U.S. stocks, stuck in their biggest pullback of the year, are still seen leading global markets higher over the coming months, powered by a dovish Federal Reserve, a resilient economy, and the increasing chances of a November victory for former President Donald Trump.
That at least appears to be the verdict of two key reports on the flow of funds from the world's biggest investors. They are allocating cash to U.S. stocks despite the recent tech-driven decline that has pared second-quarter gains over the past week.
Bank of America's closely-tracked 'Flow Show" report noted global investors plowed nearly $45 billion into U.S. equity funds last week, the fourth largest tally on record. The report also noted big outflows from Europe, where around $47.7 billion left the region.
Small-cap stocks were also in favor, with the second-largest inflow on record, pegged at $9.9 billion. Tech stocks also saw the biggest increase in a month, at $2.4 billion.
"The stock market is experiencing a long overdue rotation, where investors are taking money out of big tech stocks which have performed so well and moving that money into other areas of the market, such as small-cap stocks," Glen Smith, chief investment officer at GDS Wealth Management in Flower Mound, Texas.
Stocks rotate, not retreat
"This rotation is being driven in part by optimism about future rate cuts, as lower interest rates help small-cap stocks, many of which have lower earnings power and rely on debt to finance their operations."
According to the BofA' Flow Show' report, the small-cap allocation suggests investors are in rotation, not retreat. The prospect of a Trump win and the lower taxes and lighter regulations it's likely to deliver is bullish for smaller company stocks.
Bets on an autumn Fed rate cut are also cementing into consensus, with the CME Group's FedWatch pegging the odds of a September reduction at 98.1% now that inflation pressures appear to be moving consistently back to the central bank's 2% target.
Related: CPI inflation report fuels Fed interest rate cut bets
The odds of a second Fed rate cut before the end of the year have also improved to around 90%, according to FedWatch data.
Cooling labor market conditions are also seen as adding less upward pressure on wages, allowing headline inflation to recede. However, robust hiring and the overall resilience of the U.S. economy point to a so-called 'soft landing' that avoids recession while taming inflation.
The Atlanta Fed's GDPNow forecasting tool, which tracks real-time U.S. growth, shows a second-quarter growth rate of 2.7%, well ahead of the 1.4% advance recorded over the year's first three months.
That set-up is keeping global investors firmly allocated in U.S. stocks, according to BofA's July Global Fund Managers' Survey, unless there is a "shock to the soft landing narrative" that currently underpins their conviction.
Supermarket sweep?
Where concern does arise, however, is in the bond market should either party win a sweep in the November elections, allowing control of both Congress and the White House.
Investors say that could trigger tax, spending, and tariff policies that could rekindle inflation risks and possibly trigger a rate response from the Federal Reserve.
Around 77% of those polled in the BofA survey said a sweep would lead to higher 10-year Treasury yields, with just over half betting it would boost the dollar's value against its currency market peers.
That said, a similar percentage think a sweep would ultimately be positive for U.S. stocks, as well, although earnings growth remains the key variable to second half performance.
Related: Stocks face summer slump as tech rally fades, political risks rise
LSEG data suggests collective S&P 500 earnings will rise 11.1% from last year, a firm improvement from earlier forecasts of an 8% advance, with third-quarter profits up 8.3%.
For the full year, analysts see S&P 500 earnings rising 10.5% from 2023, with a further 14.7% gain estimated for 2025.
More Economic Analysis:
- June jobs report bolsters bets on an autumn Fed interest rate cut
- Biden debate flop boosts Trump, but economy may be tougher opponent
- First-half market gains come with a dash of investor unease
"Valuations are high, and future equity market gains will rely heavily on earnings growth continuing to positively surprise against a backdrop of much loftier expectations," said Marc Zabicki, chief investment officer at LPL Financial, in his mid-year outlook report.
"While incremental gains are certainly possible in the second half, volatility is likely to pick up," he added. "Investors should be prepared for potential setbacks, especially considering the upcoming presidential election and the heightened geopolitical situation."
Related: Veteran fund manager sees world of pain coming for stocks
