BofA strategists highlight that historically, a lower Treasury yield and an improving manufacturing PMI have driven the outperformance of the equal-weighted S&P 500 index. Recently, a surge in U.S. small-cap stocks has led investors to speculate whether this marks a shift away from this year’s Big Tech frontrunners. According to BofA Global Research strategists, a lasting stock-market rotation depends on the 10-year Treasury yield remaining below 4% and the ISM manufacturing PMI index staying above 50%. Historically, the equal-weighted S&P 500 index has outperformed the market-cap-weighted S&P 500 90% of the time when the 10-year Treasury yield dropped by more than 1 percentage point from its 12-month peak, and the ISM manufacturing PMI improved by over 4 percentage points from its 12-month low, as noted by BofA strategists led by Ohsung Kwon. For this rotation to continue, the 10-year yield needs to be around 3.99%, below its 52-week high of 4.99% recorded on October 19, and the ISM manufacturing PMI index should be above 50%, indicating expansion in the manufacturing sector. “The manufacturing economy is experiencing its second-longest downturn in history, with 21 months without two consecutive months of PMI above 50%,” Kwon and his team wrote, attributing this mainly to the destocking cycle, which they expect to moderate in the second half of 2024. The Institute for Supply Management’s manufacturing index fell to 48.5% in June from 48.7% in the previous month, with the lowest level in the past 12 months being 46.5% in July 2023. A PMI below 50% indicates contraction in the sector. On Monday, the 10-year Treasury yield increased by 2.1 basis points to 4.259%, influenced by speculation that Vice President Kamala Harris might become the Democratic Party’s presidential nominee. This year, the 10-year rate has risen by nearly 40 basis points due to persistent inflation concerns, keeping the Federal Reserve cautious about cutting interest rates, according to FactSet data. Despite this, traders in the federal-funds futures market on Monday saw a 93.6% probability that the Fed will start cutting its benchmark rate in September, based on the CME FedWatch Tool. However, policymakers will review upcoming inflation data before making a decision. U.S. stocks closed higher on Monday, led by the “Magnificent Seven” and chip stocks like Nvidia, which rose by 4.76% after a challenging week. The Nasdaq Composite increased by 1.6%, the S&P 500 by 1.1%, and the Dow Jones Industrial Average edged up by 0.3%, according to FactSet data.

Not long ago, investors were confident in the continuation of the big-tech trade and expected former President Donald Trump to win the upcoming election. Now, the landscape has shifted. The market is rotating from tech-based momentum trades to the previously unpopular small caps. Investors who were banking on a “Trump-trade” now face the higher probability of a Democratic victory after President Joe Biden exited the race. This environment of increased volatility and uncertainty is exactly what Ruffer Investment Company has positioned its portfolio for. The London-based fund is wary of equity market valuations, especially in the U.S., and expects global inflationary pressures and growing fiscal deficits to negatively impact bond prices, driving yields higher. “The risks of a correction in equity and credit markets are high given the level of real interest rates alongside the uncertainty driven by elections, central bank policy decisions, liquidity risks, and a softening U.S. economy,” says Ruffer in its fiscal year-end review. Ruffer’s portfolio includes what it calls deeply unloved “ugly ducklings.” These assets, often overlooked by investors, have the potential to transform into valuable investments. Among the ugliest ducklings are Chinese shares, which are under-owned due to reputational risks. Ruffer finds these equities attractive because they are among the cheapest globally, despite bad news being priced in. Ruffer allocates only a quarter of its funds to stocks, with Chinese equities comprising around 4% of its portfolio. U.K. equities account for 11.2%, benefiting from low valuations and the potential for a re-rating driven by a stable new Labour government, increased pension fund stock holdings, and foreign takeover interests. Precious metals miners are also part of Ruffer’s portfolio, with 4% in gold mining equities and another 3% in silver and platinum. Ruffer sees value in this sector due to geopolitical concerns, inflation worries, and tax avoidance strategies. They believe earnings revisions in the sector could be spectacular if gold prices rise significantly. Ruffer also holds a long position in the Japanese yen, viewing its current valuation as a “historic opportunity” and expecting the yen to benefit from its haven status during market volatility. Finally, U.S. treasury inflation-protected securities (TIPS) and UK inflation-linked gilts make up 19% of Ruffer’s portfolio, reflecting the fund manager’s concerns about persistent inflation. Investors can currently secure a return of inflation plus 2% by lending to the U.S. for the next 10 years, which Ruffer considers a sensible core holding for capital preservation.

