Second Quarterly Investment Newsletter – Q2 2024

ECONOMIC OUTLOOK

Solid economic activity, including a robust labor market and continued consumer and business spending, has diminished recessionary fears. While the Fed is likely to start lowering rates in 2024, the timing of such moves remains unclear. Also, consumers and the U.S. government face a higher interest burden on outstanding debt, potentially weighing on economic growth. However, these challenges could be offset by the Treasury’s liquidity infusions and artificial intelligence (Al)-led productivity gains.

Investor Optimism Creates Risk

• The prospect of lower interest rates and Al-fueled productivity gains for corporations has inspired high optimism among investors. This translates to high valuations and may create volatility if reality falls short of elevated expectations.

Discretionary Spending Under Pressure

• Credit card balances continue to rise while excess savings have been mostly depleted. Higher interest expenses will eventually weigh on discretionary consumer spending.
• The rise of borrowing costs on U.S. government debt has outpaced GDP growth, causing deficits to spike. As interest expense continues to rise, other discretionary items will face increasing scrutiny.

Political and Geopolitical Uncertainty

• Multiple global elections and ongoing conflicts create a heightened period of uncertainty with a wide range of potential outcomes.

The No-Landing Economy

• Businesses and consumers continue to show resilience. Expectations for a soft landing (that is, waning inflation and weak economic growth) have pivoted to a no-landing outlook where inflation fears continue to subside while economic growth reaccelerates.

The Power of Productivity

• Mega-cap technology companies have been early Al investors and adopters, reaping the benefits of operational efficiency and revenue enhancement. Increasing Al adoption should expand these benefits across the market, providing a significant productivity tailwind.

Election Year Liquidity

• Election years have historically been favorable for markets, especially when incumbents are running for reelection. The U.S. Treasury will soon have full coffers, after higher-than-average expected tax collection. This should provide ample liquidity to maintain market stability.

EXPECTATIONS ADJUST AGAIN, WITH TALK OF NO LANDING

Equity markets finished the first quarter with an impressive run, despite a rapid repricing in the number of expected Federal Reserve interest rate cuts, which fell to three. While the rally benefited mega-cap growth companies first, by March, participation expanded as the consensus narrative refocused from a soft landing with waning inflation and weak economic growth to a no-landing scenario where inflation slows and growth accelerates.

Sources: Asset class returns are represented by the following indexes: Bloomberg U.S. Aggregate Bond Index (U.S. bonds). S&P 500 Index (U.S. large-cap stocks). Russell 2000′ (U.S. small-cap stocks). MSCI EAFE Index (international developed market stocks). MSCI Emerging Market Index (emerging market stocks), Dow Jones U.S. Real Estate Index (real estate), and Bloomberg Commodity Index (commodities).

• All major U.S. stock indexes posted gains, with the growth style outperforming the value style across market capitalization tiers. Small-cap stocks lagged, as they tend to be the most sensitive to Fed rate cut expectations.
• Bond investors faced headwinds as prices moved lower and rates moved higher.
• Oil prices rose by double digits. pushing the energy sector. a 2023 laggard, to a top spot. Gold reached a new high.
• Real estate slipped modestly, adversely impacted by higher interest rates.
• Outside the U.S., international developed and emerging markets saw modest gains. Japan was the exception, continuing to outpace most of its peers on the heels of investment-friendly structural reforms. Chinese markets still struggle.

RECEDING RECESSION FEARS

In 2022, the Fed responded aggressively to inflation pressures, raising the federal funds rate by more than 400 basis points. The result was the most anticipated recession in U.S. history. Heading into the fourth quarter of that year, the Conference Board predicted a 96 percent probability the country would enter a recession in the next twelve months, but U.S. economic resilience has proven everyone wrong.

Sources: Recession References, FactSet Insights 3.8.2024; Federal Reserve Bank of St. Louis; 2024 Fed Funds Estimates, CME Group’s Fed Funds Probabilities 2024 Headline PCE Estimates Survey of Professional Forecasters, Federal Reserve Bank Philadelphia 2.9.2024; CAPTRUST Research.

The much-anticipated recession was top of mind for corporate management in 2022, with nearly half of S&P 500 company earnings calls referencing the risk in Q2. However, as the U.S. economy remained strong, confidence in an economic soft landing climbed. Now, there is increasing optimism that the U.S. economy is positioned for a no-landing outcome with economic growth reaccelerating. The result has been a rapidly diminishing fear of recession by corporate management teams.

*Real effective federal funds rate is calculated as the effective federal funds rate minus headline personal consumption expenditures (PCE) year-over-year.

Sources: Recession References, FactSet Insights 3.8.2024; Federal Reserve Bank of St. Louis; 2024 Fed Funds Estimates, CME Group’s Fed Funds Probabilities 2024 Headline PCE Estimates Survey of Professional Forecasters, Federal Reserve Bank Philadelphia 2.9.2024; CAPTRUST Research. 

Today’s federal funds rate is more than 2% above current inflation, reflecting the highest federal funds real yield in more than a decade. Despite this restrictive positioning, the economy remains healthy.

With inflation trending lower and the Fed expected to begin easing, real yields are projected to gradually decline, providing support for a no-landing economic outcome.

However, the risk of a policy error remains elevated. Premature easing could reignite inflation, and waiting too long could stoke recession fears.