The Tale of Two Markets: Healthy Reset or “The Big Divergence 2.0”

Thoughts on the Market

The major banks delivered a clean earnings sweep, and inflation surprised significantly to the downside — just as we expected. The catch, though, was that the price action that followed didn’t really look like the clearing event we were expecting.

Our first chart for today shows the impact of the much softer CPI and PPI reports, but we were expecting rate hike probabilities to get wiped out a lot more aggressively and the US dollar to take a much bigger leg lower. The one thing that has fully round-tripped is the yield curve, which has steepened back above the levels seen ahead of Warsh’s first FOMC meeting in June.

To be clear, we do think the latest inflation report has reduced the biggest tail risk for this bull market — namely, the Fed making a policy mistake by hiking rates. But at the same time, we can’t ignore the clear upward bias that markets are still pricing into the rate path, something we think the Fed will need to start pushing back against.

As our next chart shows, over the next 15 months, markets are assigning roughly the same probability to one Fed cut as they are to four rate hikes. And more importantly, the most likely outcome priced by rates traders is for the Fed to hike at least twice by the end of next year, which would put Fed Funds 50 basis points above the just recently updated median dot for the end of 2027.

To be fair, though, last week’s weakness has mostly been hiding beneath the surface. In fact, you even have to dig one layer deeper than usual to see what’s really been driving it.

While the S&P 500 finished the week lower, the S&P 500 ex-Tech was flat, meaning the entire decline came from Technology. Now, what’s interesting is that Software stocks didn’t just finish the week higher — they also quietly outperformed both the equal-weight S&P 500 and the S&P 500 ex-Tech index. That leaves one obvious bidless group: Semiconductors, which have been doing most of the heavy lifting on the downside.

Fun Fact: Strip out Semis, and the Technology sector has actually outperformed the S&P 500 ex-Tech so far this month, delivering twice the return of the rest of the market.

👉🏼 In other words, everything in Technology outside of Semis has been doing better than the rest of the market.

Fortunately, we got rid of our Semis overweight two weeks ago, thanks to a more selective approach within Technology. So, if last week’s price action hurt your portfolio, there’s a good chance that you’re still carrying too much Semiconductor exposure.

Generally speaking, though, we think what we’re seeing is simply the aftermath — or, better yet, the late-stage effects — of the shift in market characteristics that began in early June. If you remember…