Q2 Recap: Like the Previous Quarter, but Different

SUMMARY

• US Growth equities remain among the top performers.
• US Large Cap slips from the top spot due to poor value performance.
• China drives emerging markets to the top, while developed markets struggle.

Quarterly Recap: US Growth Remains Near the top, with Some Leadership Changes in the Pack Below

The second quarter was a positive one for stocks, with many similarities to the prior quarter on the surface. From an economic perspective, the US Fed continues to be contemplating a pivot towards cutting rates, though they have not provided much additional clarity as to when that pivot will take place. From a market perspective, US growth is still the hot topic, with artificial intelligence (AI) driving both conversations and earnings.

However, when diving a little deeper, one can see some differences between the quarters. In the US, ‘value-oriented’ stocks struggled, damaging breadth in the S&P 500. This effect can also be seen in the struggles for developed international equities and US small/mid-cap, both of which tend to have larger allocations to ‘value’ sectors.

US Sectors: ‘Growth’ Sectors Remain on Top

Second quarter performance for US sectors had some similarities to Q1 and some differences (see chart, below). Starting with the similarities, both Technology and Communication Services built on a strong first quarter and continued their leadership. Like last quarter, strong earnings and enthusiasm surrounding AI provided the foundation for this rally. The only other sector to beat the S&P 500 was Utilities. We categorize Utilities as ‘interest rate-sensitive’ and, like fixed income, the moderating 10-year rate helped propel these equities.

At the bottom of the table, we see four sectors that we categorize as ‘Value’ sectors. This is a change from last quarter, where Financials, Energy, and Industrials all beat the S&P 500 and Materials posted a total return above 8%. For Materials and Energy, falling commodity prices were the culprit for poor returns, in our view. On the Financials and Industrials front, investors could be worried about slowing growth, with Q1 GDP slowing more than expected. However, we see some potential in these sectors going forward. We believe a ‘reflationary’ economy, where growth is strong but inflation averages well above 2%, may be a strong backdrop for ‘value’ investing.

International Stocks: China Rebounds, Developed International Lags

In the second quarter, we can see some shifts in international equities. In particular, China rebounded strongly, posting the best total return of any equity market within our international universe. China’s performance was enough to push emerging markets to the top of the leaderboard, outperforming even US large caps. This Chinese rally is particularly of note, given it was preceded by four straight quarters of negative returns (the reason China remains negative on a trailing twelve-month basis).

While China’s quarter was certainly impressive, we believe that its fundamental headwinds are still too pronounced to make large allocations to their equities. The Chinese government’s aggressive geopolitical posturing and anti-capitalistic track record still create an uphill battle for publicly-traded companies within China.

On the developed side of international, EAFE posted negative total returns in US dollar terms, with Japan being a detractor and Europe’s returns being positive but anemic. In local currency terms, things looked a little better, with returns being positive; this is due to developed currencies (and particularly the Japanese Yen), falling relative to the US dollar this quarter. However, this currency weakness could provide a silver lining, as we believe that weaker currencies tend to bolster future earnings and returns for export-oriented countries like Japan.

Looking forward: Portfolios remain overweight in US equities

Our portfolio positioning has remained roughly the same as where we began 2024, relative to our global benchmarks, we remain overweight equites relative to fixed income, and overweight the US relative to international equities.
When we consider the current fundamentals, we believe this positioning is still prudent. However, there is some potential room for this positioning to evolve as we move towards 2025.

Domestically, the underperformance in ‘value’ sectors has created a valuation gap between them and ‘growth’ sectors. While the strong fundamentals of mega-cap technology do warrant a high valuation, potential reinvestment into value sectors could begin to make sense given lower valuations. However, for these lower valuations to be truly ‘cheap,’ we believe we must see some stronger revenue and earnings from these sectors in the coming quarters. As mentioned previously, our highest probability outcome of ‘reflation’ (moderately elevated growth and inflation) should provide some tailwinds for these companies’ fundamentals.

Internationally, there are some reasons for optimism tactically, as we laid out in our Weekly View. Again, just as with US ‘value,’ we believe that there must be some earnings confirmation to warrant further investments into international equities. As these markets tend to skew towards ‘value’ sectors, the ‘reflationary’ environment we envisage could provide a tailwind to these regions as well.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.