Mega-cap technology companies continued to drive the equity market to record highs during the second quarter as enthusiasm for artificial intelligence and expectations for lower interest rates overshadowed concerns over softening economic data. The S&P 500 returned 4.3% during the quarter, bringing its year-to-date performance to 15.3% on a total return basis. Despite signs of the market rally broadening out during the first three months of the year, Q2 featured narrow leadership from the index’s heavyweights yet again, with only the Information Technology and Communication Services sectors outperforming. Six of the eleven sectors in the S&P 500 posted negative returns, compared to just one sector in Q1. U.S. large-cap equities continued to significantly outperform mid- and small-cap stocks, both of which posted negative returns for the quarter, further highlighting just how concentrated market gains have been as we head into the second half of the year.
The U.S. Bloomberg Aggregate Bond Index had a positive total return of just 0.1% during the quarter, masking intra-quarter volatility that saw the 10-year treasury yield surge from 4.2% to 4.7% in April before retreating over the following two months. The combination of a strong jobs market alongside higher-than-expected inflation during the first three months of the year added to fears that the Fed’s progress on bringing inflation down to its 2% target had stalled. As the second quarter progressed, those fears were put to rest as the rebound in inflation quickly reversed course and the downward trend resumed. At the same time, the labor market began showing concrete signs that jobs growth was slowing, leading investors to once again price in more interest rate cuts by the end of the year. Indeed, the second quarter was another example of how quickly expectations can shift, especially during a time when investors are laser-focused on each piece of monthly data relating to inflation and the labor market to predict the trajectory of monetary policy. Currently, the expectation is for two interest rate cuts by the end of the year.
The softening labor market was a notable development in the second quarter as the unemployment rate ticked up each month to reach 4.1% in June. Since the Fed embarked on its rate-hiking campaign in March of 2022, the unemployment rate fluctuated around 3.7%. Consumer spending has also seen a slowdown, with excess savings from the pandemic mostly spent and the saving rate remaining close to historical lows, leading consumers to rely more on their income or take on more debt. Overall, slower economic activity was expected relative to last year as the lagged impact from higher interest rates continued to filter through to the economy. As the Fed approaches the last mile in its fight against inflation, balancing lower price growth with continued economic expansion will become increasingly delicate as it seeks to navigate the economy toward a soft landing.
Looking ahead, an important earnings season is upon us as companies begin reporting their second quarter results. Earnings growth for the first quarter surpassed expectations, driven by mega-cap technology companies benefiting from the surge in artificial intelligence. Second quarter results will provide more clarity on how much more runway the AI boom has left. While profit growth is expected for the remainder of the year, an unexpected slowdown by any one of the largest companies in the index could have an outsized impact on the overall market. Broader participation from the rest of the index would be necessary to sustain a market rally driven by just a select few names.
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