated. 

In March, Sequoia Capital estimated that $50 billion has been invested in Nvidia chips, but generative AI startups have generated a mere $3 billion in sales. Nvidia’s stock price may already be pricing in a great deal of good news, but comparisons to past bubble stocks like Cisco may be excessive. The Bear Traps Report notes that Nvidia’s P/E ratio peaked at around 46 times earnings, significantly lower than Cisco's 400 times earnings during the dot-com bubble. Cisco's stock was buoyed by unrealistic earnings expectations, as were many dot-com stocks. Bridgewater argues that Cisco’s earnings would have needed to grow by about 50% annually for a decade to justify its valuation's normal risk premium over bonds. By contrast, Nvidia's 10-year earnings growth needs to be around 15%—a high bar, particularly given recent earnings increases, but not as unattainable as Cisco's past projections. 

Nvidia: chipmaker or market maker? 

We usually wouldn't dig so deeply into a single company, but Nvidia's impact on the S&P 500's recent performance is disproportionate. Should it and the select group of AI market leaders falter, they could drag the entire index down with them. Conversely, the broader market could catch up. Bank of America suggests that markets exhibiting poor breadth tend to mean-revert eventually, though weak breadth isn't always a precursor to a market correction. Since 1986, the S&P 500 has gained an average of 12% in the year following periods of mega-cap stock leadership. However, Bank of America also warns that prolonged divergence between market breadth and the index, as witnessed in 2021, has led to market corrections. Goldman Sachs adds that drawdowns following a period of narrowing market breadth tend to be more severe. 

For market breadth to mean-revert without triggering a market correction, bond yields must decrease (or at least not rise) without the economy sliding into recession and dragging corporate earnings down with it. So far, so good. The recent drop in rates has helped bond investors recoup most of their year-to-date losses, but sustaining a winning streak longer than two months has proven difficult.  

Technical outlook on 10-year rates. 

Strategas believes that 10-year rates may decline, driven by a rapid drop in the Economic Surprise Index and a trend of lower highs since April. Historically, as noted by Ned Davis Research, 10-year yields tend to fall before the Fed initiates a new rate-cutting cycle. Raymond James points out that yields have averaged an 85 basis point drop 12 months post-Fed Funds peak, followed by another 101 basis points the year after. Last summer, yields peaked at 4.1% and ended June at 4.4%. If these trends hold, Raymond James predicts a decline to about 3.3% this summer and around 2.25% by summer 2025. However, current yields have not yet fallen to levels typically seen during economic downturns. 

The stability of credit spreads suggests no urgent action is required.  

The stability of credit spreads also suggests the Fed need not act urgently. Apollo reports that investment-grade and high-yield rates have remained around 5.5% and 8.0%, respectively, for the past year, even amidst a new default cycle following the Fed's rate hikes. Recently, some stress has emerged in lower credit quality, with CCC bond spreads widening at the end of June. While there's slight deterioration in spreads between AAA and BBB-rated bonds, this change is minimal, and the S&P 500 appears unfazed. It’s worth keeping an eye on, but it hasn’t significantly impacted the market yet. 

Economic signals are sending mixed messages. 

The credit market reflects broader economic trends, showing some cracks but not enough to alter market trajectories. According to the ISM Purchasing Managers Index, U.S. manufacturing has been contracting since March, and the services sector also slipped into contraction territory in June. However, indicators based on survey data can sometimes be misleading. For instance, the Conference Board’s Leading Indicators Index is sharply down, suggesting a potential recession, but the Coincident Indicator has been rising since April 2020, failing to confirm this recession prediction. A recent Wall Street Journal survey puts the likelihood of a recession in the next year at just 28%. 

Employment remains a key recession indicator. 

Employment will likely be the final arbiter of recession timing. The U.S. added 206,000 new jobs in June, but prior months saw downward revisions. Bloomberg reports that Q2 saw the fewest job additions since the pandemic's peak in 2020, with the unemployment rate rising above 4% for the first time since November 2021. This rise is attributed mainly to an influx of 4 million workers over the past two years rather than companies reducing hiring plans. The Beveridge curve suggests job openings may be nearing an inflection point that could push unemployment higher. Although job openings peaked in early 2022 at 12.2 million, they unexpectedly rose to 8.14 million in May. 

Consumer spending remains steady. 

Slower job growth could impact consumer spending, but for now, that doesn’t appear to be the case. Apollo notes that wealthy Americans account for a significant portion of spending, with the top quintile responsible for 39% of all consumer expenditure. A recent report produced by Rosenberg Research underscores that high-income consumers drive major spending fluctuations. Currently, affluent consumers seem undeterred, as evidenced by Apollo who noted that a record number of Americans are planning foreign vacations in the next six months. This K-shaped recovery indicates that while lower-income earners may face challenges, the wealthy continue to fuel economic growth.

News on inflation reveals a mixed bag. 

