July 2024 Market Commentary

Navigating the markets has always been challenging, but July presented unique complexities. We witnessed the early stages of a potential regime shift within the S&P 500, as investor sentiment appeared to be transitioning from the dominant "Magnificent Seven" tech giants to the other 493 companies in the index. For a significant period, these mega-cap tech stocks were buoyed by enthusiasm around AI and its transformative potential. However, as we approached a critical juncture in earnings season, questions arose about the sustainability of this momentum. It became evident that some investors may have been too complacent, as they assumed that the massive investments in AI infrastructure over the past 18 months would seamlessly translate into profits. The market's dynamics in July suggested that the answer was not so straightforward.

As the year's second half began, uncertainties surrounding AI capital expenditures and the broader economic outlook came to the forefront. Pivotal earnings reports from Microsoft, Meta, Amazon, Apple, and AMD were crucial in determining whether the market's narrative would shift. Would the earnings of the broader S&P 500 align with expectations of acceleration, or would doubts persist? This month’s commentary provides an overview of July's key events, including the Jobs Report, Inflation Report, market volatility, and our outlook on the economy and the stock market for investors.

In July, the U.S. labor market showed clear signs of slowing down, reinforcing the view that the economy may be approaching a stalling point. Hiring and wage growth continued decelerating, with the unemployment rate ticking to its highest level since late 2021. According to the Bureau of Labor Statistics, nonfarm payrolls rose by 206,000 in June, slightly surpassing economists' expectations of 190,000. However, revisions to job growth in April and May revealed a downward adjustment of 111,000 jobs, signaling a more subdued labor market than initially thought.

At first glance, adding 206,000 new jobs might seem like positive news, but the underlying details tell a different story. The unemployment rate rose to 4.1%, marking the first time it has exceeded 4% since 2021. Moreover, average hourly earnings increased by 3.9% year-over-year in June, the smallest gain since 2021. These figures suggest that while the labor market is not collapsing, it is certainly leveling off, which many investors interpreted as a sign of relief. A cooling jobs market, as opposed to an overheated one, offers the Federal Reserve more flexibility in setting monetary policy without the immediate pressure to raise interest rates further.

The data from July also pointed to a growing number of people struggling to find new employment. Recurring applications for jobless benefits rose for the ninth consecutive week, the longest stretch since 2018, indicating a softening demand for labor as the economy slows under the strain of higher borrowing costs. Continuing claims reached 1.86 million in the week ended June 22, the highest since November 2021, while first-time claims increased to 238,000. Additionally, U.S. based employers announced 48,786 job cuts in June, the highest number for any June since 2009, excluding the pandemic year of 2020. These scattered signs of companies reducing headcounts due to cost-cutting and softer economic conditions further underscore the labor market's challenges as we move into the second half of the year.

Jobs weren't the only thing cooling in July, as U.S. inflation also decelerated significantly, marking the slowest pace since 2021. This was largely driven by a long-awaited slowdown in housing costs, which sent the strongest signal that the Federal Reserve may soon consider cutting interest rates. According to the Bureau of Labor Statistics, the core consumer price index (CPI), which excludes volatile food and energy prices, rose by just 0.1% from May, the smallest increase in three years. Meanwhile, the overall CPI saw its first decline since the onset of the pandemic, thanks to a drop in gasoline prices. Like the May CPI report, which Fed Chair Jerome Powell described as "really good," the June data bolstered the Fed's confidence that inflation is finally under control, making a rate cut more likely in the coming months.

Shelter prices, the largest component of services within the CPI, increased by only 0.2%—the smallest gain since August 2021. Owners' equivalent rent, a critical subset of shelter costs, rose by 0.3%, the most modest increase in three years. Additionally, other service costs such as airfares, hotel stays, and inpatient hospital care all saw declines from the previous month. At the same time, prices for new and used vehicles led to broader decreases in the core goods basket. Despite these positive developments, U.S. consumer sentiment unexpectedly dipped to its lowest level in eight months in early July. According to the University of Michigan's preliminary reading, the sentiment index fell to 66, down from 68.2 in June. High prices continue to weigh heavily on Americans' perceptions of their financial health and the broader economy, with nearly half of consumers voicing concerns that rising costs are eroding their living standards—a frustration level that matches the all-time high reached two years ago.

