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Investment Strategy

A tale of two markets: Divergence amid the post–Labor Day sell-off

September jitters

After a +1% gain in August, the S&P 500 closed out its first week of September down -3%.

While September has historically had the lowest average monthly return over the last 30 years, we think there is a bit more to the story than seasonality. For starters, the September Federal Reserve meeting is less than two weeks away, and all eyes are on the labor market: 

  • The August jobs report was released on Friday. The data showed an acceleration of job growth to 142,000 positions added last month, and a move down in the unemployment rate to 4.2% from 4.3% in July. That said, job growth over the prior two months was revised down by 89,000 jobs. The report is likely to be a major factor in the Federal Reserve’s decision to deliver a 25-basis-point or 50-basis-point rate cut. Immediately after the print, markets slightly increased the odds of a 50-basis-point move.
  • U.S. manufacturing data suggested more sluggish activity. Even though the ISM Manufacturing Index ticked up to 47.2 in August versus 46.8 in July, any reading below 50 indicates contraction. According to the ISM survey, manufacturing activity has now shrunk in 21 of the last 22 months, extending the second-longest downturn in history.

Elsewhere, a smattering of geopolitics, trade and commodity moves gave investors angst:

  • Japanese restrictions on Chinese chipmakers added to increasing uncertainty around global chip supply chains. The Semiconductor Index was down -9% and Nvidia was down -10%.
  • Oil prices broke $75/bbl, selling off nearly -5% on Tuesday due to weak Chinese demand and excess supply.

But it’s not all doom and gloom. In fact, we saw other pockets of the market excel despite the sell-off. That divergence is reminiscent of what we would like to call a “tale of two markets.” In this week’s note, we dive into the “haves” and “have-nots” in markets, and what it all may mean for your portfolio.

A tale of two markets

“It was the best of times, it was the worst of times.” While the opening of Charles Dickens’ A Tale of Two Cities may be a bit dramatic to use here, we think it is an apt description of what we saw unfold over the last few days.

Let’s start with stocks: 

1. The AI trade felt the pain. Nvidia fell more than 10% on the week and set the record for the largest single loss in market cap in history. Investors are starting to ask the same questions that our Chairman of Market and Investment Strategy Michael Cembalest started to ask in his latest note, COVIDIA. Here are a couple of factors:

  • Hyperscaler capital expenditures are through the roof. Mag 7 capital spending now exceeds that of the entire energy sector. In fact, in the second quarter hyperscalers have spent $53 billion on cap-ex—that’s up +58% year-over-year (versus +30%) in the first quarter. Investors tend to meet capital spending plans with more scrutiny because they want assurance that the investment is going to be worth it.
  • If you build it, will they come? The first phase of the AI buildout is deeply rooted in ensuring enough infrastructure is in place. This means building the basics: producing things such as semiconductors and data centers, and sourcing the energy needed to power AI models. On top of it all, the hyperscalers need to train those models. All of that seems to be progressing, but the next leg of the journey is putting generative AI into practice to increase productivity and generate profits. While we have seen powerful examples of “inference tasks” like those from customer service provider Klarna, broad adoption is still in its early days.

We are believers in the long-term investment potential of AI. Bad days are to be expected, but over the next decade, we see AI-linked names outperforming the broader market. We think the questions surrounding stretched valuations and fears of AI overhype are healthy. Skepticism is a good thing, as it keeps markets in check, and this week’s price action seems to be a momentum story, not one of economic fundamentals. Investors today require companies to “show” and not just “tell.”

Hyperscalers grew capex 58% year-over-year

Hyperscaler capex YoY growth, %

Source: Bloomberg Finance L.P. Data as of August 27, 2024. Hyperscalers are MSFT, META, GOOGL, and AMZN.

2. On the flip side, defensive and certain interest-rate-sensitive stocks shined. Enter the “boring is not bad” story. While the risks of an economic slowdown may make some investors feel that adding to risk is a not-so-good idea, opportunities across sectors still exist.

