U.S. Economic Slowdown and Market Rotation

With unemployment rising to 4.3% and other indicators beginning to show weakness in the economy, it is clear the environment in the U.S. is slowing. However, the recent movement in stocks represents a correction and is a normal, healthy part of market rotation.

As of Friday, the Tech sector (as measured by the XLK, an exchange-traded fund which tracks major technology companies) was down 11.7% from its peak on July 11. This compares to a sell-off of just 4.2% for the S&P 500 overall during the same time frame. The softness in Tech stocks has been driven by a slowdown in earnings and is reminiscent of the seasonal drop experienced at this time last year before stocks moved higher during the fourth quarter. The Tech stocks that are down the most recently are those that have enjoyed the highest returns. Because we have been underweight in some of the most expensive Tech names which have been largely responsible for the S&P 500’s returns, our clients’ portfolios have outperformed during the recent pullback. Meanwhile, most stocks outside the Tech sector are outperforming in this environment, suggesting a healthy market rotation is occurring.

The 10-year U.S. Treasury fell to a 52-week low last week, meaning its price increased in the face of stock softness. With a positive return of 2.57% since July 11, bonds are providing a cushion against stock volatility, as intended. The yield curve, which graphs the interest rate on short-term to long-term maturities of Treasuries, is now normally shaped for the first time in two years, indicating that longer-term bonds yield more than short-term bonds rather than the curve being inverted as it had been for an abnormally long period of time. The scenario above points to a higher probability of a larger September rate cut by the Federal Reserve.

Even with the recent drop, the S&P 500 remains up 13% so far this year which represents an unusually strong return given that the long-term average of full calendar year tends to return between 9% - 11%. While the volatility in stocks may continue and some indicators are signaling the possibility of a recession, we remain optimistic about the market long-term and are confident that well-diversified portfolios will continue to be the way to preserve and grow wealth for those who can maintain a long-term perspective.

Sources: Bloomberg, FactSet, and Bespoke