9 minute read
The first half of the year unfolded much better than expected for U.S. equities. The U.S. economy stayed resilient in an environment where inflation and interest rates remained higher than expectations. Strong corporate earnings and the continued strength of the U.S. consumer propelled the market to record highs.
The S & P 500 was up nearly 4.5% in the 2nd quarter, reaching a new all-time high. The gains came with some volatility in the three-month period. The S & P 500 fell 4.1% in April, pressured by a stronger-than-expected March inflation report and rising bond yields. In May and June, stocks rebounded led by technology stocks. Chipmaker Nvidia became the world’s most valuable company in late-June after its share price climbed to an all-time high. We also saw the continuing trend of large-cap stocks outperforming small cap stocks and growth beating value. Overseas, results were mixed with developed international stocks (MSCI EAFE) falling .4%, while emerging markets stocks (MSCI EM Index) rose 5% for the 2nd quarter.
In the bond markets, returns were positive across most fixed-income segments. The benchmark 10-year Treasury yield ended the quarter close to where it started, but rates were volatile in the period. The 10-year Treasury started at 4.2%, rose to 4.6% before coming back down to the mid 4.2% range. In this environment, the Bloomberg U.S. Aggregate Bond Index gained .3% and credit performed well in the quarter as high yield bonds were up 1% in the quarter.
Finally, our alternatives strategies which include real estate, private credit, and equity performed well in the quarter and were right in line with our expectations.
We are pleased with our Global Asset allocation strategies as most have outperformed their strategic benchmarks for the quarter, though there is never a guarantee this will continue or result in future profits. Returns were strong across the board, with higher returns from our most growth-oriented strategies as would be expected in a strong period for equity returns.
The sharp 2nd quarter rally was driven by a resilient U.S. economy and strong corporate earnings. All eyes remain on Fed policy. The next move for the Fed Funds rate is likely lower, even if the cuts are taking longer than expected.
Macro Outlook
During the second quarter, the U.S. economy began its fifth year of expansion after the brief pandemic-related recession in April 2020. Ongoing economic growth has defied widespread expectations of a recession that were present for most of 2023. The U.S. economy has continued to prove resilient despite the Fed maintaining a higher level of interest rates for longer than most expected. The main driver of this better-than-expected economic growth has been the continued strength of the U.S. consumer. The combination of robust job gains and steady positive real income growth has allowed consumers to continue spending despite higher rates. The strong economy has also benefited corporate earnings.
As the economy and corporate earnings have continued to grow, it is apparent that Fed policy has not been too restrictive, or at a minimum, rate increases are taking longer than expected to have an impact. Today, economic growth remains stronger than expected in the 2% to 3% range, a level that is above the Fed’s long-run growth estimate for the U.S. This robust activity seems to have been driven strong consumer spending.
Some cracks are beginning to form in the labor market and consumer spending. There’s been a continual erosion of pandemic savings and as a result consumer confidence has been dented by the high cost of living. There was also another tick higher in the unemployment rate to 4.1%. This is up from the cycle’s low of 3.4%, while it’s also continued to climb above the 36-month moving average. Job security holds the key to future consumer spending.
Looking ahead, our base case is for the economy to continue growing, albeit at a slower pace, for the remainder of the year. We also expect inflation and labor markets will slow but not seize – in the near-term, and we think this backdrop remains supportive for risk assets and equities.
Inflation and Interest Rates
Last year, it seemed as though the Fed was decisively winning the inflation battle. But in the first quarter of 2024, particularly in January, inflation came in higher than expected. These higher readings seem to set the bar higher in terms of evidence that the Fed will need to see before cutting rates. As a result, the market dramatically repriced 2024 rate-cut expectations, going from an estimated 6-7 rate cuts at the start of the year, to 1-2 cuts as of June.
