Markets are on edge. The slightest economic tremors trigger seismic waves of fear or exuberant relief rallies, highlighting the market’s capricious nature. The recent deflation of the artificial-intelligence bubble adds to the confusion, leaving many investors scratching their heads over seemingly inexplicable stock movements.
Yet, beneath the surface, two distinct themes are emerging. The market’s focus has shifted from inflation to economic growth, marking a potential paradigm shift. Simultaneously, previously overlooked stocks are outperforming the market’s former darlings, buoyed by the prospect of impending Federal Reserve rate cuts.
The critical question for investors is whether these shifts will persist.
“The market is attempting to chart the course ahead and is exploring the possibility of a regime change,” observes one expert. However, they caution, “a majority still anticipates a soft landing, and the data seems to support that view.”
These two emerging themes are rooted in logic. The change in focus to economic health occurred as inflation appeared to be contained while the job market showed signs of weakness. The Fed’s concerns have pivoted from excessive growth to insufficient growth, and the specter of recession has begun to loom, albeit from a very low starting point.
“Six months ago, the risk of recession was negligible,” notes another seasoned investor. Now, they acknowledge a potential risk that weakness among lower-income households could ripple through the broader economy.
The markets are exhibiting heightened sensitivity to economic indicators, a reflection of investors’ acute awareness of the delicate balance required for a soft landing.
This week, slightly weaker-than-expected manufacturing data triggered another reassessment of the outlook, sending stocks tumbling and the 10-year Treasury yield plummeting. Such dramatic moves in Treasuries have become commonplace lately but were once reserved for major shocks. For context, there was only one drop of this magnitude in the entire year of 2018.
The focus on economic weakness is also evident in the altered relationship between stocks and bonds. During the inflation-centric era, positive economic news was generally perceived as negative for stocks, as it implied upward pressure on prices and the likelihood of higher interest rates from the Fed.
Now, positive economic news is welcomed by stocks, as it alleviates concerns about growth, and rate cuts are already anticipated. The inverse is also true: negative economic news now casts a shadow over stocks.
Consequently, the year-long correlation between the S&P 500 and 10-year Treasury yields has reversed. Stocks and bond yields now exhibit a slight tendency to move in tandem, a departure from their previous inverse relationship.
Declining yields are partly responsible for the resurgence of unloved stocks, the second prominent theme. Since the Juneteenth holiday, which marked the last peak for AI superstar Nvidia, inexpensive “value” stocks have significantly outpaced growth stocks. The Russell 1000 value index has gained 5%, while its growth counterpart has declined by 4%, although this only partially reverses the impressive gains for growth earlier in the year. The average S&P stock has also comfortably surpassed the index, after lagging behind in the first half of the year.
The reversal also extends to the best- and worst-performing sectors. Technology and communication services, once at the top, have slid to the bottom, while highly leveraged real estate has ascended from worst to best, thanks to falling Treasury yields.
However, the market’s narrative isn’t without its inconsistencies. Banks performed well in both periods, benefiting from the steeper yield curve as longer-dated bond yields fell less than shorter-dated ones. Utilities were aided by lower yields but also received a boost from the surge in electricity demand for AI processing. And mundane consumer-staples stocks, typically favored in a weak economy, outperformed the more exciting consumer-discretionary sector in both periods.
Smaller companies are also defying the trend. They haven’t reaped the benefits of lower bond yields, despite carrying more debt. Furthermore, there has been little differentiation in the performance of small growth and small value stocks.
The prevailing sentiment suggests that the market will remain hypersensitive to signs of economic weakness, even after the Fed initiates rate cuts, as the risk of recession will linger for some time. The sustainability of the value stock resurgence is less certain. After all, for over a decade, no value rebound has managed to endure.
