Q1 2024 Summary – Higher Forever?

Macroeconomic Environment

While it may feel like we are in a “higher forever” world with respect to stock prices or interest rates, we know this scenario is implausible, if not impossible. Amid a backdrop of low volatility mixed with investor enthusiasm (especially around anything to do with artificial intelligence) and better-than-expected economic news, the S&P 500 Index closed the quarter at a new high—its 22nd record high over the course of the quarter. A cut in the Fed Funds rate did not materialize as anticipated, and the Fed appears to be in no hurry to cut rates.

Views are mixed with respect to the trajectory of both stocks and short-term rates. Lone voices have suggested that the Fed’s next move could be a hike, but the more widespread expectation is for a cut, with the market assigning a roughly 50% chance at the Fed’s June meeting. With respect to stocks, some see continued increases given strong earnings and a healthy economic outlook, while others float a “bubble” theory, especially with respect to some large growth stocks. Compelling evidence is presented to support both the economic nirvana/soft landing view, as well as the hard landing scenario that is not as rosy.

The U.S. economy grew at a healthy 3.4% annual rate in 4Q23, slightly up from the initial estimate of 3.2%. Consumer spending, especially in health care, was a key driver in the quarter’s gain, as was federal and local government spending. First quarter GDP forecasts are mixed, with 2% being an average. The Atlanta Fed’s GDPNow forecast was 2.3% as of quarter-end. The median projection from the Fed for full 2024 GDP growth is 2.1%, a notable increase from the 1.4% median expectation in December.

As expected, the Fed held the Fed Funds rate at 5.25% – 5.50% at its March meeting. Its median expectation for year-end Fed Funds remained unchanged at 4.6%, implying roughly three cuts in 2024. Market expectations are similar at roughly three cuts, down sharply from the six expected just a few months ago. Statements from Chair Jerome Powell as well as Governor Christopher Waller indicated that they are in no hurry to cut rates and are willing to wait to see more evidence that inflation is waning. This is not a surprise given that we have not yet seen widespread evidence that the economy is weakening.

Consumers are also feeling pretty good about current conditions, according to the University of Michigan Index of Consumer Sentiment, which revealed a March print that was the highest since December 2020, beating expectations and up nearly 30% over the past year. However, the Conference Board’s Consumer Confidence Index declined slightly in March, falling short of expectations. Notably, while the Present Situation component rose, the Expectations component fell to 73.8; a level of 80 or lower has historically signaled a recession in the next 12 months.

Inflation surprised to the upside in February; +3.2% year-over-year with services sectors being the key drivers over the past year. The Core measure was up 3.8%. Notably, after four consecutive months of declines, the energy index rose 2.3% in February (month-over-month). Gasoline prices were up 3.8% and WTI Crude closed the quarter at $83.20, up from $71.70 at year-end. The Personal Consumption Expenditures Price Index, the Fed’s favored measure, rose slightly from 2.4% to 2.5% (year-over-year) while the Core PCE fell slightly from 2.9% to 2.8%, the lowest level in nearly three years. “Supercore” inflation, which includes services but excludes energy and housing and is viewed as a proxy for labor costs, slowed in February but is up 3.3% over the last 12 months.

The labor market remained tight. Non-farm payroll gains were 275,000 in February and the 3-month average was a robust 265,000 despite downward revisions in the first two months of the year. Unemployment was 3.9% and wage growth was 4.5%.

While the preceding paragraphs paint a seemingly rosy scenario for the economy, if inflation does not reaccelerate, there is also evidence of cracks that would thwart the soft-landing scenario. The commercial real estate sector remains under pressure, lending has sharply slowed, and the lagged effect of higher rates has not yet fully materialized. There is also a notable difference in well-being across income levels, which could have implications for the most important part of the U.S. economy: consumer spending.

According to Federal Reserve data, the delinquency rate for credit card loans for all commercial banks ticked up to 3.1%, a steady increase from the all-time low of 1.5% in 3Q21 (delinquency rates were helped by stimulus payments during the pandemic). The New York Federal Reserve publishes a Quarterly Report on Household debt and credit, and its March publication noted that “both auto loans and credit cards have seen particular worsening of new delinquencies, with transition rates now above pre-pandemic levels.” Savings have also been depleted for those with lower incomes. The bottom 20% income bracket lost 18% of deposits (inflation-adjusted) between 4Q19 and 3Q23 while the top 20% gained 13% (Source: JP Morgan Guide to the Markets). A recent Household Pulse Survey from the Census Bureau showed that for those with less than $50,000 in income, nearly 80% were “moderately” or “very” stressed by recent price increases and over 25% said paying for normal household expenses was “very difficult.” These issues feed the hard landing narrative, which is not currently the prevailing view but merits consideration.

Of note from overseas, Switzerland became the first central bank to cut interest rates; the Swiss National Bank cut its policy rate 25 bps as inflation fell to 1.2%. And Japan moved in the opposite direction! The Bank of Japan (BOJ) raised interest rates for the first time since 2007 and became the world’s last central bank to end its negative interest rate policy. From -0.1%, the BOJ raised its overnight interest rate to a range of 0.0% to 0.1%. Inflation in Japan climbed to 2.8% (annual) in February, up from 2.2% in January. Core inflation (excludes fresh foods) was also 2.8%, above the central bank’s 2% target for the 23rd consecutive month.

