Newsletter - 1st Quarter 2024
RECAP
Equity markets continued to defy the wall of worry during the quarter on the diminished rate cut outlook by a less dovish Federal Reserve. Stocks remained resilient and trended higher from the previous quarter, with the S&P 500, Dow Jones Industrial Average, and Nasdaq indexes reaching new all-time highs. Bonds, on the other hand, were not as durable as stocks in processing the Fed’s renewed outlook of “higher for longer” interest rates, with the bond market printing a slight loss to start the year. However, this minor adjustment in bond prices occurred after the bond market staged a remarkable 4th quarter rally that was one of its best in the past 3 years.
Inflation remains stubbornly elevated, leaving the Fed in an unenviable position. Most Fed officials had wanted to start cutting rates this year if inflation trends aligned with their long-term target. However, the 1st quarter inflation data has come in much hotter than anticipated, causing market participants to reduce the number of rate cut projections for 2024. Although policymakers have remained hawkish on their stance to combat inflation at the risk of slowing the U.S. economy, it seems that we have managed to avoid a hard economic landing for the time being. The strength of the labor market is most likely the reason for this. Though waning consumer confidence continues to remain a threat.
U.S. stock valuations ended the quarter markedly higher than their long-term average, with growth stocks continuing to outpace their value-oriented peers. Even though earnings growth expectations have come down slightly since January, there have still been many positive revisions, most favoring mega-cap growth companies in the Technology and Communication Services sectors.
Like last year, most of the market’s returns have been dictated by just five stocks: Nvidia, Meta, Amazon, Microsoft, and Alphabet. Given the data, the market’s advance and narrow leadership may very well be justified in the near term. However, the breadth of market performance is beginning to broaden across many of the other sectors, and this could persist as the trend in earnings growth begins to favor the remaining stocks in the S&P 500.
As we enter the 2nd quarter, markets will be very sensitive to the trend in inflation readings and expectations. Currently, the market is pricing in at least 2 interest rate cuts for the year, and the risk of a policy error by the Fed remains high. But if they manage to thwart inflation earlier in the year, this could, in turn, accommodate the much-anticipated interest rate cuts, which both stock and bond markets would well receive. It has been 249 days since the Fed last hiked rates in July 2023. Even if the Fed further delays interest rate cuts, history has shown that rate pauses exceeding 100 days have generally produced positive return environments for stocks.
Aside from the Fed, many other risks could still increase market volatility in the quarters ahead. The continued conflicts in Ukraine and the Middle East, as well as the impending 2024 U.S. election cycle, are just a few to name. As the year progresses, it will be important for investors to maintain proper risk controls within their portfolios to ensure they adhere to their long-term investment objectives. The process of portfolio rebalancing is a critical part of the risk management process, which allows investors to stay within tolerance for their stock and bond allocation targets. Given the outperformance in equities during the quarter, we took advantage of this opportunity and completed a full portfolio rebalancing for all our managed portfolios.
THE FED & INTEREST RATES
In a widely anticipated move during their March meeting, The Federal Open Market Committee opted to maintain its federal funds interest rate at the current target range of 5.25% to 5.5%. FOMC members voted to keep language in the post-meeting minutes that they wouldn’t consider cutting rates until they “gained greater confidence” that inflation was on track toward their 2% inflation target.
As per the minutes, “Participants generally noted their uncertainty about the persistence of high inflation and expressed the view that recent data had not increased their confidence that inflation was moving sustainably down to 2%.” With higher-than-expected inflation readings in January and February, Fed Chair Jerome Powell stated that it was possible that seasonal issues could cause these readings. However, some members disagreed, noting that the recent increases in inflation had been relatively broad-based and should not be discounted by the committee.
Aside from rendering its policy decision, committee members estimated a year-end Fed Funds rate of 4.6% for 2024, suggesting three rate cuts by the end of the year. However, the Fed’s Dot Plot depiction of individual members’ interest rate expectations suggests that 9 of the 19 FOMC members still expect two rate cuts or less in 2024.
US ECONOMY
The Consumer Price Index (CPI), a broad measure of goods and services across the economy, accelerated at a faster-than-expected pace for the month of March, pushing inflation higher and derailing hopes that the Fed will cut rates in the near term. The CPI rose 0.4% for the month, causing the 12-month inflation rate to hit 3.5%. This is 0.3% higher than the rolling 12-month reading for February. Shelter and energy were the main drivers behind cost increases for the index. Energy rose over 1% after printing a 2% increase in February, while shelter costs, which account for one-third of the CPI index, were higher by 0.4% for the month and up almost 6% from one year ago.
Employers delivered an outsized number of job additions for the last month of the quarter, adding over 300,000 workers. February’s jobs growth was also revised upward to 270,000. The U.S. Labor Department reported that the unemployment rate fell from 3.9% to 3.8% by the end of the quarter. This burst of hiring is certainly a testament to the economy’s ability to withstand inflation pressures, and the jobless rate has now remained below 4% for 26 consecutive months, which is the longest streak since the 1960s. Usually, a robust number of new jobs would raise employer concerns about attracting or keeping talent and would, in turn, force them to raise pay. However, the March report showed that wage growth was muted for the month. Additionally, many economists questioned the quality of jobs being added to the March figures, with many criticizing that most of the new jobs were lower-paying part-time positions.
When assessing the overall health of the US economy, the US Leading Economic Index (LEI Index) is one of the most prominent sources. This index, consisting of 10 leading econometric readings, showed a noticeable improvement in economic conditions for February’s reading despite the gauge being negative for the past year. This uptick could point to signs of renewed economic growth for the U.S. in the quarters ahead.