More recently, the April inflation reading showed moderate signs that inflation might again start to trend lower. Our belief has been that despite some higher readings earlier this year, the Fed’s aggressive rate hikes have tamed inflation, and we expect to see continued disinflation. The chart below shows CPI and CPI ex-shelter (Shelter is the estimated cost of home ownership, or the rent a homeowner would pay for a similar property nearby – this is the largest component of CPI). If you exclude shelter from CPI, you can see that inflation has been tamed at or around 2% since May of 2023. We expect the shelter component to gradually decline over the remainder of the year and, thus, CPI too. Across most of the economy, price increases have been in line with the Fed’s 2% target.
It seems like the Fed is concerned about a second wave of inflation, and without strong evidence of an imminent recession, they will be reluctant to cut rates aggressively. The risk of keeping rates too high for too long is that the Fed sacrifices the economy in the near-term for the sake of reaching what seems to be an arbitrary target. We believe the Fed is inclined to cut rates this year, recognizing the risks of waiting too long. Our sense is that Fed officials recognize higher rates are causing some economic strains in areas such as commercial real estate, regional banks, and lower-end consumer, and that some of today’s offsetting factors such as fiscal policy might not last forever. Furthermore, we suspect there is some risk to smaller-cap companies if rates remain elevated for much longer. Smaller-cap companies have a meaningful amount of expensive floating-rate debt that is tied to short term rates, and that is nearing maturity. The Fed certainly doesn’t want to cause a recession when it’s unnecessary, and that’s the fine line they are walking today. We also think any further weakening in the labor market might push the Fed to cut rates before the 2% inflation target is reached.
Financial Markets Outlook
Last year, the Fed made it clear they believe the end of the war on inflation is near, and not only are they preparing to take their foot off the brake, but they are also anticipating interest rate cuts in 2024. At the same time, the Fed also said it foresees the economy remaining relatively healthy with steady growth and modest levels of unemployment. Historically, the end of the Fed’s hiking cycle usually serves as a tailwind for stocks.
U.S. Stocks again led the charge with all three major indexes – the Dow Jones, Nasdaq, and S & P 500 – each making new all-time highs in the quarter. Continuing the theme from last quarter and 2023, only a handful of U.S. mega-cap technology stocks continue to lead the way for domestic equities. Last year just 30% of stocks within the S & P 500 outperformed the index. This was a historically low figure – a level not seen since the late 1990s. Yet so far in 2024, the concentration of returns moved even higher. Through late June 2024, only 27% of stocks are outperforming the S & P 500. This is the lowest reading on record going back more than 50 years. The top 10 contributors in 2024 have accounted for 70% of the S & P 500’s year-to-date return.
Our portfolios have meaningful exposure to many of these strong-performing mega-cap stocks, which has benefitted portfolio performance. But we remain balanced, also owning large cap value and smaller-cap U.S. stocks that are trading at more attractive valuations and offer important diversification especially if the Fed starts cutting interest rates. Smaller cap U.S. stocks, for example, are trading at valuations relative to large-cap stocks that have not been seen in years, dating back to the late 1990s. We should also note that we think it’s quite possible that areas of the equity market which have lagged and have lower valuations – small-cap companies and value stocks – could benefit from an ongoing expansion and have a broadening out of the market rally if the Fed starts cutting interest rates.
From a valuation perspective, the discount for developed international stocks versus the U.S. is the widest it’s been in decades. From 2006 through 2016, the U.S. and developed markets traded within one multiple point of each other. The average forward P/E for the S & P 500 over the period was 14X compared to 13X for MSCI EAFE. Since 2016, the valuation gap has widened substantially. The S & P 500 now trades at nearly 21X forward earnings, while the MSCI EAFE remains close to 14X. The story can be seen in the chart below. U.S. stocks trade near peak valuations, while other regions offer better relative values as their valuations are not extended.
Our portfolios have a slight overweight to large-cap. We do think, however that small-cap stocks will close the performance gap as the year progresses which will broaden out market returns and areas of the market that have significantly lagged will perform much better. We think international developed equities will continue to do well and will close the performance and valuation gap versus the U.S. market. Our equity strategy is to remain fully diversified among U.S. large-cap, mid-cap and small-cap equities while also investing in developed international equities with an underweight in emerging market equities.
