Newsletter - 2nd Quarter 2024
RECAP
Equity markets experienced a favorable second quarter, sharing many similarities with the previous quarter at the surface. Both the S&P 500 and Nasdaq Indexes reached new record highs during the quarter, managing to end the quarter near these levels. This movement was, of course, driven by many of the artificial intelligence (AI) related stocks that dominate these indexes. The Dow Jones Industrial Average also reached a new all-time high early in the quarter. However, it was unable to hold onto these gains and ended the quarter slightly lower than where it began. This was primarily due to the index’s composition, which has significantly less exposure to the Technology sector and AI-related companies than the other two indexes. Bonds made little progress during the quarter as investors looked for signs as to when the Federal Reserve would begin to ease rates this year. Nevertheless, the current yield for the Bloomberg US Aggregate Bond Index sat at an attractive 5% level at the end of June.
The U.S. Federal Reserve left interest rates unchanged at its June meeting with signs that inflation is starting to moderate closer toward their long-term policy goal of 2%. Although inflation readings are heading in the right direction for now, there are several economic metrics that are beginning to show some signs of deterioration. The nominal rise in unemployment during the quarter, as well as the noticeable increase in credit card and auto loan delinquencies, are just a few to name. Even though policymakers had throttled their rate cut projections in the prior quarter, many have started to address the risks that their current interest rate policy could pose to the consumer and economy. This, in turn, revitalized the projection for rate cuts to occur sooner than previously anticipated, with the interest rate market pricing in one to two rate cuts by this year’s end.
Stock fundamentals continued a similar path as the previous quarter, with valuation levels closing the quarter well above historical averages. The S&P 500’s forward price-earnings (P/E) multiple ended June at 21 times next year’s earnings, which marks a 25% premium to its 30-year average. However, most of the equity market’s richness has resulted from narrowing market breadth, as evidenced by the top 10 S&P 500 stocks driving the bulk of the returns for the entire index. Most of these market cap leaders are growth companies in the Technology or Communication Services space, which are segments that have benefitted substantially from the investor momentum surrounding the AI theme. During the previous quarter, market pundits were hopeful that market leadership would shift for the second quarter. Unfortunately, this did not materialize for the remaining S&P constituents and, in particular, many value-oriented companies that continue to trade at more attractive levels than their mega-cap growth peers.
Looking toward the second half of 2024, the prospects of a Fed rate cut are promising, given the current trend of inflation. This Fed action will certainly be supportive of equity market levels and lower volatility to an extent. However, there is a growing concern surrounding the valuation premium of many AI-related companies and their ability to continue growing both earnings and revenue to justify their current stock prices. Should the earnings reports of the AI leaders disappoint investor expectations, this could very easily lead to a swift repricing of these companies to the downside in the quarters ahead. The upcoming U.S. Presidential Election could also pose a risk to equity market volatility. Nevertheless, this could present a buying opportunity for client portfolios.
THE FEDERAL RESERVE
The Federal Open Market Committee (FOMC) opted to maintain interest rates at the current target range of 5.25% to 5.5% during their June meeting. The FOMC’s dot-plot projections indicated that only one interest rate cut would be likely for this year. However, the interest rate market was still hinting at the potential for a second rate cut later in the year.
In the final month of the quarter, the Fed started to taper its Quantitative Tightening program by reducing its balance sheet runoff of Treasuries and Mortgage-Backed Securities (MBS), deciding on a maximum runoff of $25 billion in Treasuries and $35 billion in MBS a month going forward. This is a clear indication that the Fed is setting the stage for a rate cut this year.
The strong labor market and tight housing market have made it difficult for the Fed to justify a rate cut in the first half of 2024. Even after getting positive inflation reports for the quarter, the FOMC said that it will need to see a broader trend of declining inflation toward its 2.00% policy goal.
The Fed has not raised or cut rates since July of 2023, but it seems likely that it will pivot to rate cuts before the end of the year. Both economists and investors have anticipated multiple rate cuts in the second half of the year, but Fed officials have repeatedly warned against the dangers of cutting rates prematurely and triggering a rebound in inflation.
US CONSUMER
The inflation picture in the U.S. continued to improve with the headline CPI readings coming in at 3.3% and 3.0% annualized for both May and June. The decline in energy prices was mostly the cause for this decrease. Although this trend is helpful to the consumer’s wallet, one must remember that this lower inflation rate is still based off a higher price level as the result of much higher inflation rates in 2022 and 2023.
The unemployment rate rose gradually to 4.0% in May but is still at a historically low level. Job openings, on the other hand, continue to decline, with the Job Opening and Labor Turnover Survey (JOLTS) showing that there were roughly 8 million available jobs in the U.S. labor market. The number of job openings has fallen significantly from the March 2022 high of nearly 12.2 million jobs and now stands at a level that is nominally above pre-pandemic readings.
Both credit card and auto loan delinquencies rose to 9% and 8%, respectively. These are now noticeably above 2019 levels. High interest rates have undoubtedly contributed to this move. Conversely, student loan delinquencies have ebbed lower and finished the quarter at just 1%.