The U.S. LEI rose in February 2024 for the first time since February 2022,” said Justyna Zabinska-La Monica, Senior Manager of Business Cycle Indicators, at The Conference Board. “Strength in weekly hours worked in manufacturing, stock prices, the Leading Credit Index™, and residential construction drove the LEI’s first monthly increase in two years. However, consumers’ expectations and the ISM® Index of New Orders have yet to recover, and the LEI's six- and twelve-month growth rates remain negative. Despite February’s increase, the Index still suggests some headwinds to growth going forward. The Conference Board expects annualized U.S. GDP growth to slow over the Q2 to Q3 2024 period, as rising consumer debt and elevated interest rates weigh on consumer spending.” (Source: The Conference Board)
EQUITY MARKETS
The S&P 500 posted an impressive 10% return to start the year, with the Dow Jones Industrial Average and Nasdaq trailing slightly. All three indexes reached new all-time highs during the quarter and now stand at valuation levels well above historical averages. The S&P 500's 20.9 forward P/E (Price to Earnings) valuation is now markedly higher than its historical average of 16.5x. Markets have certainly moved ahead of earnings, putting pressure on corporate earnings growth to meet analyst forecasts.
Similarly to last quarter, U.S. market leadership was very concentrated in the 1st quarter, with just a handful of companies primarily driving market returns. The dominance of the Magnificent 7 (Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, and Tesla) that was seen in the previous quarter was diminished, with Apple and Tesla ending the quarter sharply lower. But the remaining Magnificent 5 still accounted for roughly half of the market’s return for the year so far. With the valuation levels of these growth stocks exceeding historical averages, many analysts are beginning to question whether the price moves in these companies have been justified. The current price levels seem well supported when considering the double-digit earnings growth expectation for the Magnificent 7 in 2024.
However, the earnings growth trajectory for this group is expected to decline toward the end of the year, which could limit further gains. With the remaining 493 stocks in the S&P expected to show earnings momentum in the double digits later this year, equity markets could still trend higher as the rest of the market starts to contribute more to valuation levels.
Even though growth stocks took the spotlight again for the quarter, it is fair to suggest that U.S. equity market performance is beginning to broaden, with value stocks showing signs of leadership. During the quarter, the value-oriented sectors of Energy, Financials and Industrials outpaced the growth-heavy sectors of Technology and Consumer Discretionary. Yet, the rate-sensitive value sectors of Real Estate and Utilities continued to underperform the market on worries that the Fed would further delay rate cuts. Regardless, market breadth has indeed expanded with more than half of the stocks in the S&P 500 having notched 52-week highs for the quarter.
FIXED INCOME
The U.S. bond market posted a slight loss to start the year as investors digested hotter-than-expected inflation data and an outlook for fewer rate cuts in 2024. Treasury yields crept up slightly across the curve as market hopes for a 1st quarter rate cut by the Fed were dashed. Longer-term U.S. Treasuries experienced most of the losses as yields adjusted higher, with the 10-year U.S. Treasury yield increasing by 0.30% to end the quarter at 4.20%.
When reviewing the bond market's sector performance for the quarter, the longer-dated and more rate-sensitive sectors experienced the brunt of negative performance. Intermediate and Long-Term U.S. Treasuries, as well as Mortgage-Backed Securities, were the worst-performing sectors. The lower quality segments, on the other hand, were the best-performing sectors, with U.S. High Yield and Convertible Bonds delivering nominally positive total returns.
Although bond returns in aggregate were slightly negative to start the year, investors need to be mindful that bonds staged one of the largest rallies in 3 years during the 4th quarter of 2023. As rate cut expectations adjust, it is normal to see some volatility after a large move in bond prices. Regardless, current bond yields are very attractive compared to recent years, and bonds continue to offer investors many additional diversification benefits compared to cash.
INVESTOR OUTLOOK
As we enter the 2nd quarter, investors need to be aware that this period has tended to provide seasonally weaker returns. With equity markets delivering positive results to start the year, there are several risks that could contribute to equity market volatility in the months ahead. The ongoing war in Ukraine and recent tensions in the Middle East pose many geopolitical risks that could upset global equity markets. Additionally, the U.S. election cycle is fast approaching, which could also start to create market uncertainty for future regulations and fiscal policy. However, the inflation trajectory and the Fed’s rate-cut policy remain the largest risks for capital markets.
As the Fed continues to battle stubbornly high inflation, the prospect of delayed rate cuts for this year should not be viewed as entirely negative for investors. In looking at the last 10 rate hike cycles, history has shown that when the Fed holds rates steady for longer, markets typically move higher. During periods where the Fed’s rate pause exceeded 100 days, the market was up on average in the low-double-digits. When the rate pause was less than 100 days, the market, on average, was down. The good news is that the current pause now ranks second in duration at 249 days.
With many uncertainties on the horizon, it will be critical for investors to be cognizant of risk management within their portfolios. One of the most important ways that risk management can be accomplished is through regular portfolio rebalancing, as this process allows investors to maintain the proper exposure of stocks and bonds in relation to their long-term investment objective. When markets move higher, it is very easy for an investor’s stock allocation to exceed their long-term target, which in turn adds to portfolio volatility. Trimming equity risk back on market strength will help maintain the proper risk level. Conversely, when equity markets recede, an investor’s stock allocation may be underweight, preventing them from participating fully in the next bull market.
As financial professionals, we are dedicated to keeping you informed about changes that might impact your unique circumstances. Our commitment is to offer you quality service and ensure your investments align with your goals, time horizon, and risk tolerance. Please contact us to schedule your free consultation.
