A Volatile July, A Broader Market

Market leadership broadened even as inflation, rates and geopolitical risks weighed on sentiment

Key Observations

• July was a volatile month as investors weighed strong corporate earnings against renewed concerns about AI-related valuations, heavy capital spending, and the durability of the recent growth-led rally.
• The Federal Reserve held rates steady at 3.50% to 3.75%, but three dissents in favor of a hike and a continued focus on elevated inflation pushed Treasury yields higher and pressured rate-sensitive areas of the market.
• Market leadership continued to broaden as value-oriented sectors, real assets, and select non-U.S. equities held up better than mega-cap growth, while Middle East tensions and higher oil prices reinforced the importance of diversified portfolio exposures.

Market Recap

July served as a reminder that markets continue to navigate a complex environment where economic resilience, persistent inflation pressures, evolving monetary expectations, and geopolitical developments all compete for investor attention. An escalation in tensions involving Iran contributed to higher energy prices and increased volatility late in the month, while investors also digested another Federal Reserve meeting with mixed signals and lack of clarity on the direction of policy. The Federal Open Market Committee voted to keep the federal funds rate unchanged at 3.50% to 3.75%, though a notable number of policymakers favored tighter policy, leading Treasury yields to move higher and weighing on interest rate sensitive asset classes.

U.S. equities finished modestly lower, but performance broadened beneath the surface. The S&P 500 declined 0.1% for the month, giving back a portion of its strong year-to-date gains, while the Russell 2000 fell 3.0% as rising bond yields and tighter financial conditions created a headwind for smaller cap companies. The market's leadership continued to rotate away from some of the largest growth-oriented stocks that had led earlier in the year, while investors favored sectors tied to energy, financials and more value-oriented areas of the market.

International developed equities delivered positive results despite the uncertain environment. The MSCI EAFE Index gained 2.0%, supported by strength across parts of Europe and the United Kingdom, where equity markets benefited from relatively attractive valuations. A weaker U.S. dollar also provided a modest tailwind for U.S.-based investors. Emerging markets faced a more difficult month. The MSCI Emerging Markets Index declined 3.1%, driven largely by weakness in several technology-heavy Asian markets as investors reassessed growth expectations and semiconductor-related shares experienced a significant pullback after a strong first half of the year.

                      
Fixed income markets struggled as yields moved higher following the July FOMC meeting. The Bloomberg U.S. Aggregate Bond Index fell 1.3%, reflecting pressure across both Treasury and investment-grade corporate bonds. The market had mixed interpretation of the Fed's messaging, particularly with inflation remaining above target and energy prices rising amid Middle East tensions. Credit markets proved relatively resilient. The Bloomberg U.S. Corporate High Yield Index slipped just 0.2%, as healthy corporate fundamentals and limited default activity helped offset the impact of rising rates.

Real assets were among the strongest performers during the month. The FTSE NAREIT All Equity REITs Index gained 2.4%, supported by continued strength in data center, industrial and specialized property sectors. Commodities delivered the best performance among major asset classes, with the Bloomberg Commodity Index rising 7.5%. 

Small Cap Equities Providing Diversification Benefit

There is a growing concern about AI concentration and elevated valuations within the U.S. large-cap equity market. Diversifying portfolios through exposure to U.S. small- and mid-cap equities, as well as non-U.S. equities, remains important. These companies were expected to be part of the AI flywheel, benefiting from the adoption and use of AI despite not being the direct builders of the technology. Attractive relative valuations of small cap relative to large further supported the case for allocating. Enthusiasm for AI has been a tremendous tailwind for many large cap companies, but growing concerns about valuations and the path to monetization of extreme capex spending has put pressure on some of the mega cap names that have led the market over recent years. Seven months into the year, the benefits of maintaining diversified portfolio exposures have become evident, with small- and mid-cap stocks gaining 18.9% and 14.6%, respectively, versus a 10.1% gain for large-cap stocks.

Outlook

This year has reinforced the importance of remaining diversified as market leadership has continued to broaden beyond the largest U.S. companies. The strong relative performance of small- and mid-cap equities year to date highlights that investors do not need to rely solely on the largest AI beneficiaries to participate in the next phase of the cycle. As AI-related investment spreads across the economy, smaller companies, non-U.S. equities and real assets may all play a role in capturing a broader set of opportunities. With valuations still elevated in parts of the market, interest rates remaining high and geopolitical risks unresolved, the case for balanced portfolios remains strong. Such portfolios can participate in broadening market leadership while maintaining exposure to high-quality managers and a diversified mix of asset classes.


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