July rotation puts spin on 2024 market story

What started as a sleepy summer got a wake-up call from a July that reintroduced volatility on several fronts. The S&P 500 pulled back from new record highs to fall into negative territory for the month, then rebounded to end July with a small gain. The tech sector experienced its biggest setback of the year, the November presidential election was reset, and geopolitical uncertainty triggered the biggest one-day move in the oil market since last October.

But the dominant market story was arguably the role reversal experienced by the Nasdaq Composite (COMP) and the Russell 2000 (RUT) as investors pivoted out of tech and into small caps and cyclical stocks. On July 5, the tech-heavy COMP was up nearly 23% for the year, while the small cap RUT was in negative territory. By end of the month, the RUT trailed the COMP by only six percentage points, 17.2% to 11.2%, even though the COMP closed out July with its biggest up day since February.

July may have been the second-strongest month for small caps since October 2022, but Morgan Stanley & Co. analysts were skeptical about their potential to sustain a longer-term rally—noting, among other factors, that the group has historically underperformed following “outsized, tactical rallies.” The strategists favor quality and defensive equities as “nominal growth slows and rates come down.”¹

Despite continued signs of cooling inflation, the Fed left interest rates unchanged on July 31. While the markets are currently anticipating a 0.25% cut at the Fed’s September meeting, Morgan Stanley Wealth Management explains the long-awaited easing cycle contains a risk of potential investor disappointment: “A slow and shallow rate-cutting cycle is apt to foster impatience and frustration.”²

Although the presidential election may have appeared to be turned upside down by President Biden’s decision to drop out of the race, Morgan Stanley & Co. strategists point out this development didn’t alter the Democratic ticket’s policies or their potential impact on the markets.³ And regardless of who wins the election, Morgan Stanley & Co. argues the business cycle will likely have more influence on the stock market than who is in the White House. One example: The cyclical areas of the market widely assumed to be strong during a Trump presidency—and which did, in fact, outperform in 2016 and through part of 2017—were even stronger during President Biden's first year in office.⁴

Bond prices climbed in July as yields retreated from their early-month highs. The benchmark US 10-year Treasury yield fell for the third month in a row (the longest such streak in three years), ending July at 4.05%. Morgan Stanley & Co. notes that over the past 35 years, August and September have historically been tougher months for riskier assets such as stocks and corporate bonds. US high-yield bonds, for example, lost about 1% relative to government bonds during August-September.⁵

Insight of the month: Rise of the machines. Large Language Models and Generative AI may be triggering a futuristic inflection point, according to Morgan Stanley & Co. analysts. By 2028 they expect “humanoid robots” to be working in industries ranging from manufacturing to healthcare, followed by expansion into recreation and transportation in the 2030s. By 2040, as many as eight million units could be deployed and adoption could go “vertical.” While that may sound a long way off to investors, the strategists point out the capital formation is already underway.⁶

Looking ahead to August. Earnings season will be winding down, but election season will be heating up, along with the countdown to the September Fed meeting. Since 1990, August has been one of the softer months for US stocks: The S&P 500 had a positive August return more often than not (up 18 times, down 16), but that was the second-worst winning percentage (53%) of any month, to go along with the third-smallest median return (0.14%).⁷

Key dates: Employment Report (8/2), Producer Price Index (8/13), Consumer Price Index (8/14), Retail Sales (8/15), housing starts (8/16), options expiration (8/16), FOMC minutes (8/21), Durable Goods Orders (8/26), home prices (8/27), GDP (8/28), PCE Price Index (8/30).

^1,4 MorganStanley.com. Weekly warm-up: Does The Cycle Matter More Than The Election Outcome? 7/22/24.
² MorganStanley.com. Revisiting Risk Premiums. 7/29/24.
³ MorganStanley.com. Investors’ Questions After Election Shakeup. 7/25/24.
⁵ MorganStanley.com. Three Risks for the Third Quarter. 7/26/24.
⁶ MorganStanley.com. Almost Human: Robots in Our Near Future. 7/23/24.
⁷ Figures reflect S&P 500 (SPX) monthly closing prices, 1957–2023. Supporting document available upon request.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Technology stocks may be especially volatile. Risks applicable to companies in the energy and natural resources sectors include commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Health care sector stocks are subject to government regulation, as well as government approval of products and services, which can significantly impact price and availability, and which can also be significantly affected by rapid obsolescence and patent expirations.

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.