In Short

• July saw a notable shift in market focus from large-cap technology stocks to more cyclical, domestically oriented small-cap stocks
• Significant geopolitical events, including the withdrawal of Joe Biden from the presidential race and increased uncertainty as to Donald Trump’s election chances, also contributed to market volatility and shifts in investor sentiment
• Despite strong performance earlier in the year, commodities pulled back while cooler inflation data resulted in the Treasury yield curve steepening and nearing a potential "un-inverting"
• The Federal Reserve (Fed) held rates steady in July but signaled potential rate cuts in the future; upcoming CPI and nonfarm payrolls reports could be critical in determining their next steps in September
• While we do not view recent data as indicative of a near-term recessionary scenario, we continue to expect at least two to three rate cuts this year and encourage thoughtful capital deployment, particularly as it relates to lengthening duration for cash and short-term fixed income assets

A Big-to-Small Rotation

So much can change in a month. In last month’s Markets Score, Elections Roar commentary, our focus was on mega-cap technology stocks as market leaders with index concentration an ongoing risk. We also highlighted the U.S. presidential election as a source of potential volatility as November approached. In a period of roughly 30 days, the nation witnessed the attempted assassination of the Republican nominee and former president, and the subsequent withdrawal of the Democratic nominee and current president, among other significant geopolitical events. Even before these political shockwaves occurred, the first negative month-over-month inflation read, which further solidified expectations for a September start to the Federal Reserve (Fed) easing rates and shifted market leadership away from larger growth stocks and into more cyclical areas. This rotation was reinforced by the “Trump Trade” and uncertainty surrounding Joe Biden’s candidacy as various Democratic leaders urged him to step aside. As a result, domestically oriented small-cap stocks, represented by the Russell 2000 Index, returned 10.2% in July. Small-cap value stocks benefitted even more, up 12.2%.

The concept of a “Trump Trade” originated after the 2016 election and reflects the idea that his platform of less regulation, lower taxes, limited immigration and higher tariffs could benefit certain areas of the market. During his term, small caps outperformed large caps, energy stocks outperformed the broader S&P 500 Index, and the 10-year Treasury yield rose. With the probability of a Trump reelection peaking at 66% in July, many speculated that the Trump Trade would reemerge. The question is whether the trend will continue beyond July, as the expectation of potentially strong Republican gains has been hindered by the pivot to Vice President Kamala Harris on the Democratic side of the ballot. Since Harris became the presumptive nominee for her party, betting markets and early polls have shown a much closer race.

The extent of the rotation in July was notable in our view, with the Russell 2000 Index outperforming the S&P 500 Index by 9%—its best month of relative outperformance in nearly 25 years. Despite its strong one-month performance, the Russell 2000 Index is still below its November 2021 all-time high. Meanwhile, the S&P 500 Index has set 38 new record highs so far this year (including seven in July). Other market trends reversed during the month as the top 10 stocks in the index detracted from index returns (-0.75%). Meanwhile, the bottom 490 stocks contributed +1.97%, making up for the losses added by the largest companies in the index for an S&P 500 Index total return of 1.22%. In June, we mentioned the S&P 500 Index market cap-weighted index outperforming the equal-weighted index for the year, with the equal-weighted negative in the second quarter. This trend also reversed in July, with the equal-weighted index outperforming the S&P 500 Index at the highest level since 2021. With so much focus on the strength of mega-cap technology stocks this year, we believe investors are relieved to see the broadening of market performance.

It is important to note that despite equity price action signaling a cyclical upswing, commodities pulled back in July, giving back gains seen earlier in the year. Commodities were the second-best performing asset class year-to-date only two months ago and this type of decrease typically implies a cyclical downswing, counteracting the strong performance in small-cap equities, and further calling into question whether the rotation will continue.

Looking ahead, we believe there is a higher hurdle for earnings this quarter, with over half of S&P 500 Index companies reporting through July. At the end of June, the expected blended earnings growth rate for the index was +8.9%, which if it holds, would mark the highest level of growth since 4Q 2021 (+31.4%) and the fourth consecutive quarter of year-over-year earnings growth. Results have been mixed so far, but the blended rate has been better than expected through July at +10.9%. A handful of the major technology companies reported last month, with names like Alphabet and Meta beating estimates due to artificial intelligence tailwinds, while Microsoft struggled due to disappointing cloud results. The remainder of earnings season, with the major retailers set to report in August, may provide insights into how companies and consumers are faring in the face of higher interest rates and economic concerns.

Cooler inflation data held down fixed income yields, with two-year yields dropping at a faster rate than 10-year yields. Investors usually keep an eye on the shape of the Treasury yield curve because it may reveal market expectations on monetary policy and the economy. The Treasury yield curve has been inverted (meaning shorter-term yields are higher than longer-term yields) for almost two years now. Typically, an inverted yield curve is an indicator of a recession, but with growing expectations of a September rate cut amid a resilient U.S. economy, the yield curve has steepened and is close to “un-inverting.”

Fed Holds Steady but Stands Ready

Though the Fed held rates steady during its July meeting, the strength of the U.S. economy alongside cooling prices bolstered its confidence that inflation can sustainably move towards its long-term 2% target, opening the door to a potential rate cut in September. Chair Jerome Powell did not commit to the number nor cadence of interest rate cuts for the remainder of the year, but he did note that the Fed’s inflation and employment mandates have moved into better balance and that a rate cut is “on the table” for the next meeting. Growth remains strong with Q2 GDP posting a 2.8% annualized rate, outpacing expectations. However, shortly after the Fed meeting, the July ISM Manufacturing index missed expectations, contracting for the fourth consecutive month for its lowest reading since November, and sending the U.S. 10-year Treasury yield below 4%. The labor market has remained sturdy this year, though a miss for nonfarm payrolls in July and an uptick in initial jobless claims have raised questions about whether that has changed.

