iCapital Market Pulse: Mid-year Checkpoint: What are the Risks for the Second Half?

As we approach the second half of the year, the S&P 500 has continued its strong run as it has posted 31 record highs in 2024.¹ While we see reasons for continued market optimism, the S&P 500 is currently trading around 5,500 to 5,600 – a reasonable fair value assumption when taking into account 2025 EPS estimates.² But, with equity markets back in overbought territory, the potential for increased headline risks surrounding both domestic and international elections, and any further growth weakness as the Federal Reserve (Fed) maintains their higher-for-longer view, are reasons why we could see markets consolidate in the near term. So while we maintain our positive view on equities for the remainder of the year, we do see five potential catalysts/themes that could potentially present risks to markets during the second half of the year.

Five potential catalysts/themes we are monitoring in the second half of the year

1. All eyes on the U.S. presidential election. With a rematch set for the 2024 presidential election, we think there are policy proposals by both candidates that could worry investors and ultimately lead to an uptick in volatility. If President Biden is re-elected, more stringent regulatory oversight and a sunsetting of the temporary tax cuts under the Tax Cuts and Jobs Act (TCJA) could pose headwinds to financial markets and the economy. Conversely, if former President Donald Trump is elected, investors will be very focused on the risks from tariffs, especially at a time when inflation is still running above the Fed’s target. We believe the presidential election will become more top of mind for investors as the first presidential debate is scheduled for Thursday, June 27.

We know that volatility tends to rise one to three months (August-October) ahead of presidential elections. Additionally, this is a time of historically weak seasonal returns for equity markets. Indeed, the S&P 500 has posted negative monthly returns over the last four Septembers.³

While this could pose a risk in the near term, we would note that the S&P 500 usually posts positive (+16%) returns in the year following a presidential election (see Exhibit 1), irrespective of what party controls the White House.⁴ Despite headline risks that will likely impact markets in the near term, equity performance over the long run will likely be driven by fundamental factors such as earnings and GDP growth.

2. Two-tailed risks to the growth outlook. Coming into the year, we shared the view that the economy was on the path towards a soft-landing. However, over the last few weeks we have started to see some weakness in economic data, highlighted by the latest ISM Manufacturing PMI and weak GDP for the first quarter. As a result, economic surprises have been falling, indicating that data has been coming in below expectations. Indeed, the Bloomberg and Citi Economic surprise indices are at their lowest levels since July 2019 and January 2023.⁵ Additionally, the Atlanta GDPNow tracker briefly fell below 2%, which is the U.S. economy’s trend rate (see Exhibit 2).⁶ This weaker than expected data briefly weighed on markets at the end of May.

However, there are also risks to growth remaining too strong. While growth has not been as “boomy” as the second half of 2023, the economy has largely been growing at an above trend rate (see Exhibit 2). Indeed, despite the weaker than expected and downwardly revised Q1 GDP print, private domestic final purchases grew at 2.8% year-over-year (YoY), which is in line with the 30-year average of 2.9%.⁷ If the economy remains in a no-landing environment, inflation would likely remain sticky and above the Fed’s target, which would support their higher-for-longer view, and keep risks tilted towards rate hikes. This would likely keep upward pressure on yields, which could weigh on equities, similar to what we saw in Q3 2023 and in early April this year.

We expect growth to continue to normalize throughout this year and ultimately finish slightly above the economy’s 2% trend rate, as growth should remain supported by a resilient U.S. consumer and service-level activity. Service activity remains healthy as highlighted by the recent S&P U.S. Service PMI, which came in at 55.1, its highest level in two years. This activity should be further supported during the summer travel season as a record 71 million Americans are expected to travel over the Independence Day holiday,⁸ and a recent Bank of America Summer Travel Survey suggested that 72% of respondents intend to take a vacation this summer.⁹ Additionally, we think the economy could be supported by an additional tailwind of a renewed manufacturing upturn that we see not only here in the U.S. but broadening out globally.

3. Regional banking stress reignites. Given the resilient economy and higher interest rates this year, we have seen continued weakness in regional banks. Indeed, regional banks are down roughly 10% so far year-to-date¹⁰ and unrealized losses on investment securities remain deeply negative (see Exhibit 3).¹¹ Investors remained concerned about regional bank’s asset quality, potential credit losses and muted growth since the regional banking crisis last spring. While not to the magnitude in the spring of 2023, we have seen flair ups this year regarding New York Community Bank (NYCB) and to a lesser extent the Bank OZK, which saw their shares slide by the most since 2020 as it was downgraded over concerns about its loan book at the end of May.¹² Regulatory pressures are another concern for investors, as the FDIC last summer increased capital requirements on banks with more than $100 billion in assets – the cause of NYCB’s weakness earlier in the year. If rates remain elevated in the second half of the year, we think this could continue to put pressure on the industry.

