Calm waters disrupted

Equity volatility increased
Small-caps vs. large-caps
Beyond the political noise

The market's spotlight expanded last month to include the evolving political landscape. However, the shift in the US presidential election matchup wasn't the only notable development; a significant rotation within the stock market also drew considerable attention. Stocks saw wide swings throughout the month, beginning with an early month rally that pushed U.S. markets to new highs, followed by a decline toward month-end, primarily driven by weakness in the tech sector. Investors concerned about the recent stock pullback are hoping the upcoming earnings season will provide a boost to their enthusiasm.

As a result, developed markets’ equities (measured by MSCI World index) have risen 0.79%, while emerging markets’ equities (measured by MSCI Emerging Market index) declined 0.66%. During the same period yields on bonds have decreased, with 10-year US Treasury bond yields declining to 4.03% from 4.41% a month ago, while German 10-year Treasury bond yields decreased to 2.3% from 2.49% a month ago.

Equity volatility increased

The recent downturn in the stock market has made headlines and sparked some nervousness among investors. It's reasonable to anticipate that some weakness may persist as market participants navigate election uncertainties, upcoming quarterly earnings reports, and potential central bank actions influenced by the ongoing balance between high but decreasing inflation and positive but slowing economic growth. Meanwhile, the VIX Index¹, commonly known as Wall Street’s “fear gauge,” has risen to its highest levels since April. This surge in the VIX reflects heightened investor concern, similar to when equity indexes experienced this year's first correction in April, marked by at least a 5% decline.

In July, equity market indexes displayed some weakness, but there are two key aspects to this pullback. First, the decline comes from an all-time high, with the stock market still up more than 13% year-to-date. Second, the dip is largely driven by weakness in big tech stocks, which have been among the significant outperformers this year. At this stage, this decline does not appear to be a broader market downturn. It may instead reflect the profit-taking activity in the stocks of the biggest gainers rather than being driven by new risks or concerns about the underlying fundamentals.

Chart. CBOE Volatility Index (VIX)

Source: Investing.com

Small-cap stocks surge amid market rotation

Last month saw a notable shift with a resurgence in small-cap stocks. After spending much of 2024 relatively stagnant, small-caps surged, with Russell 2000, a key benchmark for this market segment, notably outperformed, rising more than 10%. This outperformance suggests a potential shift in market leadership towards more economically sensitive investments, as the prospect of easier Fed policy boosts these segments. The second-half consensus earnings estimates for small-caps are healthy, but their realization will depend on the economy demonstrating resilience in the coming quarters. Conversely, signs of slowing growth or a less favorable stance from the Fed could hinder this progress. For context, small-caps rallied 27% in November and December of 2023 amid growing signs of economic resilience, but that rally dissipated as persistent inflation dashed hopes for a spring Fed rate cut. Sustained evidence of a soft landing will be crucial for maintaining this momentum.

Political violence during July

The major political events leading up to November’s presidential election have been nothing short of extraordinary. From Biden’s debate performance to Trump's guilty verdict and rise in the polls following the assassination attempt, this election is shaping up to be unprecedented. Despite these jarring events, the equity markets for the most part have remained mostly calm. Finally, in a surprising announcement, President Joe Biden stated that he will not seek reelection in November as the Democratic nominee, endorsing Vice President Kamala Harris for the nomination. This decision comes amid increasing pressure from Biden’s Democratic allies to step aside following the June debate. This latest twist in the political landscape adds potential uncertainty to the final outcome of the U.S. election. However, the stock markets reacted relatively calmly to the news, and this market response suggests that investors do not anticipate significant policy changes from the forthcoming Democratic nominee. Meanwhile, Donald Trump remains the favorite to win the election according to polls, though his odds have decreased following the recent developments.

Market view

Despite the flow of political news, we remain in generally early days of the presidential election process, significant developments and changes in the election process are still expected as these major events approach. While there may be shifts in polling and news ahead, most probably markets will continue to be driven by the fundamentals rather than the political headlines. We continue to see a macroeconomic environment where economic growth is cooling but remains positive, inflation appears to be easing, and the Fed looks poised to lower interest rates in the back half of the year. Regarding fundamentals, the markets will have to digest the upcoming corporate earnings reports. Healthy profit growth across various sectors could broaden market leadership in the coming months and potentially extend the current bull market.

1 The Cboe Volatility Index (VIX) is considered by many to be the world's premier barometer of equity market volatility. The VIX Index is based on real-time prices of options on the S&P 500 Index and is designed to reflect investors' consensus view of future (30-day) expected stock market volatility. The VIX Index is often referred to as the market's "fear gauge" (cboe.com).

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