Inflation decelerates

June CPI came in meaningfully below expectations, with headline CPI declining 0.4% month-over-month after rising 0.5% in May. Core CPI was unchanged for the month, while year-over-year headline inflation declined from 4.2% to 3.5% and core inflation fell from 2.9% to 2.6%. Energy was the primary driver of the improvement, falling 5.7% in June as gasoline prices declined 9.7%, although energy prices remain 15.7% higher than a year ago. In response, the market reduced the implied probability of a July rate hike to 10% from 35% before the report, while still pricing approximately 28 basis points of hikes by December.

• The report was clearly better than expected, particularly the flat core reading
• Much of the improvement came from lower gasoline prices, which may prove temporary given the renewed conflict in the Middle East
• The market has moved away from expecting an immediate hike, but it has not returned to expecting rate cuts
• One favorable report does not resolve the broader inflation issue, especially while energy prices remain elevated year-over-year
• The Fed will likely need to see additional improvement before changing its stance materially.
• We will have to see whether the June report represents the beginning of a trend or simply a temporary reprieve

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The crowded AI trade begins to unwind

A sharp reversal has taken place beneath the surface of the equity market, concentrated in semiconductor and momentum stocks. The Philadelphia Semiconductor Index has fallen 23.5% from its June 22 high, while the S&P 500 Momentum Index is down 10% in July compared with a 0.8% decline for the broader market. The weakness continued despite strong results and forecasts from TSMC and ASML. Hedge funds have sold technology hardware stocks for four consecutive weeks, with information technology the most heavily sold U.S. sector. The selling follows a period in which gross leverage among Goldman Sachs prime-brokerage clients reached record levels, leaving crowded positions vulnerable as managers reduced risk.

• The recent reversal appears to be more technical than fundamental
• Hedge fund de-grossing can force selling in recent winners even when underlying results remain strong
• This helps explain why semiconductor stocks declined despite continued strong demand and earnings
• As funds reduce gross exposure, they sell longs and cover shorts, which pressures winners while supporting prior laggards
• The broader market has held up relatively well, suggesting this is not yet a broad-based risk-off move
• The key question is whether investors use this pullback to add back to AI exposure or continue rotating into less crowded areas
• We will have to see if the market begins to distinguish more clearly between companies benefiting from AI spending and those ultimately generating returns from it

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