US equities rallied further in the second quarter and now hover near all-time highs, even as volatility emerges in response to shifting market factors. As a result, the S&P 500 is up about 15% year to date, but with the pace of the rally slowing. The primary reason for the pickup in volatility has been two-fold: first, shifting inflation data that is changing expectations for interest rate cuts later this year, and second, stretched valuations, caused by the run up in AI related technology stocks. While a sticky inflation print early in the quarter caused a spike in bond yields and drop in stock prices, this was largely offset by a cooler subsequent report which caused equities to rebound to new highs. A strong earnings season coupled with developing slack in the jobs market added further positive momentum. Overall, these competing factors have resulted in the market moving steadily higher, but now awaiting its next catalyst.
Despite the volatility, the fact that markets are still trading at these levels in the face of current interest rates speaks well to underlying resilience in the economy. The labor market remains strong, with job growth still totaling several hundred thousand jobs per month, and an unemployment rate below 4%. Consumer spending, the largest component of GDP, continues to grow at a healthy clip as personal income grows and inflation comes in lower. As a result, the economy is still expanding despite the tighter monetary conditions. And while the Q1 GDP was weaker than expected, a holistic view still shows an expanding economy, even if it’s slowing.
For markets, this resiliency has been borne out of corporate earnings, which continue to rise even as forward outlooks moderate. A healthy 80% of companies in the S&P 500 beat expectations for the bottom line in the first quarter. And while margins have come lower amid inflation, they are still holding steady. Much of this has been due to strength in the Technology sector, notably from increased demand from generative artificial intelligence. While high valuations remain an ongoing risk to the sector, the trend has so far remained intact with companies delivering powerful bottom-line growth. Nearly a third of Microsoft’s growth in the first quarter came from increased AI demand for example, with bellwether Nvidia continuing to blow past earnings expectations. And other companies like Google and Meta are investing heavily in AI infrastructure based on accelerating demand.
While this backdrop has been supportive, the recent volatility shows much is priced in at current levels. As a result, earnings strength will need to continue for the market to “grow into” its elevated multiple. For Tech, this mainly means beginning to build profitable business models atop their ambitious AI investments, as well as continued strength in core business lines. This is because the market demands higher profit growth from stocks when bonds are offering such attractive yields. Fortunately, recent actions from the Federal Reserve have bought the market some time on this front, having downplayed the potential for further rate hikes. This was a fear early in the quarter amid bottoming out inflation trends. Nevertheless, the Fed could opt to hold rates higher for longer than anticipated, which could challenge the market’s current assumptions regarding rate cuts and increase the chances of a correction.
Overall, we remain cautiously optimistic on markets right now given the underlying strength of the economy. At the same time, we recognize that markets have moved sharply in a short amount of time, which means volatility is likely to continue into the fall. This is particularly true given the market’s sensitivity to evolving inflation data as well as the combination of rebalancing, profit taking, and technical factors currently driving stock prices. Geopolitics and the presidential election also remain in the background, even if they have had limited impact so far this year. Collectively, these factors reinforce the importance of maintaining a steady and structured approach to capital deployment.
We will continue to monitor these developments closely and remain on the lookout to add value in portfolios as opportunities present themselves.