While we anticipated that the narrative would shift from inflation to growth in 2024, the first three months of the year created a difficult situation for the Fed as inflation reports pointed to a potential reacceleration. With disinflation now seemingly back on track, we believe the risk to the Fed’s other mandate—maintaining maximum employment—is likely to dominate, particularly if economic data begins to point to a deceleration of economic growth past the point of a soft landing. In terms of next steps, we believe the next CPI and nonfarm payrolls reports, along with the July PCE release, will be critical in delivering the confidence the FOMC needs to begin cutting rates. Following July’s job report, rates markets are pricing in four rate cuts before the end of the year. While we are not anticipating that recent data is indicative of a near-term recessionary scenario, we do continue to expect at least two to three interest rate cuts this year and, as a result, encourage thoughtful capital deployment, particularly as it relates to lengthening duration for cash and short-term fixed income assets. This is especially true after witnessing the recent drop in yields in response to economic data and with interest rates likely set to decline during the remainder of the year.

Meanwhile, other central banks have already begun to make policy changes. The day after the Fed meeting, the Bank of England lowered its key rate for the first time since 2020. The move by central banks to cut interest rates was first kicked off by the Swiss National Bank in March, followed by the European Central Bank in June. The Bank of Japan remains the outlier, raising interest rates in July after abandoning its loose monetary policy in April.

All things considered, we continue to emphasize the importance of diversification, both across asset classes and active-versus-passive vehicles, to provide better risk-adjusted return potential and downside protection. We favor active fund managers with demonstrated investment processes, which seek to invest in quality companies. In our view, this approach emphasizes stability and resilience, aiming to insulate assets from unpredictable swings in the market while positioning for sustainable long-term growth.

Portfolio Implications

Equities were generally higher, with small caps outperforming large caps and value outperforming growth. We maintain an at-target overall view across equities, with an overweight to small caps, a sector that had priced in a hard-landing scenario, as we anticipate further broadening of equity-market performance. Within equities, we still favor lower-beta, higher-quality names, with an at-target view on value versus growth. In this more challenging environment, we also favor employing active management to select companies with high earnings visibility.

Fixed Income was higher as yields fell, with longer-duration bonds gaining more than short duration. We continue to favor credit markets, maintaining an overweight view on investment grade securities, reflecting a general bias towards quality. We maintain an underweight view on cash, preferring to lock in yields in anticipation of a decline in cash rates. We maintain an at-target view on high yield debt, given the recent tightening of spreads (yield advantage over Treasuries), which has reduced the risk-adjusted return potential of the asset class.

In a challenged fundraising, exit, and financing environment, we believe significant opportunities exist within Private Markets for firms and strategies that can act as liquidity and solutions providers to help close the capital supply/demand gap and support value-added transactions. This backdrop, along with Neuberger Berman’s deep relationships and unique position within the private equity ecosystem, has translated into record levels of deal flow across our platform. We continue to see potentially compelling opportunities across secondaries, co-investments, private credit and capital solutions. We are cautious on core private real estate, but this is offset by what we see as abundant market-dislocation opportunities in the value-add and opportunistic sectors, and particularly in real estate secondaries.

Index Returns as of July 2024

Source: Bloomberg, total returns as of July 31, 2024. S&P 500 Index is represented by S&P 500 Total Return Index. Nasdaq Composite NASDAQ-Composite Total Return Index. Dow Jones is represented by Dow Jones Industrial Average TR. Large Cap is represented by Russell 1000 Total Return Index. Mid Cap is represented by Russell Midcap Index Total Return. Small Cap is represented by Russell 2000 Total Return Index. All Cap is represented by Russell 3000 Total Return Index. Large Cap Growth is represented by Russell 1000 Growth Total Return. Large Cap Value is represented by Russell 1000 Value Index Total Return. Small Cap Growth is represented by Russell 2000 Growth Total Return. Small Cap Value is represented by Russell 2000 Value Total Return. ACWI is represented by MSCI ACWI Net Total Return USD Index. ACWI ex US is represented by MSCI ACWI ex USA Net Total Return USD Index. DM Non-U.S. Equities is represented by MSCI Daily TR Gross EAFE USD. EM Equities is represented by MSCI Daily TR Gross EM USD. Cash is represented by ICE BofA US 3-Month Treasury Bill Index. U.S. Aggregate is represented by Bloomberg US Agg Total Return Value Unhedged USD. Munis is represented by Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD. Munis Short Duration is represented by Bloomberg Municipal Bond: Muni Short (1-5) Total Return Unhedged USD. Munis Intermediate Duration is represented by Bloomberg Municipal Bond: Muni Intermediate (5-10) TR Unhedged USD. Investment Grade is represented by Bloomberg US Corporate Total Return Value Unhedged USD. High Yield is represented by Bloomberg US High Yield BB/B 2% Issuer Cap Total Return Index Value Unhedged USD. Short Duration is represented by Bloomberg US Agg 1-3 Year Total Return Value Unhedged USD. Long Duration is represented by Bloomberg US Agg 10+ Year Total Return Value Unhedged USD. Global Aggregate is represented by Bloomberg Global-Aggregate Total Return Index Value Unhedged USD. EMD Corporates is represented by J.P. Morgan Corporate EMBI Diversified Composite Index Level. EMD Sovereigns – USD is represented by J.P. Morgan EMBI Global Diversified Composite. Commodities is represented by Bloomberg Commodity Index Total Return. Commodities ex Energy is represented by Bloomberg Ex-Energy Subindex Total Return. U.S. 10-Year Yield is represented by US Generic Govt 10 Yr.