In China, factory output and retail sales beat expectations in January and February, but the property sector remains under pressure. In the first two months of the year, China’s National Bureau of Statistics showed a 7% gain in industrial output in the first two months of the year with retail sales rising 5.5%. On the downside, the value of homes sold by the top 100 developers plunged nearly 50% in the first quarter (year-over-year). China targets growth of about 5% this year but signals continued reluctance to use deficit spending for economic stimulus.

Global Equity

U.S. stocks rallied sharply in 1Q with the S&P 500 Index (+10.6%) closing the quarter at a record high for the 22nd time during the quarter. Communication Services (+15.8%), Energy (+13.7%), and Technology (+12.7%) were the top-performing sectors with Real Estate (-1.1%) being at the bottom and the only sector to deliver a negative return. The equal-weighted version of the Index gained a more modest 7.9% as the largest stocks continued to outperform. The top 10 holdings hit another high at 33.5% of the Index on a cap-weighted basis. Growth (R1000 Growth: +11.4%) outperformed Value (R1000 Value: +9.0%) and large cap (R1000: +10.3%) outperformed small (Russell 2000: +5.2%). Of the “Magnificent 7,” only Apple (-10.8%) and Tesla (-29.2%) suffered losses. The Mag 7 were up 13% for the quarter, with the S&P 500 Index ex Mag 7 up 6%.

The U.S dollar strengthened against most currencies, most notably the Japanese yen (-7%). The MSCI ACWI ex USA trailed the U.S. with a 4.7% gain (Local: +8.2%). Technology (+10.7%) was the best-performing sector. Most countries delivered gains but from a regional perspective, Pacific ex-Japan (-1.7%) was hurt by weak performance from Hong Kong (-11.7%). In contrast, Japan (+11.0%) saw double-digit gains that were even better in local terms (+19.2%). Emerging Markets (MSCI EM: +2.4%) were up modestly, trailing developed markets. Latin America (-4.0%) was dragged down by poor results from Brazil (-7.4%) and Chile (-4.5%). China (-2.2%) also weighed on emerging market performance.

Global Fixed Income

Bond yields rose modestly in 1Q as expectations dwindled for aggressive rate cuts amid stubbornly high inflation. The U.S. Treasury 10-year yield rose from 3.88% as of year-end 2023 to 4.20% at the end of 1Q 2024. The Bloomberg US Aggregate Bond Index fell 0.8% for the quarter. Ten-year breakeven spreads, a measure of the market’s expectation for inflation over the next decade, rose from 2.16% to 2.32%. U.S. TIPS outperformed nominal U.S. Treasuries (Bloomberg US TIPS: -0.1%; Bloomberg US Treasury: -1.0%). Investment grade corporate bonds outperformed U.S. Treasuries by 89 bps on a duration-adjusted basis, fueled by strong demand that easily absorbed record supply for a first quarter and the second largest quarterly issuance ever. High yield corporates (Bloomberg HY: +1.5%) outperformed the investment grade market despite an uptick in the default rate to 5.7%, according to data from Barclays Research. Leveraged loans performed even better (CS Leveraged Loan: +2.3%).

Rates rose in most developed markets and U.S. dollar strength eroded returns for unhedged investors (Bloomberg Global Aggregate ex US: -3.2%; Hedged: +0.6%). Emerging market debt performed relatively well, especially high yield. The JP Morgan EMBI Global Diversified Index rose 2.0% with the high yield component up 4.9%. Conversely, the local debt GBI-EM Global Diversified Index sank 2.1%. Currency depreciation vs. the U.S. dollar hurt returns; the local currency return for the Index was +0.7%. Most currencies were down vs. the dollar for the quarter.

Municipal bonds outperformed taxable bonds for the quarter. The Bloomberg Municipal Bond Index fell 0.4% with lower quality sharply outperforming higher quality (AAA: -0.8%; BAA: +0.6%). The Bloomberg Managed Money Short/Intermediate Index fell 0.9%. Robust demand easily absorbed supply and most municipal/Treasury ratios remained well below historical averages.

Closing Thoughts

Callan’s Jay Kloepfer summarized it well, “So while the Fed removed ‘higher for longer’ from its outlook language in the fall of 2023, the economy and the capital markets have put the notion back in play.” Competing views exist with enthusiasts for the soft-landing scenario and solid financial market returns highlighting robust earnings, a resilient consumer, strong labor market, and moderating inflation that will enable the Fed to gradually cut rates. The less sanguine view notes sticky inflation that calls rate cuts into question, commercial real estate woes, rising loan delinquencies, and stress in lower income brackets. Geopolitical worries and a growing deficit are cited by both sides as potential sources of volatility and uncertainty. As usual, we recommend adhering to a disciplined investment process that includes a well-defined long-term asset-allocation policy.

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