Monthly Market Summary
- The S&P 500 and Nasdaq notched six straight record closes in late July, as trade deals with Japan and the EU de-escalated tensions and reduced headline risk. The “Magnificent 7” and mega-cap tech led the way, but small caps and equal weight signaled broader participation.
- AI-driven capital spending has become a major GDP tailwind, but its long-term productivity impact is still unproven. The S&P 500 now trades above 22x forward earnings, making it reliant on a continued capex boom and productivity gains to justify premium valuations.
- The Fed’s cautious stance has shifted market rate expectations, with rates unchanged in July and a less than 40% probability of a September rate cut.
- Economic data shows signs of a gradual slowdown. Core GDP growth is weakening, and our U.S. Business Cycle indicator remains in Contraction territory.
- Sentiment remains uneven, with retail embracing risk while asset manager positioning remains light. If the economy outperforms expectations, the pain trade could be higher.
Key Market Themes
Trade De-Escalation Boosts Risk Appetite. July saw meaningful trade de-escalation as Washington reached separate agreements with Japan and the EU. The frameworks set tariffs at 15% on most exports, along with still-undefined additional investments in the U.S. The trade deals boosted risk appetite and helped the S&P 500 set fresh records in mid-to-late July. The agreements provide visibility on trade policy, remove the worst-case outcomes for economic growth and inflation, and reduce headline risk. The market’s takeaway: the outcome is less bad than feared despite a sharp rise in the effective tariff rate.
AI-Driven Capex Boom Lifts U.S. GDP Growth. AI-related capital spending has become a major driver of U.S. economic growth. Estimates suggest spending on GPUs, servers, and data center construction has added ~0.50% to real GDP growth over the past four quarters, with AI capex now rivaling consumer spending as one of the biggest contributors to GDP growth. The boost to GDP growth is real and significant but cyclical, making the AI boom more of an investment-led sugar high. Long-term gains depend on broader adoption and productivity improvements, which remain largely theoretical today but could deliver sustained benefits in the years ahead.
Market Performance Recap
Stocks Set New Highs. Stocks rose to new highs in July, with the S&P 500 and Nasdaq logging six straight record closes near month-end. Smaller companies outperformed the S&P 500 early in the month, but by month-end, market leadership was top heavy again, with the “Magnificent 7” gaining over +5% after reporting strong Q2 earnings. The High Beta and Growth factors outperformed, while the Minimum Volatility, Momentum, and High Dividend factors ended flat to modestly lower. Technology, Utilities, Industrials, and Energy led sector performance, while defensive areas lagged, with Consumer Staples and Health Care finishing lower. Commodities traded higher, with oil jumping nearly +8% after Trump threatened tariffs on India over its Russian energy imports, while gold posted a modest loss. International markets traded lower and underperformed U.S. stocks as USD strengthened, with developed accounting for most of the losses while emerging traded higher.
Rest of World. The S&P 500 returned +2.2% with the index reaching several all-time highs before retreating at month-end. Resilient economic data and a strong start to the earnings season were the key factors for the market’s rise, though the constant threats of tariffs and general acceptance that the Fed is in no hurry to cut interest rates kept the advance in check. The continuous rally has, however, stoked concerns about high valuations and a revival of meme-stock froth. Mid cap stocks (+1.9%) and small caps (+1.7%) also rose though they lagged large caps. Information technology (+5.2%) and utilities (+4.9%) were the best performing sectors in the S&P 500; healthcare (-3.3%) was the worst performing sector during the month and has been on a YTD basis amid pressure from the administration to lower drug prices. EAFE markets returned -1.4% in July as the dollar rebounded to gain +3.2%. EM returned +1.9% with strong gains in China (+4.8%) and Korea (+4.0%) offset by losses in Brazil (-6.9%) and India (-5.1%), the latter hit by tariff threats.