In contrast, the Federal Reserve's preferred measure of underlying inflation, the core personal consumption expenditures (PCE) price index, rose at a subdued pace of 0.2% from May. Core PCE increased by 2.6% year-over-year, with the three-month annualized rate cooling to 2.3%, the lowest since December. This report provided encouraging evidence that the Fed's tightening campaign is working its way through the economy without inflicting significant damage. However, the personal saving rate fell to 3.4%, the lowest since December 2022, suggesting consumers may have less capacity to sustain current spending levels in the coming months.

With both the jobs and inflation data trending toward the Fed's targets, Chair Jerome Powell indicated that an interest rate cut could come as soon as September. At its July meeting, the U.S. central bank voted to keep its benchmark rate at the highest level in over two decades. Notably, policymakers made subtle yet significant adjustments to their post-meeting statement, signaling they are moving closer to reducing borrowing costs. The committee shifted its language to express attentiveness to "the risks to both sides of its dual mandate" rather than focusing solely on inflation risks. The statement acknowledged progress toward the 2% inflation objective and noted that the risks to achieving employment and inflation goals are becoming better balanced. While the Fed acknowledged that job gains had moderated and unemployment had ticked up, they also held the cautious stance that lowering borrowing costs would not be appropriate until there was "greater confidence" that inflation was sustainably moving toward their target.

While the economic data largely met expectations, Big Tech earnings delivered a sobering reality check, falling short of the lofty expectations set by investors. The much-anticipated megacap earnings season highlighted growing concerns that the artificial intelligence frenzy, which had been a major driver of the bull market, might be overblown. As a result, the S&P 500 experienced its worst day since December 2022, and the Nasdaq 100 tumbled over 3.5%, with significant losses in the tech sector. Alphabet Inc. slid 5% after its AI-driven spending exceeded analyst forecasts, while Tesla Inc. saw its stock plummet 12% following a profit miss and a delay in its Robotaxi project.

Investors are beginning to realize that the massive investments in AI are currently more of an expense than a revenue generator. After leading the rally in 2024, big tech companies have hit a wall, prompting traders to rotate out of megacaps into other parts of the market, fueled by bets on future Fed rate cuts and doubts about the near-term profitability of AI Among S&P 500 companies that reported results, profits beat analyst estimates by the smallest margin since late 2022, and sales surprises were the worst in at least two years.

The top tech giants—Microsoft, Alphabet, Amazon, and Meta—have collectively invested over $150 billion in capital expenditures over the last four quarters, much of it focused on AI infrastructure. Despite these investments, the returns have yet to materialize as anticipated. For instance, Microsoft noted that AI services contributed seven percentage points to Azure's 31% sales growth, but without specifying the dollar impact. Similarly, Amazon's AI business has been described as having a "multi-billion-dollar revenue run rate," but with little clarity on actual profitability. Salesforce also faced a reality check when its shares tumbled after projecting the slowest quarterly sales growth in its history despite its heavy promotion of AI.

The broader picture reveals that generative AI adoption is moving slower than expected. Only 1 in 4 companies have successfully launched AI initiatives in the past year, and just 63% plan to increase AI spending, down from 93% in 2023. Alarmingly, 42% of companies have yet to see significant returns on their AI investments. This data underscores the challenges in AI implementation—costs are higher than anticipated, data security concerns have more than doubled, and issues with response accuracy have increased fivefold. Many companies feel pressured to adopt AI quickly to stay competitive. Still, this rush often leads to poorly planned initiatives, highlighting the paradox that while AI holds enormous potential, its path to profitability is fraught with challenges.

As we close out July, it's clear that the U.S. economy continues to defy expectations with its resilience. The second quarter saw GDP growth surpass forecasts, with an annualized rate of 2.8%, driven largely by strong personal spending. However, while this uptick is encouraging, it also reflects a broader moderation compared to the more robust figures of last year. The persistent pressure of high interest rates has begun to temper consumer spending and overall economic activity, contributing to a gradual cooling of inflation.

The latest data from The Conference Board’s Leading Economic Index (LEI) also signals caution, with a 0.2% decline in June, continuing a downward trend that has characterized the first half of 2024. Although the pace of contraction has slowed, the LEI's trajectory suggests that economic momentum may continue to wane in the coming months. Cooling consumer spending is expected to further drag on GDP growth, potentially bringing it down to around 1% in the third quarter.

Considering these developments, it's an opportune moment for investors to reassess their portfolios and consider their current risk levels. The economic landscape remains complex, with both opportunities and challenges on the horizon. As we move into the second half of the year, ensuring that your investments are aligned with your risk tolerance and long-term goals is more crucial than ever. A balanced approach, with a keen eye on market conditions, will be key to navigating the uncertainties ahead.