Given the lasting effects of inflation, the slight deterioration in the labor market, and increased debt pressures, it comes as no surprise that the U.S. consumer may be showing signs of fatigue. This notion is supported by the steep drop in the University of Michigan Consumer Sentiment Index (below), which started the quarter near 80 but sank to a reading of 68. It is important to note that although this index declined for the quarter, it is still up sharply from the June low of 2022, when inflation was at its worst.
EQUITY MARKETS
Stocks continued to become more expensive for the quarter, with the S&P 500 Index trading at 21 times next year’s earnings, well above its 30-year average of 16.7. Even though this valuation level has become a growing concern for investors, it is essential to note that the top 10 stocks in the S&P have heavily skewed the Index’s P/E multiple. As of June 30th, the forward P/E for just the top 10 companies by market capitalization stood at just over 30 times next year’s earnings. This is nearly a 50% premium to the top 10’s historical average and over an 80% premium to the entire Index’s 30-year average.
There’s no doubt that this valuation skew is the result of narrow market leadership since many of the names in the top 10 ranking for the Index are growth stocks that benefitted substantially from the AI-driven earnings and revenue momentum for the quarter. Consequently, the top 10 S&P companies accounted for nearly 40% of the Index’s value and contributed to over two-thirds of the composite’s share of returns for the first half of 2024. Despite their contribution to market capitalization and returns for the Index, these top 10 companies still only account for just 28% of the S&P 500’s total earnings. This could be an indication that valuations for the mega-cap growth segment could be near an interim peak.
Large-cap value stocks continued to underperform their growth peers by a wide margin for both the quarter and the year. This is again attributed to the AI-driven investment theme, which primarily excluded traditional value companies.
From a sector perspective, the leaders for the quarter were the growth sectors of Technology and Communication Services, which provided high single-digit returns. The only other sectors that posted a positive return for the second quarter were Utilities and Consumer Staples, which reacted positively to the lower inflation readings. The remaining seven sectors in the U.S. market all posted nominal negative returns to close the quarter.
U.S. small-cap and mid-cap stocks lagged their large-cap peers for the period, posting nominal single-digit losses. The returns for U.S. small-cap stocks were barely positive for the year at the quarter’s close. Many analysts point to the Fed’s interest rate policy as the primary reason for this performance disparity as smaller companies tend to be more dependent on lending rates than larger firms that have greater access to lending and capital. The Fed’s delay in cutting rates this year has certainly put a damper on this segment of the market.
FIXED INCOME
The return for the U.S. Bond Market was essentially flat for the quarter, with the Bloomberg Aggregate Bond Index closing the quarter at a 5% yield. 2-year U.S. Treasury yields ended the quarter at 4.7%, while 10-year U.S. Treasury yields finished the quarter at 4.4%. Although the yield curve is still inverted, with short-term rates being higher than long-term rates, it is essential to note that the level of inversion has declined since the yield curve’s peak inversion in June of 2023. This can be explained by the Fed’s recent dovish shift in response to more benign inflation data, as this will tend to affect short-term rates more. Nevertheless, the bond market was in a holding pattern for the quarter, waiting for more positive inflation data or more definitive action from the Fed.
For the quarter, short-term bonds nominally outperformed their long-term counterparts as the bond market revised its prospects for lower rates. The returns across the various bond sectors were influenced more by their maturity and yields than by their credit quality. This is very evident in the fact that both High Yield Corporates (which typically have shorter maturities) and Short-Term U.S. Treasuries were return leaders, posting slight gains for the quarter. Conversely, longer-duration issues such as Long-Term Treasuries and Convertible Corporate Bonds posted slight losses during the quarter.
With the yield of the bond market sitting at 5%, bond investors are receiving an attractive rate of return while obtaining additional diversification benefits to stocks and other asset classes. With inflation at 3.4%, bond investors are also enjoying a healthy, positive real yield of 1.6%, which has been absent from bond investors for quite some time. Although short-term CDs and U.S. Treasuries are offering yields that may be incrementally higher than the broad U.S. Bond Market, these instruments may become less attractive when the Fed finally begins to cut short-term rates.
INVESTOR OUTLOOK
Inflation and the Fed’s policy response continue to be the key focal points for the equity markets, and a rate cut later this year could very well provide an additional tailwind for stocks. With signs that the economy is slowing, the Fed may be forced to act sooner than later.
The AI-driven rally in stocks is now exceeding 20 months, and with valuations at high levels, the risk of a correction in this segment could propagate additional market volatility in the quarters ahead. It will be necessary for these companies to deliver both revenue and earnings growth to the extent that they have had in past earnings periods. Even the slightest disappointment in reported numbers or guidance could trigger a repricing for many AI companies.
Despite the risks posed by the growth segment of the U.S. Stock Market, there are still plenty of attractively priced opportunities in the value segment of the market. Many of these sectors/companies have not participated in the current bull market to the extent as their growth peers. So, even if a correction in the AI space were to ensue in the quarters ahead, the value segment has the potential to be less affected by this volatility.
With the U.S. presidential election just four months away, we could also see an uptick in market volatility as investors discount the policy prospects of both candidates and the impact that each could have on future economic growth. Regardless of the cause of market volatility, this could pose an excellent opportunity for investor portfolios.
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