Bond Market Dynamics. Bond traded lower as the Treasury yield curve shifted higher. The front end experienced the largest move, with the 1-year to 7-year maturities rising over 15 basis points as the market priced out rate cuts after a strong June jobs report and a hot CPI reading. Long Duration underperformed the Bond Aggregate, as the 10-year and 30-year yields ended the month ~10 basis points higher. In the corporate bond market, high-yield benefited from spread tightening, particularly CCC-rated bonds, where spreads tightened by nearly 50 basis points. IG underperformed HY due to its longer duration, unable to shake off rising yields. Bond market volatility declined to the lowest levels since early 2022, with the 10-year stuck between 4.25% to 4.50% the past three months. The decline has been driven by the Treasury favoring T-bill issuance over notes and bonds, monetary policy unchanged with the Fed on hold, and economic data generally meeting expectations. We continue to favor below benchmark duration and prefer IG over HY.
Munis Matter. We believe the municipal bond market continues to offer certain taxable investors compelling reasons to allocate. Yields remain elevated by historical standards, and valuations are attractive relative to both taxable debt and even U.S. equities. A combination of durable tax-exempt income, solid credit fundamentals, and the potential to capture relative value supports the case for a larger role in investor portfolios. As of June 30, 2025, at 3.96%, the yield-to-worst (YTW) of the Bloomberg Municipal Bond Index has only been higher 4.9% of the time over the last ten years.
Total Return. Investment grade fixed income asset classes had mixed returns as rates rose across the curve, though tempered by spread compression. Municipals returned +0.1% (+1.2% YTD) as supply-demand technicals, which had impacted the asset class all year, reversed somewhat. The Bloomberg Aggregate Index returned -0.3% (+3.8% YTD) while investment grade corporate returned +0.1 (+4.2% YTD). High yield bond returns returned +0.5% (+5.0% YTD) as spreads compressed 12bps. Leveraged loan returns returned 0.9% (+3.7% YTD) during July. Emerging Market debt returned +1.3% (+6.7% YTD) as US dollar rose 3.2% and spreads compressed 35bps.
Currencies & Commodities. The dollar index rose 3.2% as some uncertainty around tariffs abated with deals announced with Japan and the E.U. The commodities complex rose 2.6% with energy prices rising 7.5%. Brent prices rose 7.3% to $73/bbl. US natural gas prices fell 10.1% while European gas rose 4.5%, both based on expectations of around weather-related demand.
Fed Policy & Interest Rate Outlook
Fed Remains on Hold. The central bank held rates steady this week. Throughout the month, Fed speakers reiterated the need for patience due to ongoing policy uncertainty and inflation risks tied to tariffs. While they haven’t ruled out rate cuts later this year, officials stressed that any decision will depend on incoming data. Our base case remains that, barring a major economic shock, rates are likely to remain at current levels. As mentioned in prior reports, we expect the Fed to wait for hard data to deteriorate before acting, which raises the risk of cutting too late.
Rate Cut Expectations Pushed Back and Inflation Expectations. At the start of July, fed funds futures priced in a >80% probability of a September rate cut and a slim chance of a July cut. The forecast proved too optimistic, and expectations were reset lower throughout the month. After a stronger-than-expected June jobs report, the probability of a July cut fell below 5%. A hotter-than-expected CPI report showed signs of early tariff-related inflation pressures, and after the July Fed meeting, the probability of a September cut is less than 40%. A second rate cut is not forecast until January 2026. Last month, rates rose across the curve amid the resilient economic data, inflation numbers that surprised to the upside and the expectation that the Fed remained in “wait and see mode” before cutting rates. The recession-watch 3M-10Y spread widened 11bps and has flipped positive again to +3. The 2Y-10Y spread compressed 9bps to +41. Rates rose in other developed markets. The spread between Italian and German 10Y bonds is 0.82%. 5-year breakeven inflation expectations rose 18bps and now sit at 2.48%; 10-year breakeven inflation expectations rose 11bps and now sit at 2.39%; the 10Y real yield rose 5bps to 1.98%. At month end, the market expected between one and two cuts in 2025 vs the Fed’s guidance of two cuts. At year-end 2025, the market expects the Fed Funds rate to be 3.99% vs. the Fed’s guidance of 3.75%-4.00%.
Investor Sentiment & Positioning
Technicals Improve as Breadth Expands. The S&P 500’s trend remained constructive into late July, with multiple record closes and the VIX falling below 15. Market breadth improved at the margin. Historically, strong market breadth is a tailwind, where is may lead to stronger forward returns and above-average win rates. The risk is that the next few months tend to be the most seasonally weak.
