Softer inflation and labour market data from the US heightened expectations of rate cuts, spurring a rotation into small cap stocks and other interest-sensitive asset classes.
July proved to be a volatile month as markets digested a number of notable economic and political developments. A weaker than expected US Consumer Price Index (CPI) reading early in the month, combined with weaker US labour market data, reassured bond investors that the Federal Reserve (Fed) will soon begin cutting interest rates. Investors now expect the first Fed rate cut in September and are currently pricing almost three US rate cuts this year, with around 150 basis points worth of cuts by June 2025.
Against this backdrop, interest-rate sensitive asset classes outperformed. Small-cap returns were up 6.9% over the month, with global REITs posting a healthy 6.0% and the Bloomberg Global Aggregate Bond Index delivering 2.8%.
In contrast, developed equities returned a more muted 1.8% over the month. Growth stocks were particularly weak, falling by 1.0%, as investors grew more sceptical about the potential for future returns from investment in artificial intelligence (AI). Despite the pullback observed throughout the month, growth stocks have returned 16% year to date, contributing to the 14% year-to-date gains in broader developed market equities.
Elsewhere, commodities lost ground, with the broad Bloomberg Commodity Index decreasing by 4.0% over the month. Oil prices contributed to the decline as the market weighed the impact of weaker demand from China against supply issues arising from tensions in the Middle East.
Equities
In the US, earnings season continued with four of the ‘magnificent seven’ reporting results for the previous quarter. Broadly, investors appeared underwhelmed by the releases, resulting in the tech sector coming under pressure for most of July before a rebound into month end. Overall, the S&P 500 gained 1.2% over the month. With over half of S&P companies having reported, more than two thirds have beaten analysts’ expectations, suggesting a resilient US economy is contributing to a broadening of earnings. Concurrently, this year’s laggards played catch up in July, with investors shifting towards small-cap equity stocks, which are more sensitive to interest rate cuts. This shift led to the largest one-month outperformance of the Russell 2000 versus the Nasdaq 100 in over 20 years.
UK stocks outperformed, with the FTSE All-Share rising by 3.1% over the month. Robust service sector PMIs in July, coupled with stronger than expected economic growth for the second quarter, both pointed to improving economic momentum. Markets did not react significantly to the general election, given that a Labour victory was already assumed.
European stocks lagged their US and UK counterparts, with the MSCI Europe ex-UK returning 0.6% over the month. A disappointing Purchasing Managers’ Index (PMI) print, which indicated a slight tempering of eurozone economic growth over the summer, coupled with uncertainties around the French election, likely contributed to the weakness.
The Japanese TOPIX index underperformed last month, falling 0.5%. This decline partly reflected the weakness in global tech stocks, but returns were also pressured by a strengthening yen. Expectations of earlier Fed interest rate cuts, coupled with an interest rate hike from the Bank of Japan led to the yen appreciating by 6.5% versus the US dollar, the strongest monthly move since June 2016.
Chinese equity markets fell last month, due to continued challenges in the real estate sector and the spillover effects on the broader economy. The MSCI China Index fell by 1.2% in US dollar terms. However, Chinese authorities implemented measures to provide liquidity support to the financial system, including cutting the reverse repo rate, a key short-term policy rate, and lowering the benchmark loan prime rate. These efforts aim to stimulate lending and support economic growth amid ongoing market challenges.
Fixed income
In the US, June's soft CPI print and a weakening labour market have heightened investor expectations for Fed rate cuts in 2024 and 2025. This optimism boosted US Treasuries, which gained 2.2% over the month. The rally at the front end of the curve also caused the yield curve to steepen, with the spread between the 10-year and 2-year US Treasury yield reducing to -21 basis points, its narrowest level since January 2024.
In the UK, stronger than expected GDP growth in the second quarter, combined with persistent services inflation, suggests that interest rate cuts may be more gradual compared to the US and Europe. UK Gilts underperformed, returning only 1.9% over the month.
In the eurozone, government bonds in the periphery continue to outperform core bonds as investors seek higher yields in anticipation of further European Central Bank interest rate cuts. Italian and Spanish sovereign bonds returned 2.8% and 2.3% over the month, respectively, with Italy maintaining its status as the top-performing major sovereign bond market year to date.
In Japan, the Bank of Japan continued to normalise monetary policy in July, raising its policy rate by 15 basis points to 0.25% and stating that it will reduce the pace of Japanese Government Bond (JGB) purchases by 400 billion yen per quarter starting in August. Consequently, JGBs were flat over the month.
In the credit market, investment grade (IG) bonds outperformed high yield bonds. The Bloomberg Global Aggregate Corporate Index – which measures the performance of developed market IG bonds – returned 2.4% over the month. In contrast, US high yield bonds returned 2.0% and European high yield bonds returned 1.2% over the same period.
Overall, July was a volatile month in the markets. Softer inflation and labour market data from the US heightened expectations of rate cuts, spurring a rotation into small cap stocks and other interest-rate sensitive asset classes. While we anticipate this sector rotation to continue, there is a risk that bond markets may have moved too quickly. The extent of policy easing implied by current market pricing seems unlikely without a recession. With this in mind, we remain cautious about sustained small-cap outperformance. Instead, we continue to focus on more regionally diversified exposures. Stronger economic momentum and more attractive valuations can be found in areas such as the UK and continental Europe, with the additional benefit of some diversification against US market and political risks.