Investment Overview: 2nd Quarter 2024

The economy

The U.S. economy, while still resilient, is showing signs of slowing. First-quarter GDP was reported to be 1.4%, which marked its slowest pace of growth in two years. Consumer spending, which accounts for over two-thirds of U.S. GDP, advanced just 1.5% in what is perhaps a telling sign that higher rates are starting to take a toll on the economy. Spending on consumer goods declined, while spending on services and business investment kept overall GDP in positive territory. Despite the potential cracks in the economy, major stock market indices hit record highs during the quarter, although the gains largely remained concentrated among a handful of mega-cap technology stocks. The wealth effect from higher asset prices may continue to contribute to a growing economy in the near-term, although the consensus among economists is that growth will likely slow further in the second half 2024 as the lagged effects of higher interest rates take hold.

As the markets remain seemingly fixated on the potential for rate cuts, inflation levels are equally as important to the outlook as GDP growth numbers. While the overall level of inflation has been trending in the right direction, there were some worrisome signs of a resurgence in inflation earlier in 2024. However, the most recent reading showed the core PCE Index (the Fed’s preferred inflation measure) rose just 0.1% in May, which puts inflation 2.6% higher than a year ago, the lowest annual level of increase in three years. In all, with the progress made on inflation, it is likely that the Fed will begin cutting interest rates sometime during the second half of year.

The U.S. labor market remains strong and has provided for a very healthy consumer backdrop. However, recent data is showing more mixed results. The economy added over 270,000 jobs in May, and wage growth was just over 4% versus a year ago. Meanwhile, weekly jobless claims continue to edge higher and continuing claims reached their highest level in 30 months. Further, the unemployment rate touched 4.0% for the first time in over two years. Given the importance of the consumer to the economy, any further weakening of the employment situation is likely to cause further slowing of the economy. 

In contrast to the generally positive state of the consumer, the manufacturing side of the economy continues to reside in contractionary territory. The June ISM report came in at a below expected 48.5, marking 19 out of the last 20 monthly reports with a reading below 50, which generally indicates a slowing manufacturing sector. Both demand and production figures showed weakness while inputs to the manufacturing sector showed some improvements to accommodate future production. 

With positive economic growth and inflation still above targeted levels, longer-term interest rates continued to trend modestly higher during the quarter. The bond market is now more closely aligned with the Federal Reserve’s “higher for longer” mantra. Higher interest rates benefit savers but are often a headwind to economic growth, especially among capital-intensive industries. With mortgage rates moving higher alongside interest rates, both existing and new home sales are slowing. However, home prices continue to rise and have reached record levels despite rising supply and slowing demand. 

While the U.S. economy is expected to achieve a soft landing, risks abound both at home and abroad. First, on the economic front, we are most concerned that any further weakening in the jobs market could push the U.S. economy into an unexpected recession. Globally, many foreign central banks have started easing rates, which could impact growth relative to the United States as well as currency levels. Secondly, national elections are underway across the globe, and a possible shift to more nationalistic positioning and potential impacts to global trade policies will be monitored. Of course, the 2024 U.S. election is now officially underway and as of now, the only certainty is to expect more uncertainty, which typically leads to higher volatility.

Fixed income

Interest rates increased over the second quarter on all but the shortest of maturities, which remain tethered to a Federal Funds Target Rate that has remained unchanged since last July. The 10-year Treasury Bond finished the quarter at 4.40%, up from 4.20% at the end of the first quarter and significantly higher than the 3.88% notched at the beginning of the year. Corporate bond returns outpaced their government counterparts as credit spreads remain historically tight.

Coming into the year, prognosticators expected the Fed to cut its benchmark short-term rate six times throughout 2024 as higher interest rates slowed the economy. However, markets have come to the realization that the Federal Reserve isn’t going to embark on the rate-cutting spree that was embedded into prices earlier in the year. Minutes from the Fed’s June policy meeting indicated officials were broadly comfortable with their wait-and-see stance on changing interest rates.

Nevertheless, recent comments from Fed Chair Powell suggest that a rate cut may be in the cards given that the Fed has made “quite a bit of progress in bringing inflation down toward our target.” The Fed’s preferred inflation measure is now running at a 2.6% annual rate, down from the 7.1% peak reached during the COVID-19 pandemic while June’s payroll gains weren’t enough to keep the unemployment rate from ticking up to 4.1%.

Investors will be focused on inflation data coming out over the next few weeks to see if indeed the Fed is ready to engage in a more accommodating interest rate regime in the months ahead. If inflation continues to abate, many expect Fed officials at their July 30-31 meeting to lay the groundwork for a rate cut at their subsequent gathering in September.

Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).

Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).

Equities

Stock markets presented a mixed bag of performance during the second quarter. The ubiquitous S&P 500 Index increased over 4% which followed a first quarter that witnessed 21 record highs and its best start to the year since 2019. The index is up almost 25% over the last 12 months. Conversely, smaller-capitalization and more value-oriented large-cap stocks were down, evidenced by the small-cap Russell 2000 and blue-chip Dow losing 3.3% and 1.3%, respectively. 

The divergence can be explained by the tremendous momentum of Artificial Intelligence or AI stocks. AI stocks have largely fueled market returns since late 2022. According to a Wall Street Journal article, within the S&P 500, companies related to the AI theme gained 14.7% in market value this past quarter, whereas the rest lost 1.2%. In June, chip maker Nvidia, the posterchild of the AI movement, briefly became the world’s most valuable listed company. The stock rose 37% in the second quarter and is up 149% for the year. Nvidia alone has accounted for nearly one-third of the S&P 500’s total return through the first six months of 2024.

International equities generally lagged their domestic counterparts. Emerging market equities were a notable exception, rising 5% for the quarter. This resurgence was somewhat unexpected but certainly welcomed given the well documented weaknesses in Chinese property and credit markets that have plagued returns over the last several years. 

Overall, U.S. large-cap stocks carry above average multiples heading into the third quarter of 2024. Companies in the S&P 500 are trading around 21 times their projected earnings over the next 12 months, above the five-year average of 19, according to FactSet. We are finding compelling value in select domestic equities and smaller-capitalization stocks and continue to trim outsized “growth” exposure where stocks in the “Magnificent Seven” trade at an average of 37 times their expected earnings.

Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).

Sector returns

Second-quarter sector returns were largely dominated by the AI movement, with the Information Technology (up 13.8%), Communications Services (up 9.4%), and Utilities (up 4.7%) sectors leading the way. Outside of those sectors, much of the rest of have languished. The average stock in the S&P 500 is trailing the broad index by over 10% so far this year. This marks the largest underperformance since at least 1990, according to Dow Jones Market Data and testifies to the market’s narrow AI-focused breadth.  

Interestingly, in the past few months, the Utilities sector has markedly outperformed the rest of the market after a very dismal 2023, where the sector underperformed the S&P 500 by over 30%. Typically known as the most “defensive” sector, these usually dull stocks have become the newest way to play AI as AI requires a lot of computing power, and computers use a lot of electricity.

As we move into the third quarter of 2024, sector performance could be heavily influenced by the election season pitting President Biden against former President Donald Trump, with traders racing to discount the shifting likelihood of policy changes. Also in play will be the Fed’s key decision to leave or lower its target rate. Sector rotation away from large-cap technology firms may be in the cards as such names were largely unscathed by the Fed’s aggressive hiking campaign and similarly may not get as much of a boost from a rate-cutting cycle.

The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).