Good morning! If you’re reading this, congratulations on successfully booting up your personal computer, a feat not everyone around the globe has managed today. More on that later. Correction: Thursday’s Need to Know newsletter incorrectly reported the Nasdaq Composite’s performance. The decline on Wednesday was the sharpest since mid-December 2022. Despite recent market turbulence, the S&P 500 is only 2% away from a record high, and the Nasdaq Composite is just 4% from a new peak. Taking an optimistic stance, the UBS chief investment office has raised its S&P 500 target to 5,900 by the end of the year and 6,200 by mid-2025. Previous targets were 5,500 for December and 5,600 for June 2025. UBS cites several positive factors for U.S. equities: strong earnings growth, disinflation, the Fed’s anticipated rate cuts, and increasing investments in artificial intelligence. “While economic growth readings have cooled, we believe growth remains on solid footing. Healthy labor market dynamics should continue to support further gains in consumer spending,” said strategists led by David Lefkowitz. UBS, like many others, expects the Fed to start cutting rates in September. They note that the second-quarter earnings season has started well, though the mega-cap tech companies have yet to report. “We think trends in this segment will remain favorable with strong demand for AI infrastructure as tech companies jockey for leadership positions in the emerging AI ecosystem, and companies across the economy look to deploy AI tools into their business processes,” they say. Consequently, UBS has maintained its S&P 500 earnings per share target at $250 and raised next year’s target to $270 from $265. Addressing concerns about high valuations, UBS argues that they are reasonable given the macro environment. “Historically, when the Fed is cutting rates in the context of a soft landing, equities tend to perform well in the 12 months before and after the first Fed rate cut.” In their optimistic scenario, UBS sees the S&P 500 surging to 6,500 this year if the Fed cuts rates amid an investment and innovation boom. Their downside scenario predicts the S&P 500 could drop to 4,800 if inflation remains stubborn, higher rates weigh on growth, or geopolitical tensions escalate. Markets U.S. stock-index futures (ES00, YM00, NQ00) are inching up, with benchmark Treasury yields mixed. The dollar index is higher, oil prices (CL) have slipped, and gold (GC00) is trading around $2,417 an ounce.

An inverted Treasury yield curve is typically seen as a harbinger of recession, although the U.S. economy has held up so far. An inverted Treasury yield curve is often viewed as a signal of an impending recession. But does the curve’s return to normalcy signal an all-clear for the market? History suggests otherwise. According to Tom Essaye, a former Merrill Lynch trader and founder of Sevens Report Research, the reversal of a yield-curve inversion has frequently signaled upcoming economic and stock market troubles. This potential shift is significant as the gap between short-term and long-term Treasury yields has narrowed recently. On Monday, the gap between the 2-year and 30-year yields briefly turned positive for the first time since January, according to Dow Jones Market Data. Additionally, the gap between the 2-year and 10-year yields reached its narrowest point in a similar timeframe. Analysts at Macquarie attribute these bond movements to the broader “Trump trade,” which encompasses higher tariffs, tax cuts, and restrictive immigration policies proposed by former President Donald Trump. They argue these measures could revive inflation and push up long-term bond yields. Since 1998, the spread between the 2-year and 10-year Treasury yields has inverted six times, including the current episode that began in July 2022. Previous inversions occurred in June 1998, February 2000, January 2006, June 2006, and August 2019. Only three of these instances, including the current one, saw the yield curve remain inverted for a significant period, with the others occurring in February 2000 and June 2006. In both cases, the un-inversion preceded stock market turbulence. When the 2s10s spread returned to positive territory on Dec. 29, 2000, the S&P 500 traded around 1,320 but then declined for 22 months, bottoming at around 785 in October 2002. Similarly, when the spread returned to positive on June 6, 2007, the S&P 500 was at 1,517, but the index fell over the next 21 months as the housing market collapse triggered the 2008 financial crisis, bottoming out in March 2009. It took four years for investors to recoup these losses. Essaye explains that when the 2s10s spread turns positive, it usually means the 2-year Treasury yield is dropping quickly as investors anticipate aggressive rate cuts. These cuts typically happen because the Federal Reserve is worried about economic growth. This is currently happening, with the market pricing in a 100% chance of rate cuts in September and December, and a growing likelihood of a third cut this year. Despite warnings of an imminent recession due to the Federal Reserve’s aggressive rate hikes, the U.S. economy has shown resilience. Recent data hints at slowing growth and a softening labor market, but a stronger-than-expected retail sales report on Tuesday offered some reassurance. Many stock-market experts doubt a recession is imminent, believing that Fed Chair Jerome Powell might achieve a soft landing by cutting rates later this year. Early Wednesday, Treasury yields were rising, with the 2-year up 4 basis points at 4.47% and the 10-year up 2 basis points at 4.18%. Bond yields move inversely to prices. Meanwhile, U.S. stocks opened mostly lower, with a sharp selloff in technology stocks. The S&P 500 was down 1% at 5,610, the Nasdaq Composite down 1.7% at 18,186, and the Dow Jones Industrial Average traded about 30 points, or 0.1%, higher at 40,989.