After years of unprecedently narrow leadership in the equity markets, many investors are wondering what it will take for the rally to spread to the rest of the market. We believe two drivers are likely: The first is a favorable resolution on the direction of inflation. The second is improved earnings growth for the rest of the market.

Potential Catalysts for Broader Equity Participation

After a few hot inflation reports to start the year, the broad disinflation trend that began a year ago is resuming. Core inflation, ex-housing, is already running at the U.S. Federal Reserve’s (Fed) 2% target (Figure 1, left), and there are reasons to believe that shelter, as calculated in official inflation statistics, will slow to match market-based leading indicators, such as the RealPage effective rent growth (Figure 1, right). The July Consumer Price Index (CPI) print confirmed this belief, as inflation data came in lower than expected.

Following the softer CPI print, we saw a dramatic rally in small capitalization (cap) stocks. On the day of the release (Thursday, July 11, 2024), the Russell 2000^® Index was up over 2.5%, while the NASDAQ (National Association of Securities Dealers Automated Quotations) was down nearly 2%. The magnitude of this price action and subsequent follow-through support our view that clarity around the direction of inflation should encourage investors to step out on the risk curve beyond the “Magnificent 7” and embrace other large, mid, and small cap stocks.

At the same time, the differential in earnings growth between large companies and small companies should close in the second half of 2024 and into 2025 (see Figure 2).

After a torrid stretch of outperformance in 2023 and into the start of 2024 by large caps, earnings growth for small and mid cap stocks is set to improve to the mid-teens, matching the earnings growth of large cap stocks (Figure 2, left). Furthermore, the earnings growth of MSFT, NVDA, AMZN, GOOGL, and META is set to decelerate as the earnings growth of the rest of the S&P 500 is expected to accelerate (Figure 2, right).

The gap in performance between the S&P 500 Index and the Russell 2000 Index, since the Fed signaled the end of its hiking campaign at the end of October 2023, has narrowed dramatically since the CPI print and the onset of earnings season. From the end of October 2023 through July 18, 2024, small caps have led large caps, with the Russell 2000 up 51.7% and the S&P 500 Index up 49.4%. While this recent outperformance has led investors to speculate on the sustainability of the rally, we expect returns from all stocks (not just the Mag 7!) to improve as earnings growth accelerates, and investors gain confidence in the price they are paying for earnings as clarity on inflation and rates continues to improve.

We believe Lord Abbett equity portfolios are well positioned to potentially take advantage of this environment. A unifying principle for our portfolios is that we seek to invest in quality companies with durable competitive advantages led by excellent management teams. We do this in growth and value stocks and in U.S. and non-U.S. companies. Low economic growth favors those companies that grow with predictable revenue and resilient earnings, regardless of the economic cycle. Higher cost of capital raises barriers to entry and favors high-quality businesses with competitive advantages and leaders that can intelligently allocate capital in efforts to maximize returns. And finally, the rapid pace of innovation favors businesses led by exceptional management teams with a willingness, even a paranoia, to embrace change and to adapt, or die.