Monthly Market Summary
- The S&P 500 Index rose +2.1% in August, bringing its year-to-date return to +10.7%. Large Cap Value stocks led with a +3.2% gain, while Large Cap Growth gained +1.2%.
- Health Care was the top-performing sector. Six additional S&P 500 sectors also outperformed the index, while Utilities and Technology both traded lower.
- Bonds traded higher as Treasury yields declined, with the U.S. Bond Aggregate returning +1.2%. Corporate bonds modestly underperformed, with investment-grade posting a +1.0% total return and high-yield gaining +1.1%.
- International stocks outperformed the S&P 500 as the U.S. dollar weakened. Developed Markets gained +4.5%, while Emerging Markets returned +2.7%.
Federal Reserve Prepares to Cut Interest Rates as the Labor Market Softens
The Federal Reserve has kept interest rates unchanged this year due to concerns that tariffs could reignite inflation. This concern, along with strong job growth and low unemployment, gave the central bank time to wait for more data. However, the Fed’s policy stance was tested in early August when the July jobs report showed U.S. employers added fewer jobs than expected and unemployment rose to 4.2%. The report suggested high borrowing costs are weighing on the economy and shifted the focus from inflation risk to slowing economic growth.
These concerns resurfaced three weeks later at the Fed’s annual Jackson Hole meeting, when Chair Powell acknowledged the balance of risks may warrant a policy adjustment. His comments hinted that a rate cut could come as soon as the Fed’s September 17th meeting. The market quickly connected the dots: a softening labor market made it easier for the Fed to pivot and opened the door to a rate cut. Stocks and bonds traded higher in anticipation that the Fed would resume its interest rate-cutting cycle.
Small-Cap Stocks Post Biggest Month of Outperformance Since November 2024
Small-cap stocks have trailed large caps for most of the past three years. Since the start of 2023, the Russell 2000 index has gained +40%, significantly underperforming the S&P 500’s +75% return. Higher interest rates have weighed more heavily on smaller firms, many of which depend on floating-rate debt to finance their operations and growth. At the same time, a handful of mega-cap tech stocks have delivered strong earnings growth and returns, fueled by the artificial intelligence industry. As investor attention and capital concentrated on these large names, small caps were left behind, resulting in one of the widest valuation discounts to large caps in over 20 years.
The soft July jobs report and Chair Powell’s Jackson Hole remarks shifted the market narrative, with investors expecting a rate cut as soon as September. The Russell 2000 jumped more than +7%, its best month this year, and outperformed the S&P 500 by over +5%. Small caps tend to benefit more from lower interest rates, and rate cut expectations attracted value seekers to small caps’ valuation discount. This isn’t the first time small-cap stocks have rallied, with recent rallies fading as mega-cap tech reclaimed market leadership. Whether this rotation lasts will depend on upcoming inflation and job reports and how the Fed responds, but small caps’s recent strength shows investors are once again testing the waters for a small-cap comeback.
Market Performance Recap
Equities
The S&P 500 returned +2.0% with the index reaching several all-time highs before retreating at month-end. The month started on a difficult note, amid weak economic data, stubborn inflation readings and expectations that the Fed remained in “wait and see” mode. However, as the month progressed, markets focused on strong corporate earnings results even as the economic data improved. Markets have looked passed potential concerns about Fed independence. The outlook, however, seems murky as inflation remains stubborn and the labor market is slowing. Leaving the Fed in a dilemma. Mid cap (+2.5%) and small cap (+7.1%) stocks both performed better than large caps. Materials (+5.8%) and healthcare (+5.4%) were the best performing sectors in the S&P 500; utilities (-1.6%) and industrials (0.0%) were the laggards. EAFE markets returned 4.3%% in August as the dollar dropped 2.2% with strong performance across geographies led by Japan (+7.0%). EM returned +1.3% with strong gains in Brazil (+10.3%) and China (+4.9%) offset by losses in India (-3.1%) and Korea (–1.9%).
From a valuation perspective, the S&P 500, the NASDAQ and EM trade at or above +1 standard deviation based on historical forward P/E ratios with the S&P 500 at +1.9, the NASDAQ at +1.0 and EM at +1.0. For the next 12 months, EPS growth for S&P 500 is expected to be 8.2% (vs. 6.9% annualized over the last 20 years). For the next 12 months, EPS growth for NASDAQ is expected to be 13.7% (vs. 10.7% annualized over the last 20 years). Equities across markets caps in the U.S., and in non-U.S. developed and emerging markets, trade at or above their 20-year averages based on forward P/E ratios.
Fixed Income
Investment grade fixed income asset classes had positive returns as rates fell across the curve except at the very long end. Municipals returned +0.9% (+2.1% YTD), the Bloomberg Aggregate Index returned +1.2% (+5.0% YTD) while investment grade corporate returned +1.0% (+5.3% YTD). High yield bond returns returned +1.3% (+6.4% YTD) while leveraged loan returns returned 0.4% (+4.1% YTD). Emerging Market debt returned +1.3% (+8.2% YTD) even as the US dollar fell 2.2%.
Rates
Rates fell across the curve except at the very long end as the yield curve steepened. Through the month, an increasing number of Fed governors seemed open to cutting rates; Chair Powell’s speech at the Jackson Hole conference was interpreted by the markets as “dovish.” The recession-watch 3M-10Y spread widened 5bps and remains positive at +8. The 2Y-10Y spread widened 19bps to +61. Rates rose in other developed markets. The spread between Italian and German 10Y bonds is 0.86% though the spread between French and Italian 10Y bonds dropped to the lowest in 20 years. 5-year breakeven inflation expectations rose 4bps and now sit at 2.52%; 10-year breakeven inflation expectations rose 2bps and now sit at 2.41%; the 10Y real yield fell 17bps to 1.82%. At month end, the market expected 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 3.78% vs. the Fed’s guidance of 3.75%-4.00%.
Currencies/Commodities
The dollar index fell 3.2% amid continuing uncertainty around tariffs. The commodities complex fell 0.2% with energy prices falling 4.9%. Brent prices fell 6.1% to $68/bbl. US natural gas prices fell 3.5% while European gas fell 8.3%, both based on expectations of around weather-related demand.
Market monitors
Volatility fell for stocks and bonds (VIX = 15, MOVE = 79). Market sentiment, which has been weak all year, fell from +7 to -5.) 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.