The news on inflation is generally positive, with Core CPI cooling to its slowest pace since 2021. Supercore CPI, which excludes housing from Core Service CPI, has shown consecutive monthly declines of -0.05% and -0.04%. However, inflation remains a work in progress, as the June U.S. Producer Price Index came in higher than expected. According to Apollo, a significant gap is forming between mean and median longer-term inflationary expectations, which could present a major challenge for the Fed. Inflationary expectations for the bottom 33% of households have spiked dramatically higher than those for the top 33%, complicating the Fed’s ability to cut rates when these expectations are not under control. 

The Fed continues its tightrope walk. 

The Fed finds itself in a tough position. Inflation and job growth are slowing, but only gradually. Historically, major rate cuts have followed economic crises, but current conditions suggest only minor adjustments are warranted. Strategas warns against maintaining policy rates near 5.5% for too long, especially as nominal economic growth lingers around 5% or less. While financial conditions remain loose, driven by strong equity and credit markets, this could change rapidly. The Fed is acutely aware of the risks associated with prolonged high rates. 

The political landscape adds complexity to economic policy.  

The Fed’s dot plot has been effective in predicting the range of potential outcomes for the Fed Funds rate at the end of 2024. In March, the median dot forecasted three 25 basis point cuts in 2024, while financial markets were pricing in six or more. After the June meeting, the median dot called for just one 25 basis point cut by year-end, with the spread between the lowest and highest dot narrowing to 50 basis points. Chairman Powell indicated that either one or two cuts were plausible. 

Strategas notes that rate cuts with current unemployment and inflation levels are rare, especially with unemployment below 4%. However, with the unemployment rate now above 4% and higher interest rates pushing government debt interest costs to over 17% of tax revenue, the Fed is motivated to cut rates. 

While the debate over when the Fed will cut rates is significant, the June 27th debate between President Biden and former President Trump captured the most media attention last week. Set earlier in the campaign than usual, the debate aimed to help Team Biden reset and shift voter focus away from Biden’s age, but it had the opposite effect. In both polls and betting markets, Biden’s re-election odds plummeted after the debate and have yet to recover. 

Though details of Trump’s future economic platform are limited, lower taxes, reduced immigration, and higher tariffs are generally anticipated. According to Bridgewater, federal revenue is expected to decrease under a Trump administration, in contrast to an expected increase with Biden. Both Trump and Biden are likely to raise spending, although Trump may be slightly less extravagant. Overall, Bridgewater predicts the deficit will rise under Trump while remaining relatively unchanged under Biden. 

Neither Trump nor Biden is likely to address the concerning rise in U.S. federal debt as a percentage of GDP or the urgent need to rein in the budget deficit, which the Congressional Budget Office recently revised higher, forecasting a continued annual deficit around $2 trillion for at least the next five years. However, the market may respond. Following Biden’s poor debate performance, bond yields caught investors’ attention, with 10-year yields rising nearly 20 basis points over the subsequent two trading days. Apollo notes that the increasing U.S. debt is playing a more significant role in determining yields, highlighting a recent divergence between the decreasing time until the market expects the Fed to cut rates and the 10-year Treasury yield. As noted earlier, 10-year yields do not seem to reflect an imminent Fed cut, suggesting either that a cut isn't forthcoming or that other factors are influencing bond yields. 

In the long term, Apollo's observations may prove prophetic, but we expect the Fed to have a more immediate influence on market direction. The Fed is seemingly striving to maintain balance in what Apollo has termed an unstable equilibrium. We think the lagging effects of Fed rate hikes are beginning to show cracks in the economy, and the Fed must be cautious to avoid triggering a hard landing. Conversely, overly accommodative financial conditions could lead to a resurgence in growth and a second wave of inflation. 

This dilemma is reflected in recent headlines: “Why Higher Rates Are Replacing Inflation as the Thing to Hate” in the New York Times and “Americans Really Hate Inflation, and That’s a Big Problem for the Fed” in the Wall Street Journal. The Fed is expected to cut rates this year, which could be beneficial for stocks and potentially broaden the market rally. The discussion will then shift from the timing of rate cuts to the magnitude of those cuts. Unless a crisis arises, the economy is too robust for drastic reductions. While inflation is trending in the right direction, it remains volatile month to month. 

Bond yields may rise once the Fed begins cutting rates, but the long-term downward trend appears to be over. As Apollo recently noted, factors such as deglobalization, immigration restrictions, the energy transition, increased defense spending, and higher government debt are all inflationary, contributing to sustained higher rates. A Republican sweep with Donald Trump as President is unlikely to alleviate this situation; rather, it could exacerbate it. 

Bridgewater points to a significant negative shift in investment returns in the 2020s compared to the previous decade. While growth remains relatively strong and AI may serve as a long-term driver, most other factors have shifted from tailwinds to headwinds. This doesn’t mean investors won’t find promising opportunities; it just means they will need to be more diligent.