A Divergence

No Coincidence

The latest string of Q2 corporate earnings reports has highlighted a divergence that could matter for equity expectations moving forward. Tech and communication services names have largely beat expectations, demonstrating product pricing power and somewhat surprising subscription growth. On the flip side, cyclicals, including industrials, transportation and materials stocks are having a rougher time. Consistent with what we’d expect to see in a trade war environment, margins are getting pinched and order volumes are starting to show signs of decline. The weakness in transports, which goes back two years, is especially concerning because it highlights troubles in manufacturing, overall factory activity and consumer demand. If things aren’t being built and bought, truckers have nothing to ship. It fits, however, with what we’ve been seeing in July’s manufacturing PMI, which is slipping again, and truck tonnage data. The U.S. economy may still be growing, but there’s more friction building beneath the surface, particularly in the sectors that typically lead during early expansions.

Housing, meanwhile, has been flashing some concerning signals. New home sales continue to miss expectations and look sluggish, especially worrisome since it’s happening during the time of year where sales should be brisk. Prices have been able to sustain thanks to ongoing shortages in the resale market, but mortgage application numbers have largely been moving sideways and builders are growing a little more cautious. With the 30-year fixed mortgage rate still sitting close to 7%, affordability is once again in focus. Apollo recently came out with a report saying that home affordability is near historic lows going all the way back to the 1980s. It’s a reminder that even if the Fed cuts rates in September, those lower borrowing costs may not cleanly transfer into the mortgage market. Homebuilders have had a strong run since early June, but that momentum may struggle if rates remain sticky and demand begins to stall out. Financial markets have mostly shrugged off housing market concerns, but this may be one of the more vulnerable soft spots heading into Q4.

The bond market has also started to reprice expectations a bit. After weeks of assuming a September rate cut was a near lock, the recent uptick in core inflation metrics has cast some doubt. The odds of a rate cut according to the Fed Funds futures market is still about 65%, but that’s much lower than the 92% likelihood that was priced in just a month ago. Yields on the 2-year Treasury have ticked higher throughout July and the market is implying fewer than two cuts by the end of 2025. For stocks, this makes things a little murkier. High multiple growth companies have seen their stocks benefit the most from easing policy assumptions, but that could reverse quickly if the inflation data continues to lean hotter. It’s probably no coincidence that utilities, value and low volatility stocks started to stage a bit of a comeback right around the time that the most dovish of Fed expectations began to start getting priced out. It’s not a broad-based risk-off yet, but you can feel markets becoming a little more data-sensitive again.