Today marked the last trading day in July. As discussed at the end of June, July has a seasonal tendency to usher positive returns for the market and this year turned out to follow said tendency. We saw positive performance across the equity benchmarks; for example, the Russell 2000 (RUT) added about 5%, the Nasdaq Composite (NASD) gained 4%, and the S&P 500 (SPX) advanced roughly 3%. Note that since 1957 the median SPX return for July was 1.3%, meaning this year’s performance was well above the “typical” July.

As for the coming month, August, median equity returns have also been positive; in fact, August has a better hit rate than July. Since 1957, SPX has posted a gain in August 63% of the time which is higher than July’s batting average of 57%. Although August returns have leaned positive in the past, volatility has historically picked up as evident on our VIX progression chart at the bottom of this report. This uptick in volatility is perhaps further evidenced by the average August return, which is significantly lower than July. The average return in August for SPX since 1957 is just 0.5%, much lower than the 1.5% median, and more than 50% off July’s average return of 1.2%. The August average is pulled down by some notable market meltdowns: the 14% crash in 1998, the 9% decline in 1990 and 1974, and more recently, the 6% pullback in 2015.

When talking about August returns it is difficult not to jump to September, commonly known as the worst month of the year for equities. However, we will not get ahead of ourselves today, and in the hope of enjoying August which tends to be a positive month. When we are closer to September, we will certainly dedicate several pieces to the feared month.

It’s been a busy week for economic data. But there were really just four key events… 

1. Fed rate hike on Wednesday (7/26)
2. Q2 GDP (7/27)
3. PCE inflation (7/28)
4. Wage growth (7/28)

Those data were the best of both worlds for the Fed. GDP shows the economy remains resilient, while inflation and wage growth slowed a bit more than expected, helping position the Fed for the “soft landing” that looks increasingly possible. Add earnings news on top of this week’s deluge of data and it’s no wonder markets have been up and down. For the week, the major equity indices are up 1%-2% (blue line). Possibly more importantly, 10-year Treasury rates are now around 4% (green line). In case you missed it, 10 days ago they were 3.75%.

1. Fed hikes 25bps as expected, leaves door open to hike or pause going forward

As expected, the Fed hiked 25bps to 5.5% – a 22-year high. But the positive for markets was that Chair Powell emphasized data dependency going forward, so it’s possible this was the last hike this cycle – as markets have priced (light red line) – if inflation eases as the Fed wants. And we can add the Fed staff to the growing list of economists no longer forecasting recession.

2. Q2 GDP growth picks up speed on broad-based gains, signaling no recession

Q2 GDP data also helps the “no recession” camp. Q2 real GDP came in stronger than expected, seeing 2.4% annualized growth, up from 2% in Q1. And the gains were broad-based. Consumer spending remained the biggest contributor, as people continue to spend, especially on services. Government spending also helped. The big surprise was that businesses boosted investment, despite higher rates and tight credit conditions, which had depressed investment in recent quarters.

3. Broad disinflation – including key core services – sends PCE inflation lower

Headline PCE inflation is the gauge the Fed prefers. It fell to 3.0% YoY from 3.8% (orange line), and core PCE inflation slowed to 4.1% YoY from 4.6% (blue line). This pretty much mirrors the CPI data we got earlier this month (see our recap here). Energy is the biggest drag on inflation, but we’re now seeing disinflation across the board – from food to core goods and now even the sticky housing and wage-driven core services components.

4. Wage growth also slowing, partly helping PCE inflation fall

Finally, we got further confirmation that wage growth is slowing with the Fed’s preferred wage metric (the Employment Cost Index) rising at a 4.1% annualized rate (black line) – its smallest increase in two years. Based on forward-looking small business compensation plans (blue line), it looks like it should keep slowing.

Lots for the Fed… and markets… to like

So, GDP shows the economy remains resilient, and even saw a rebound in business investment – so it’s not just consumers driving the economy. PCE inflation, including core, is falling toward the Fed’s 2% target. And that’s helped by slower wage growth, which augurs well for a continued fall in inflation. From here, the Fed will get two more jobs reports and two more CPI reports before its September meeting. If we continue to see solid, but not blowout, jobs numbers and further easing in inflation – especially core – the Fed should be able to hold off on further rate hikes, as markets expect.

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Different presidential cycles have different variables that play into market returns, but we have seen similar themes play out over the years. To show this, we took the quarterly returns for the S&P 500 Index SPX since 1927 and organized them by the year of each presidential term. The data showed that the second year of a presidential term typically carries the worst returns, with SPX showing a modest gain of 3.33%, while the third year of a presidential term shows the best average return at a 13.51% gain. This general tendency has held true over the past few years, as we saw sharply negative returns last year followed by a strong gain in 2023. The quarterly data also highlights how the strength the S&P 500 experienced in the first two quarters of this year is also in line with historical norms, as the first half of the third year of a presidential term generally sees strong improvement at averages north of 4%. That improvement was amplified in the first half of this year, but we also saw amplified movement to the downside last year.

As we are often reminded, past performance is not indicative of future results. However, the consistency of recent movements with historical tendencies makes these trends important points to monitor as we move through the end of the third year of President Biden’s term. The third quarter of year three in any presidential term generally shows more muted results for equity markets, with the S&P 500 posting an average gain of just 0.39%. The fourth quarter of year three tends to show a rebound in performance, but the potential for underperformance over the next two months should be kept in mind as we round out the summer months.

Even if we might expect more muted returns from the market benchmarks, that does not mean all areas of the market experience the same movement. We dove deeper into the examination by using the historical performance of 10 broad domestic equity industry sectors using data pulled from the Ken French Data Library. This is the same Ken French from the famous Fama-French Model. This data was used as it ran from December 1926 through June 2023, allowing us to take our testing back significantly further than what the current GICs sectors offer. A breakdown of what is included in each of the ten industries can be found below:

Using these industry classifications, we filtered through the data for returns during the third year of each presidential cycle. This showed that the Technology & Business equipment classification tends to post the strongest returns in year three, at an average gain of over 26%. Consumer Durables show the next highest returns at an average of almost 22%. These themes have remained relatively consistent over the first six months of the year. Narrowing the performance down to just Q3 of the third year in each presidential cycle reveals some interesting results. First, the returns for each sector in Q3 of year three are lower than the average Q3 returns in any year. Consumer Durables show the highest average returns in Q3 of presidential year three, with Manufacturing showing the second highest returns. While these industry breakdowns may not match up directly with current sector norms, the legend provided above may suggest some interesting places to monitor for the next two months, even with the potential for more muted returns.