Sentiment Cautious Despite Record Highs. In early July, there was a surge of equity ETF inflows, but flows leveled off as the month progressed. Asset manager S&P 500 futures positioning ranks near the 59th percentile, indicating that institutional investor positioning remains light. In contrast, retail investors have embraced risk, fueling a meme stock resurgence. Weak sentiment and light positioning suggest the pain trade could be higher if the economy and earnings surprise to the upside. However, if expectations are too high, the same weak sentiment could lead to a buyer’s strike, even as prices fall. Volatility was unchanged for stocks but fell for bonds (VIX = 17, MOVE = 80). Market sentiment, which has been weak all year, improved from -5 to +7, but investors buoyed by the market’s strong rebound post Liberation Day gyrations.
Corporate Earnings & Valuations
Valuations Remain Extended. The S&P 500’s next 12-month (NTM) P/E multiple rose above 22x in July, up from around 18x in early April. This year has seen two regimes: P/E multiple compression was a headwind in Q1 and April, but over the past three months, P/E multiple expansion drove the S&P 500’s gains. The expansion has been supported by a combination of themes, including positive EPS revisions, a falling VIX, tighter corporate credit spreads, looser financial conditions, favorable market liquidity, and net inflows. However, the index’s NTM P/E multiple remains well above the 16.8x average since 2000, with the premium concentrated at the top where the largest 10 stocks make up about 37% of the index’s weight. With extended valuations, the market is more reliant on earnings growth.
Q2 Earnings Beat Expectations, But Growth is Slowing. While we are in the middle of earnings season, so far, Q2 earnings have exceeded expectations. The increased beat rate, over 80% thus far, reflects the fact that analysts revised estimates lower earlier this year due to trade policy uncertainty. While revisions breadth improved in late Q2, the bar was still relatively low entering earnings season. Despite the solid beat rate, the rate of EPS growth is slowing.
Economic Trends
June’s Data Signals a Gradual Slowdown. Labor market conditions are cooling, and job growth moderating. Consumer spending bounced back after two months of declines, though the broader trend still points to softer demand. Manufacturing activity expanded, although the rise was narrow and driven by utility output. Housing remained sluggish providing deflationary pressures, as elevated mortgage rates and weak single-family construction continue to weigh on the sector. Meanwhile, inflation data indicates price pressures are building as the first wave of tariffs filters through to prices. Economic growth appears to be losing momentum, but the slowdown remains gradual rather than severe.
Market Outlook
Bullish Talking Points. The administration is making progress on trade policy, with the Japan and EU agreements laying the groundwork for additional trade deals and reducing tariff uncertainty. Q2 corporate earnings are exceeding expectations, and trade progress stabilizes the earnings outlook. The Fed is expected to start cutting interest rates later this year, and Congress passed a tax bill in July, with provisions intended to spur business investment. Subdued investor sentiment and light positioning mean the pain trade could be higher if investors capitulate. The secular AI growth story remains intact, and mega-cap tech stocks are translating AI capex into real earnings growth.
Bearish Talking Points. Despite recent market gains, several warning signs warrant a more cautious view. Valuations remain elevated by historical standards, fueling concerns of a potential “everything bubble” across stocks, housing, and corporate bonds (tight credit spreads). The return of speculative trading behaviors, particularly in meme stocks, suggests parts of the market are disconnected from fundamentals. Economic data appears to be softening across consumer spending and business investment and job hiring, and a sharp rise in the effective tariff rate could further slow growth. While AI capex remains strong, questions remain about AI’s economics and monetization.
Our View. We see a resilient but narrowing economic expansion whose sustainability hinges on three factors: (1) how long the Fed is willing to keep rates high will be influenced more by the strength job market (weakening job market will increase probability of rate cut(s); (2) whether the AI-driven cap-ex boom sustains near-term GDP and converts to productivity gains fast enough to justify expensive equity valuations; and (3) the extent to which tariffs reignite goods inflation. Further gains depend on AI capex, resilient corporate earnings, and Fed rate cuts, but a gradual economic slowdown and rising effective tariff rate pose downside risks.