Markets experienced significant shifts across various asset classes in July. Small cap equities outperformed large cap stocks, driven by lower-than-expected inflation data that spurred expectations of a Federal Reserve rate cut in September. The Russell 2000 Index gained 10.2%, significantly outpacing the S&P 500. Interest rate-sensitive sectors such as real estate, financials, and utilities posted strong gains, while growth sectors like communication services and IT saw declines.
Internationally, developed markets performed positively, with Japan benefiting from a yen rally following the Bank of Japan’s rate hike. However, emerging markets, particularly Taiwan, faced challenges due to semiconductor industry concerns and geopolitical tensions. China remained subdued, with economic weakness and underwhelming government responses.
In fixed income, lower inflation and cooling labor markets supported gains, with longer-duration securities outperforming. High-yield bonds remained positive, though leveraged loans lagged.
Real assets generally outperformed broader markets, with U.S. real estate and infrastructure leading gains. However, energy prices declined due to economic slowdown concerns, despite increased drilling efficiencies in North America.
The domestic equity markets experienced a forceful rotation in July. Small caps posted their third best month relative to large caps since the inception of Russell indices in 1979. The Russell 2000 Index gained 10.2%, outpacing the S&P 500 by almost 900 bps. Similarly, value stocks posted their eighth best month relative to growth stocks, with the Russell 3000 Value Index returning 5.5%, outpacing its growth counterpart by roughly 670 bps.
The catalyst for this market shift occurred on July 11, with the release of the Federal Reserve’s June inflation report. With inflation coming in cooler than expected, markets began pricing in a higher probability of a Fed rate cut in September. Small caps, which carry greater leverage and have more exposure to floating debt than their large cap counterparts, are much more sensitive to prevailing rates – and were therefore the greatest beneficiaries. Likewise, value stocks benefited relative to growth stocks following the news.
Interest rate sensitive sectors, such as real estate (+7.8%), financials (+7.1%), and utilities (+7.0%) posted the strongest gains for the month. On the other hand, communications services (−3.5%) and IT (−1.9%) were the only two sectors to post drawdowns.
Developed non-U.S. markets returned 2.9% in July. The U.K. (+4.2%) experienced continued positive momentum, as investors responded favorably to the Labour Party’s victory in the general election, and economic growth surprised to the upside in the second quarter. Returns in continental Europe trailed slightly (+2.1%), amidst continued political uncertainty in France and softer economic data in the euro area. In Japan (+5.8%), currency movements were a double-edged sword. The yen rallied nearly 7% vs. the U.S. dollar, as the Bank of Japan hiked its policy rate to its highest level in over 15 years. Yen appreciation, and the potential impact on the export market, triggered weakness in equity markets (−1.0% in local terms), but U.S.-based investors reaped the benefits of the currency’s strength.
Emerging markets (EM) equities (0.3%) were weighed down by a sell-off across the semiconductor industry. In addition to concerns over the sustainability of AI-related tailwinds, including reports of capacity bottlenecks for advanced chip production, comments by both candidates ahead of the U.S. Presidential election reignited fears of geopolitical headwinds, including an escalation in chip trade restrictions and uncertainty surrounding America’s stance on China and Taiwan relations. The tech-heavy market of Taiwan (−4.3%), home to Taiwan Semiconductor (−4.6%), the largest company in EM, was hit the hardest by this sell-off.
Elsewhere, China (−1.3%) was more muted during the period, but remained challenged due to continued economic weakness and an underwhelming response to its third plenum strategy meeting, during which Party leaders emphasized a long-term focus on high-end manufacturing and upgrading the industrials sector over supporting household consumption and the property market. Policy makers reversed course after second quarter year-over-year GDP growth came in at 4.7% (below the 5% target) and pledged to increase the pace of stimulus measures aimed at boosting domestic consumption. This pledge included a surprise cut to the medium-term lending rate, in addition to planned reductions to the prime lending rate.
Economic data was accommodative for fixed income returns in July, leading to a 2.3% gain in the Bloomberg U.S. Aggregate Index. Inflation readings came in below expectations, and labor markets continued to show signs of cooling. As a result, investors increasingly piled on bets for a September rate cut. The Fed went on to reinforce this view at its July meeting. Despite making no change to policy, the Fed’s statement and subsequent press conference indicated growing comfort among FOMC members for a September cut.
Yields fell during July, especially early. The 2-year yield fell 46 bps month-over-month, while the 10-year yield fell 32 bps, resulting in a steepening of the yield curve and a 2s10s differential of -21 bps. Consequently, longer duration fixed income securities outperformed, while short duration fixed income securities lagged. The 3.6% gain in long Treasuries exceeded the 2.7% rise for Treasuries in the 5-10 year maturity range and the 1.2% increase for those across the 1-3 year maturity spectrum.
Spreads were relatively stable across most sectors, but showed some modest movement in mortgage-backed securities (MBS) and high-yield bonds. In MBS, spreads narrowed 4 bps, contributing to a robust 2.6% return for the sector. Conversely, high-yield bonds saw spreads widen by 5 bps; however, this was largely a function of falling Treasury rates. As such, high-yield bonds continued to post positive performance in the month, returning 1.9%.
Leveraged loans did not fare as well, with the S&P Leveraged Loan Index posting a return of 0.8%. Meanwhile, IG corporates saw strong performance during the month, given their higher duration exposure, with the Bloomberg U.S. Corporate Index posting a return of 2.4%
Real assets generally outperformed broader markets. Global real estate (+6.0%) and infrastructure (+4.4%) rallied in part on increased expectations for a fall interest rate cut, and the market rotation from growth to value. U.S. real estate (+6.2%) outperformed, led by office (+17.1%) and industrial (+12.7%) sectors, while single-family rentals (−2.2%) and lodging (−0.7%) experienced pullbacks.
Although U.S. REITs have risen by 11.1% over the past year and the cyclical sector’s conditions seem to have improved, headlines about distressed assets continue to spread as over-leveraged borrowers encounter loan defaults and maturity issues for properties purchased at higher prices. This trend is partly driven by strong space demand and decreasing financing costs.
Brent crude fell 4.9% in large part due to growing concerns of an economic slowdown. Natural gas was down 12.2%, bringing its year-to-date return to −17.7%. Despite numerous heat waves this summer, increased natural gas production and high storage inventories have led to an oversupplied market. While oil and gas prices have declined, North American natural resource equities were up 3.6%, as domestic oil companies reported increased drilling efficiencies and cost savings, such as Exxon announcing record production in the Permian Basin.
Gold, which is historically a safe-haven asset, was up 4.2% amid a turbulent political backdrop. While precious metal commodities increased 2.7%, general commodities declined 4.0% in the face of disinflationary pressure, with the energy subindex down 7.6% and the industrial metals subindex down 6.8%. ⬛
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