Global Market Review and Outlook

PWM Quarterly Letter: Review of First Quarter 2024

• Economic growth in the last quarter continued to surprise to the upside, easing investor fears of a hard or even soft landing with a new narrative of no landing taking shape.
• This has not resulted in any changes to the Fed’s view on forecast rate cuts, but it has caused the market to sharply scale back its expectations to now be roughly in line with the Fed’s.
• Market performance in the quarter continued to be driven by a small group of mega-cap stocks known as the “Magnificent 7” (now the Fab 4), and momentum stocks more generally.

Hard Landing, to Soft Landing, to No Landing?

Once again, this last quarter was proof that the narrative around U.S. economic growth in the post-COVID environment rarely stays stable for long. At the start of 2023, most economic prognosticators were heavily leaning to the hard-landing/recession side of the boat. However, over the course of last  year, there was a steady trickle of converts to the soft-landing camp, with this then becoming the overwhelming consensus by the start of this year. Fast forward to current expectation, as doubt has started to creep in about the prospects of avoiding a slowdown all together with the rise of the  “no-landing” scenario.

In early December, for example, real GDP growth was expected to increase by 1.3% for all of 2024, with growth in the first quarter of just 0.6%. Over the last three months, that estimate has risen to 2.2% for annual growth in 2024 and 2.0% for the first quarter. The Atlanta Fed’s GDPNow data tracker pegs this quarter’s growth at 2.5%. With respect to inflation, however, the pace of expected deceleration has been slightly scaled back and there are concerns among both the market and the Fed that this final mile back to 2% could still be a longer, bumpy ride, relative to the most recent 3.5% March 2024 reading and the high water mark post Covid of 9.1% in June 2022. As we entered 2024, the PCE index (the Fed’s preferred inflation target), was expected to fall to a 2.2% seasonally adjusted annual rate in the final quarter of this year; the market now expects a 2.3% rate, and it currently sits at 2.8%. What’s incredibly encouraging, however, has been that this softening of inflation has not—yet at least—come at the expense of employment.

The next leg lower for inflation may have to come from weaker services and shelter components, which may entail some easing in the labor market to quell still-too-high employment costs. While the labor shortage situation is improving, many companies are still reporting hiring difficulties, and the cost of that labor remains an issue. These moving pieces help to highlight the delicate balance the Federal Reserve is trying to maneuver between their two most important mandates of stable pricing and full employment.

The combination of these pressures—coupled with higher net interest costs due to higher interest rates, higher commodity costs exacerbated by geopolitical and climate issues around the Suez and Panama canals, the recent Baltimore bridge collapse, and importantly the heightened crisis between Israel and Iran in the Middle East impacting energy costs—could start to pressure corporate profit margins, forcing companies to turn their focus to their largest input cost: labor.

For now, companies have been reluctant to let go of workers that have been so hard to find following the pandemic, adjusting instead by slowing hours worked, shifting some workers to part-time, and hoping growth accelerates further or the Fed starts to lower interest rates. Meanwhile, macro economists and research analysts still do not foresee any major fallout  in earnings, with the pace of 2024 estimated earnings growth largely on track with the historical average trend for the last 20 years (exhibit 1).

The Shifting Sands of Interest Rate Expectations

Interestingly, even with all these shifts in sentiment toward growth and inflation, there has been little if any change in the expectation that we have witnessed the peak in the Fed Funds rate. Exhibit 2 highlights that although the number of Fed rate cuts have been brought in, there has not been a rise in higher rate expectations. Specifically, in January of this year, the market forecasted the Fed would lower rates from the current 5.3% to 2.8%, 250 basis points in total, starting with 150 basis points in 2024. Today however, the market anticipates about 150 basis points of cuts in total, with between 50 and 75 basis points of those cuts taking place this year. Significantly, the exhibit also highlights the trough in rates to remain above the Fed’s 2.6% estimate of the neutral interest rate (above/below which policy is deemed restrictive/accommodative). This is consistent with expectations for a stronger economy that does not require an accommodative monetary stance; i.e. the “higher for longer” stance the Federal Reserve has communicated repeatedly.

Within the credit and fixed income markets, we have also seen a material change in 10-year U.S. Treasury yields, with the yield rising from 3.79% to 4.6% at present. This has resulted in some modest re-steepening of the yield curve, though it does still remain inverted. A deconstruction of the yield reveals that this rise has been less due to fears about high and rising inflation; rather, it has been more a result of stronger real growth (i.e., a real yield).Surprisingly, despite these shifts in the Treasury market and a major surge of corporate debt refinancing during the first quarter, corporate credit spreads—for both high-yield and investment-grade corporate debt—have remained incredibly compressed. In short, credit markets are not showing any red flags and investors clearly expect strong earnings growth and solid corporate balance sheets to continue.

Perhaps the biggest anticipated risk to these spreads on the horizon is what happens in commercial real estate. Vacant office space and higher interest rates are damaging profitability, and the concern is that some entity may experience dire consequences. However, the fact that these market dynamics in commercial real estate have been top of mind for at least the last year should come as no surprise and have given investors plenty of time to mitigate the risks. With this, any fallout is more likely to be idiosyncratic rather than systemic.

Market Performance

Throughout the first quarter, the performance of the U.S. equity market has once again been turbo charged by generative AI on the technology side, and to a lesser extent the introduction of GLP-1s on the healthcare side.

Whereas the market was initially placing its bets on the Magnificent 7 as the tech winners (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) through 2023, this group has subsequently dwindled to the Fab 4 as Tesla, Apple, and Alphabet’s performance has disappointed and their prices have flattened or fallen versus their peers. Nevertheless, in the first quarter, the Mag 7 increased by 12.9%, against 8.6% for the rest of the S&P 500 excluding those 7. The rise encompasses a one-day increase of 16.2% in the price of Nvidia—a gain of $277 billion, or roughly the size of the entire market cap of the 29th-largest stock in the S&P 500 (Netflix). As the index table highlights, U.S. large cap areas of the market continued to outperform their smaller cap peers, while US markets also continued to outperform their international peers. As we start the 2nd quarter here in April, we have witnessed some shift in market leadership, however, there is still plenty of time, along with earnings and macro data, to impact both equity and fixed income returns as we move throughout the first half of 2024. Headlines are sure to also focus on the looming election, policy changes, and the heightened geopolitical risks (both in China and the Middle East).

As always, especially in this dynamic environment, we look forward to our meetings and conversations together.

Thank you for your continued trust and confidence.

The 1935 Wealth Management Team

Total Returns
Source: FactSet, Strategas