The Fed is prepared to cut rates this month, and this means the “Fed put” is in play. In other words, declining interest rates may support outperformance of more interest-rate-sensitive sectors.

This week, only three of the 11 S&P 500 sectors landed in the green: consumer staples, utilities and real estate. While other traditionally defensive sectors such as financials and healthcare were down on the week, they outperformed tech by almost double. Defensive stocks, for example, tend to be less sensitive to the ebbs and flows of the economic cycle. This means they may have the ability to produce more durable cash flows and consistent revenues. Earnings estimates show the healthcare, industrials and consumer staples (to name just a handful) sectors growing into 2025.

Our base case still calls for a soft landing, but as economic activity inevitably slows to more normalized levels, we think it’s apt to examine sector balances and risk exposures in portfolios. For investors that are feeling “big-tech fatigue,” looking across more defensive sectors could be compelling. Take today as an opportunity to assess strong performance from year-to-date portfolio standouts, as they may have put portfolios offsides in terms of desired allocations.

The story was consistent elsewhere, too: 

3. Oil prices are off more than 16% from July highs, and are at year-to-date lows. Fears surrounding a resumption of Libyan oil production, Chinese demand concerns and a mixed narrative on OPEC+ supply levels sent oil prices lower this week.

OPEC+ said in June it would restore production by 2.2 million barrels per day starting in October after a period of cuts—but has waffled since then. Rumors mounted on Wednesday, followed by an official announcement on Thursday that the proposed supply increase would be put on pause until January.

We don’t think a two-month production delay takes away the fact that production will increase sometime this year. To boot, weak Chinese demand and oversupply elsewhere are likely to outweigh the measures. Thus, we see prices moving to $81–$86 per barrel by year-end. That said, factors such as unrelenting geopolitical tensions and the upcoming U.S. presidential election could spur price action.

4. Corporate credit had a banner week. This week was one of the biggest on record for investment grade bond sales led by over 50 firms. September is typically a busy month for issuers as investors return from summer vacations, and the day after Labor Day is historically one of the busiest days.

On Tuesday alone, a record 29 borrowers, including Target, Ford and Barclays, issued investment grade bonds. Beyond seasonal factors, corporations are moving to lock in borrowing costs while yields are relatively low. First-time IG borrower Uber tapped the market on Thursday. Corporates are taking advantage of all-in investment grade yields that have come down from a year-to-date high of 5.85% in April to 5.04% today.

We think credit is the foundation of markets. Borrower fundamentals look to be rock solid, and investor demand is strong. Five-year credit spreads across investment grade maturities remain tight relative to historical medians. At the same time, all-in yields are elevated, and that could create a compelling opportunity for investors to lock in yields.

Boring is not bad. Investors should take comfort in the fact that bonds are there to provide a buffer against the shorter-term volatility we might see in higher-growth investments (such as AI). 

Corporate bond spreads ticked up but are low relative to history

5-year investment grade spreads

Source: Bloomberg Finance L.P. Data as of August 30, 2024.

While each asset class has a distinct (and important) role in portfolios, both good and bad days are inevitable. The ultimate key to notching consistent returns over the long haul is diversification across asset classes and rightsizing positions.

As the Fed prepares to cut interest rates in the coming weeks, we encourage investors to review their asset allocations, particularly when it comes to excess cash.

For those looking to add to an already diversified portfolio or diversify further, we see opportunity in adding high-quality, income-yielding stocks and investment grade fixed income (including municipal bonds for U.S. taxpayers).

At the end of the day, sell-offs are a feature, not a bug of investing, and it’s important to keep it all in perspective. 

While past performance is no guarantee of future results, the past 13 times the first day of the month was down 2% or more (as it was in September), the market was higher for the remainder of the month every time. Here’s to September being #14.

All market and economic data as of September 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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This week, AI underperformed while fixed income shined. Here’s our take on a week of volatile market moves.

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