Markets steadied on Friday after a turbulent week dominated by renewed inflation concerns and diverging data signals. The S&P 500 closed up 0.3%, buoyed by a modest rebound in tech and energy, while the Nasdaq added 0.4%. Treasury markets were less sanguine, with the 10-year yield rising to 4.38%, up from 4.30% earlier in the week, and the 2-year note climbing to 4.71%. This leaves the yield curve further inverted at minus 33 basis points, a persistent indicator of recession caution. Financial conditions remain broadly neutral, with the VIX steady near 13.2 and investment-grade credit spreads flat near 123 basis points. However, the market-implied Fed path remains hawkish: Fed funds futures are still pricing only one cut in 2025, delayed further by stronger-than-expected inflation. Core CPI held firm at 3.5% year-on-year in July, while average hourly earnings rose 0.4% month-on-month, both above the Fed’s comfort zone. Meanwhile, initial jobless claims ticked down to 222,000, reinforcing labor market tightness. The dollar rallied, with the DXY rising to 105.3, its highest in two months, reflecting both higher U.S. yields and global growth worries.

The focus now shifts to the August inflation data, due later this week, and Fed Chair Jerome Powell’s remarks at Jackson Hole on August 22. Given core CPI’s stickiness and rising shelter costs, even with goods disinflation helping headline numbers, markets may find it difficult to price in early easing. The most immediate catalyst will be the July Producer Price Index (PPI), due Wednesday, which could either amplify or blunt CPI concerns. If upstream input prices reaccelerate, it would argue for inflation persistence into the autumn. Meanwhile, the closely watched University of Michigan consumer sentiment survey on Friday may offer hints about households’ inflation expectations, which have been climbing slightly: the 5-10 year inflation expectation ended July at 3.1%, up from 2.9% in May.

Despite stronger recent U.S. data, global growth signals are looking lackluster.

China's Caixin Services PMI dropped to 51.1, its lowest since January, while German factory orders plunged 3.5% month-on-month, renewing questions about core eurozone demand. These external drags are starting to weigh on U.S. exports and could tighten global liquidity if broader risk sentiment sours. Credit remains available for now, but with the Fed maintaining a hawkish tone and quantitative tightening continuing to drain reserves; Fed balance sheet now under $7.3 trillion, down from $8.9 trillion at its peak, markets remain exposed to downside risk if volatility resurfaces. The equity risk premium, already compressed, leaves little cushion if earnings growth slows.

In this environment, we prefer a modest quality tilt within equities.

While broad index valuations remain stretched, segments with strong balance sheets and stable earnings, like select large-cap healthcare and cash-rich tech, are better positioned if yields remain elevated. The equal-weight S&P 500 has lagged the market-cap version, and that divergence could persist unless broader economic signals recover. We underweight small caps given their sensitivity to both rates and credit spreads, which while stable now could widen if macro conditions deteriorate.
In fixed income, with the 2-year yield holding near 4.71% and the 10-year near 4.38%, we maintain a neutral-to-slight-long duration stance, especially at the back end. The curve has already priced in considerable inversion, and should growth soften or Powell hint at a more flexible stance later this month, the long end may rally. For now, however, the inverted curve still penalizes excessive duration. Investors needing yield can look to 6-month T-bills (IRX at 5.37%), offering solid return with minimal duration risk. But caution is warranted as treasury supply increases: the latest refunding announcement confirmed a heavier tilt to long-term issuance, which may pressure intermediate yields.
On inflation hedges, we continue to see value in short-duration TIPS, such as VTIP. Market breakevens remain relatively anchored, 5-year breakeven inflation is at 2.25%, but the underlying data suggest upside risk, especially with services CPI and wage growth still firm. Commodities are a mixed bag: gold is losing traction, dipping to $1,920/oz amid rising real yields, while WTI crude is climbing again, trading near $84/bbl, supported by continued supply discipline from OPEC+ and modest demand resilience in the U.S. We remain neutral gold but see moderate upside in oil prices through Q3, especially if Chinese stimulus measures stabilize demand.
Liquidity remains margin-tight, with reserve balances hovering just above $3 trillion and the reverse repo facility usage declining as cash finds better-yielding homes. This argues for holding some dry powder, up to 15% in tactical cash, for deployment during potential pullbacks or volatility spikes. With the VIX below 14 and FX volatility (measured by the JPM G7 index) near cycle lows, complacency looks elevated. A modest allocation to tail protection may be prudent.

Tactically, a weak PPI print this week could support a temporary rally in long bonds and growth equities. Conversely, further upside surprises in inflation data or a red-hot University of Michigan reading could rekindle a bond selloff and drive further USD strength. Levels to watch include 4.45% on the 10-year yield as a near-term resistance and 104.8 on the DXY as support. If those break materially, it could trigger broader portfolio rebalancing and increased equity volatility.

Stay quality-biased in equities, hold moderate duration via back-end Treasuries, keep TIPS like VTIP as an inflation hedge, and maintain 10–15% tactical cash. A steady hand is warranted ahead of critical inflation data and Powell's Jackson Hole signal.

Sticky Inflation Keeps Powell Cautious, Bond Yields Edge Higher

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