Highlights:
- Markets rose in July, with the S&P 500 up 2.2%, driven by mega-cap tech stocks, while defensive sectors lagged.
- The Fed held off on rate cuts due to tariff-related inflation concerns, but weak job data in early August revived expectations for easing.
- The 10-Year Treasury yield rose 0.15%. In the tax-exempt markets, long-term municipal bonds are trading at yields that have not been seen in decades.
- Looking ahead, risks include high valuations, rising inflation from tariffs, and signs of a softening labor market, all adding pressure to the Fed’s policy decisions.
The major market indices moved up in July, led by the familiar coterie of mega-caps that were responsible for two-thirds of the gain. The S&P 500 Index rose 2.2% for the month, led by the Technology sector, which was up 5.2%. As the market tipped into new all-time highs, the driving forces were a resilient economy, some emerging clarity on volatile tariff policies, and robust earnings, particularly among the largest tech companies. Concentrated gains spelled weak returns for other areas, including the historically defensive areas of Health Care and Consumer Staples.
One hurdle the market overcame in July was the Federal Reserve's reluctance to lower rates. The main factor holding back Federal Reserve action was the percolating impact of higher tariffs on consumer prices. The expectation is that we have yet to see the full potential of the inflationary pressures of these new costs paid by importers. Fed Chair Powell’s non-committal tone at his July 30th press conference drove investors to price out a September rate cut, only to see markets reverse course following a weak August 1st non-farm payrolls report, which showed a significantly slowing job market. We had already seen some early-indicator signals from the job market, including a dip in job openings and increased worker hesitancy to leave positions, and now it seems the growing pro-easing contingent within the Fed has the support of economic data.
Bond values dropped a bit in July as the 10-Year U.S. Treasury yield moved up from 4.2% to nearly 4.4% by month-end. Stock returns over the past few years make it easy to take an eye off bonds, but areas of the bond market currently look attractive. One area of unusual interest is long-term municipal bonds, which are trading with relative yields not seen in decades. Many high-rated munis are yielding close to 5%, a level that approaches similarly rated corporate bonds. For investors in higher tax brackets, the current 4-5% tax-exempt yields equate to 6-8% tax-equivalent yields.
Looking forward, we have a number of concerns hitting our radar. Market valuations remain high and will rely on steady good news on corporate earnings. Meanwhile, margins could be stressed by the overall rise in tariffs, tariff-induced inflation, and a corresponding dip in consumer sentiment and spending. Economists ballpark the inflationary impact of tariffs at .1% for each 1% rise in tariffs. With overall rates rising from 3% to around 15%, we could expect a corresponding 1.2% increase in the inflation rate, a serious bump and one that has the Fed worried.
With the increasing stress in the job market, the Fed is in a difficult position, with conflicting signals from a slowing economy and rising inflation. Fed expectations may continue to oscillate between whichever of its two mandates (full employment and price stability) is further from its goal. Right now, signs point to a September cut, but with an economic backdrop less robust than what had been driving market enthusiasm. Meanwhile, cloaked by the boost from mega-caps, the broader market already reflects some of this caution. We believe shaking out some of the excess in the stock market is overall a healthy development. From our perspective, any market dips we may see going forward are part of the natural cycle and should not deter long-term investors.