Despite these risks, we believe they will be manageable as regional banks already have a healthy level of reserves and pre-tax, pre-provisions net revenue (PPNR).¹³ We also believe CRE debt funds will be able to help finance the funding gap for office properties as they are sitting on $77 billion in dry powder, discussed during a Beyond 60/40 segment earlier in the year.¹⁴

4. Consumer Weakness. We have maintained the view of a resilient U.S. consumer. However, with gasoline prices up 11% year-to-date and interest rates remaining elevated, this has put pressure on the low-income consumer.¹⁵ We have received a lot of questions on rising delinquencies and record high credit card balances and whether this changes our consumer outlook. While both these comments are true, if you look at these measures relative to disposable income, they are only just returning to pre-pandemic levels. Thus, indicating a normalization of the U.S. consumer and not a deterioration.

Additionally, there have been some signs that labor markets may be weakening on the margin. Indeed, initial jobless claims are near their highest levels since August 2023 and the unemployment rate has risen from 3.7% to 4.0% so far year-to-date. If labor trends continue to weaken, this could pose a risk to consumer confidence and thereby consumption.

However, if the disinflationary trend returns to a similar pace seen in the second half of 2023 and gasoline prices start to fall, this should be supportive of not only the consumer, but especially the low-income consumer. While we have seen some softening in labor market indicators, nonfarm payroll growth remains healthy. Indeed, the last six months of job gains have averaged 252k new jobs per month, almost 100k more jobs per month than what we saw during the post global financial crisis (GFC) recovery.¹⁶ While retail sales have been somewhat sluggish and possibly impacted by seasonal issues (such as an early Easter), spending on services has remained healthy and growing at a slightly faster rate than overall retail spending this year.¹⁷

5. AI tailwind disappoints in the near-term. It is very clear that artificial intelligence (AI) has been important for not only S&P 500 earnings, but the overall Index performance. Indeed, if we look at NVDA (a proxy for the AI theme), it was responsible for 37% of the S&P 500’s earnings and 11% of its total return over the last twelve months.¹⁸ While AI seems like it will be a dominant theme over the coming years, there have been historical examples of how technology cycles can be over extrapolated in the near term but underestimated in the long run. Indeed, a recent Lucidworks survey showed that 63% of companies plan on increasing AI investments over the next 12 months – down from 93% in 2023.¹⁹ While this still shows that enthusiasm around AI remains high, it also indicates that we could see a slowing in AI spending as companies try to figure out how to integrate this technology and harvest potential productivity gains.

However, we continue to see a strong case for owning semiconductors, which should benefit from the AI theme, but should also be supported by the drawdown of excess inventories and the manufacturing upturn that is still ahead of us. Software should also benefit from the large investments made in AI, but we think these names in particular represent a cheap option on the Gen AI monetization potential. Additionally, we think there is the potential for the AI theme to broaden out and benefit the power theme (see Exhibit 5), which has consolidated over the last month, after its strong start to the year.

Some consolidation today, for a better market set up later

While we still believe there is upside to the S&P 500 for the remainder of the year, we do see factors that could support some consolidation in the near term. We think investors will predominantly be focused on risks surrounding the U.S. presidential and international elections over the next few months. This could impact markets as we could see increased headline risks during a period of historically muted trading volumes. Additionally, markets are already overbought, seen with the 14-day relative strength index (RSI) on both the S&P 500 and Nasdaq 100, getting as high as 77 and 81, respectively.²⁰ To put this in context, both these readings are in their 99th percentile going back to 1990.²¹ Markets could also consolidate because of the drop we have seen in bearish sentiment (see Exhibit 6). Indeed, the American Association of Individual Investors (AAII) bearish sentiment is at 22.5%, which is near its YTD lows and in its bottom decile of observations over the last ten years.²²

While these are some of the ingredients for a market consolidation, we do not believe this is necessarily a negative, as markets will need to work off the overbought condition they have coming into the second half of the year. While we have listed some risks to our outlook, we ultimately believe that above-trend economic growth and a broadening out of earnings growth in the second half of the year should be supportive of positive returns.