Last week, the U.S. stock market showcased an intense divergence among various sectors. The Dow Jones Industrial Average, heavily weighted with cyclical stocks, experienced a significant decline, contrasting sharply with the performance of large technology companies that helped push the Nasdaq and S&P 500 to extend their previous gains. This situation unfolded amid fluctuating sentiment regarding the Federal Reserve's interest rate cut expectations, which momentarily caused sharp intraday sell-offs. However, Nvidia's strong earnings guidance played a pivotal role in stabilizing market risk appetite.

As volatility trembled to new lows for the year, the stock indices at historically elevated levels appeared poised for intensified battles surrounding monetary policies and tech stock trajectories. The whisper of potential interest rate cuts by the Federal Reserve began to face scrutiny, as distinct discord surfaced within the Federal Open Market Committee (FOMC) from the minutes released last week, indicating that multiple officials were considering the possibility of an interest rate hike rather than cuts.

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The focus on comments surrounding the neutral interest rate was particularly noteworthy, with scholars such as Bob Schwartz from Oxford Economics emphasizing that expectations might have risen higher than previously anticipated. Meanwhile, several economic indicators from the U.S. demonstrated unexpected recovery, dimming short-term hopes for any imminent interest rate cuts. For example, the May PMI from S&P Global jumped to its highest level in 25 months, buoyed not only by a stable manufacturing sector but also by robust growth within the service industry. However, rising input costs signal potential re-surfacing of commodity inflation in the upcoming future.

This shift in the economic backdrop also influenced bond markets, with U.S. treasury yields continuing their upward trend. Notably, the two-year Treasury, closely linked to interest rate expectations, reached 4.95%, marking its highest point since May 1, while the benchmark ten-year yield rose to 4.47%, an increase of five basis points over the week. As captured by the Chicago Mercantile Exchange’s FedWatch Tool, market consensus for a Fed rate cut in September was at approximately 49.4%, down from 54.8% one week prior. The likelihood of two rate cuts this year shrank to less than 30%, while it had been around 70% just a week before. This week, Goldman Sachs also revised its forecast for the Fed’s first rate cut from July to September.

Thomas Simons, an economist at Jefferies, noted a shift in anticipated economic conditions. He indicated the previous expectations of a weakening labor market, pushed by inflation-induced consumption slowdown, that would lead companies to resort to layoffs was now off the table. Instead, many companies were successfully managing workforce costs through reduced hours and part-time work, maintaining their profit margins. This approach reflects changing dynamics in labor scarcity as skilled workers become less abundant over time, suggesting that companies may adapt to this challenging landscape rather than simply downsizing.

Schwartz maintained that following a slow start to the year, the U.S. economy was showing signs of improvement. Factors contributing to this included solid consumer spending, a tight labor market, and stable business investment, all projected to accelerate GDP growth in the second quarter. However, he advised caution not to place too much weight on a single month's data, as pending inflation concerns remain persistent. Overall, the outlook for interest rate cuts from the Federal Reserve carries high probability, contingent on forthcoming data.

As discussions swirled around the capability of tech stocks to continue propping up the market, the previous week saw a mixed performance in U.S. equities. Despite signs of economic activity exceeding expectations, alongside Fed meeting minutes putting downward pressure on interest rate cut bets, cyclical sectors faced significant selling pressure, with energy and real estate sectors dipping over 3% and financials declining by 2.0%. Conversely, non-essential goods, healthcare, and utilities also recorded losses exceeding 1%.

Yet, buoyed by Nvidia's strong quarterly report, the technology and communication services sectors managed to offset losses elsewhere. The AI chip behemoth not only surpassed profit and revenue expectations for the first quarter but also presented rosy guidance for the current quarter, resulting in an increase of over $150 billion in its market capitalization, which even exceeded the total market value of Germany’s stock market.

Market analysts, including Rob Haworth of U.S. Bank Wealth Management, indicated a last-minute stabilization in equities suggests a possibly less dire situation than previously feared. He surmised that the Fed is likely to have leeway for rate cuts with an improving economic landscape, steering away from a complete collapse. Anthony Saglimbene from Ameriprise Financial highlighted the importance of Nvidia’s results as market sentiment remains sensitive to economic data challenging the anticipated rate cuts from the Fed this year. Investors, he noted, might be overreacting, reflecting the high sensitivity of the market to economic indicators.

In terms of capital flow, investors showed a willingness to buy, as evidenced by substantial inflows into U.S. equity funds. Data provided by LSEG to First Financial revealed that driven by the performance of major tech firms, net inflows into U.S. equity funds hit $9.9 billion over the past week, a notable increase from the previous week’s $4.1 billion. Saglimbene observed that investors are caring to determine if the S&P 500’s current level near 5300 marks a potential ceiling or a support area for further gains. He identified favorable conditions pointing towards an upward trajectory, primarily driven by solid earnings from American companies, particularly tech giants with greater weights within the index.

Charles Schwab’s market outlook suggested that with Nvidia’s much-anticipated earnings report in tandem with guiding capital expenditures from major tech companies, the optimistic narrative surrounding artificial intelligence remains intact for the time being. According to their analysis, a definitive turning point concerning growth has yet to emerge. However, the dread of prolonged high-interest rates was reinforced by the Fed's meeting minutes alongside the S&P PMI readings. Considering the index's uptrend over the last five weeks and the elevated forward P/E ratio nearing 21, far above the 10-year average of 17.7, the current pricing is approaching a state of perfection.

This investment firm also posits that the forthcoming April Personal Consumption Expenditures (PCE) index will serve as a short-term catalyst for market trends. As investors keep an eye on inflation metrics and treasury yield movements, a cautious stance is advised in navigating these uncertain waters.