Of course, here in the U.S., we expect pockets of volatility as the drumbeat of the November election gets louder, particularly given today’s polarized political environment. Headlines will influence short-term market fluctuations but longer-term fundamentals are what drive market performance. Our focus will continue to be on factors such as Fed policy, economic growth, inflation, valuations, etc. The U.S. economy is consumer-driven and that’s not going to change. Ultimately, the fundamentals of the economy don’t change overnight, and we don’t think an investment strategy should either. Our approach will be to stay the course and be on the lookout for opportunities that arise with market fluctuations.
Fixed Income
Inflation and Fed policy will continue to be the major drivers of the bond market in 2024. The Fed’s latest forecast is for one cut over the remainder of 2024, and then four cuts over the next two calendar years. The current market consensus is for one to two cuts this year. Our view is that longer-term interest rates (the 10-year Treasury) will be rangebound between 4% and 4.75% in 2024, and we would not be surprised to continue seeing sharp movements in yields within this range as the market continues to react to economic data and try to anticipate the Fed’s next move. As we look into the next year, we see longer rates in the 3.5%-4.0% range as the Fed reduces rates. Regarding short-term rates, we think the Fed will cut up to two times this year and potentially four times in 2025. Should we face a recession, today’s current level of rates (5.25% to 5.50%) gives the Fed plenty of room to cut rates aggressively to prevent a protracted slowdown.
The yield curve remains inverted, meaning short-term bonds yield more than longer-term bonds. Ultimately, we will have to return to a normal shaped yield curve, where investors receive higher yields for longer maturities. As we show in the chart below, investors are receiving slightly more than 1% additional yield for investing in short-term bonds compared to the 10-year Treasury with less interest rate sensitivity. At the end of June, 3-month Treasury bonds were yielding 5.48% compared to 4.36% for the 10-year Treasury. If short-term rates decline to a range of 3.0%-3.25% based on future Fed rate cuts over the next two years, then it’s likely the 10-year treasury would be in the mid- to upper-3% range. So for now, bonds finally provide a positive real (after inflation) yield. Core bonds offer good return potential with downside protection. We favor treasuries, long-term municipal bonds, and high-quality credit issues.
Alternative Strategies
Alternatives provide powerful, long-term portfolio benefits and non-correlated returns to traditional stock and bond holdings and improve risk-adjusted returns of balanced portfolios. Given the current macro risks and market backdrop, we think they are especially valuable as inflation and interest rates decline.
We favor private real estate investment allocations to multi-family, industrial and self-storage, and selected grocery anchored centers for those that can afford the illiquidity and other risks generally associated with private investments. We expect equity like long term returns from these investments with built in inflation protection and tax efficient income generation. We also favor private equity and credit opportunities and recently added a position in commodities. We will continue to add alternatives to our diversified balanced portfolios.
Closing Thoughts
The U.S. economy looks set to benefit from a continuing moderation in growth, inflation, and jobs, creating a backdrop that supports equities and other risk assets. The U.S. market continues to hit new highs as economic growth drives higher corporate earnings. U.S. concentration remains high with the Magnificent Seven representing over 25% of the S & P 500. There’s no doubt that the other 493 stocks of the S & P 500 have struggled on a relative basis, but we expect that to change with the rest of the market improving as lower interest rates will fuel the economy. We expect more volatility given the headline risks related to Fed policy adjustments and the presidential races.
Heading into the second half of the year, Fixed-income assets and high-quality bonds are also now attractively priced with mid-single digit or better expected returns. Core bonds will also provide downside stability in the event of a recession. Our investments in alternative strategies should provide further resilience and upside to our portfolio.
We sincerely thank you for your confidence and trust in us. Please do not hesitate to reach out to us if you have any questions or wish to discuss how all this relates to your specific financial situation in more depth.
