Politics Upstage Economic News
Global broad market performance was lackluster in 2Q24 (MSCI ACWI: +2.9%; Equal-weighted S&P 500: -2.6%; Bloomberg Global Aggregate: -1.1%). Economic news was also mostly humdrum. The economy continued to chug along; 2Q real GDP growth is expected to be around 2% annualized. The labor market remained resilient, inflation trended down but remained above-target, and the Fed kept rates on hold. The sought-after “soft landing” appears to have materialized, and there have been few meaningful changes in recent months. Political fireworks, however, have been front and center in the U.S. and several other countries. While the topics contributing to political shifts and polarization are complex and numerous, fiscal spending and rising deficits are among the worries that could directly impact markets.
The June meeting of the Federal Open Market Committee (FOMC) yielded no surprises for the market when the Fed Funds rate was kept on hold at 5.25% – 5.50%. Also widely expected, the median expectation for rate cuts was ratcheted down. In March (as well as in December 2023) the FOMC’s median year-end expectation for the Fed Funds rate was 4.6%, or 3-4 cuts in 2024. In June, the Summary of Economic Projections median forecast was 5.1%, one cut from current levels. Stubborn inflation and resilient economic data were the twin motivators for the Fed’s decision to delay rate cuts. The median projection from the FOMC is three more cuts in 2025, bringing the rate down to 4.1% by year-end 2025. The median forecast for the long-run rate ticked up slightly from 2.6% to 2.8%, reflecting the notion that the so-called “neutral rate” may be higher than previously thought. It is worth noting that the dispersion of forecasts is narrow in 2024 and for the long run, but expectations vary considerably for 2025 and 2026. Longer-term inflation expectations remain intact, reaching 2.0% by the end of 2026. The FOMC median GDP estimate for 2024 is 2.1%, with unemployment remaining stable at 4.0%, both expectations unchanged from March. As of quarter-end, markets were pricing in two cuts before year-end 2024 and, according to the CME FedWatch Tool, there was a 65% probability of a cut at the September FOMC meeting.
Real GDP grew at an annual rate of 1.4% in 1Q, down from the 3.4% pace in 4Q23. Consumer spending, which comprises about two-thirds of GDP, slowed from 3.3% in 4Q to 1.5% in 1Q as higher rates and declining savings took a toll. Growth is expected to have picked up modestly in 2Q. The Atlanta Fed’s GDPNow 2Q estimate was 2.2% on June 28, and a survey of 34 forecasters conducted by the Federal Reserve Bank of Philadelphia had a similar forecast of 2.1%.
Unemployment rose slightly from 3.9% in April to 4.0% in May but remains relatively low by historical standards. The JOLTS (Job Openings and Labor Turnover Survey) June report showed job openings falling to 8.1 million at the end of April, below expectations and the lowest since February 2021. That said, job growth as measured by non-farm payrolls increased by 272,000 in May, far more than forecast and significantly more than the 175,000 created in April. Jobless claims and applications for unemployment benefits have risen in recent months, fueling speculation that the labor market may finally be softening, but further evidence is needed to support that notion.
Inflation continued to moderate. The Fed’s favored measure, the Personal Consumption Expenditures (PCE) Price Index, rose 2.6% year-over-year in May, down from its 7.1% peak in June 2022. The Core measure, also 2.6% YOY, was the weakest since March 2021 and below its 5.6% peak in February 2022. Services sector inflation (+3.9% YOY) drove the gains while durable goods prices (-3.2% YOY) continued to trend down. The Consumer Price Index was flat in May (+3.3% YOY) for the first time in nearly two years as falling energy prices offset increases in shelter costs. Core CPI was up 3.4% YOY, the lowest since April 2021. Shelter costs (+5.4% YOY), one of the largest components of the CPI basket, accounted for the bulk of the increase both in May and over the past year. The “super-core” measure, which excludes food, energy, and shelter costs and thus has a greater focus on labor costs, was up only 0.1% in May (+3.4% YOY), the lowest since November 2020. Overall, inflation is headed in the right direction but the Fed would like to see more progress before cutting rates.
Housing market dynamics revealed an odd mix: rising prices alongside rising inventory. The median sales price for a home climbed to a record $419,300 in May, the highest recorded since data was first gathered in 1999, according to the National Association of Realtors, and up nearly 6% from one year earlier. (Note that prices are not adjusted for inflation.) The group also reported that pending sales fell 2.1% in May and were down 6.6% YOY. At the same time, total housing inventory at the end of May stood at 1.3 million, up from just under 1.0 million at the end of 2023. Mortgage rates continued to hover around 7%, and thus overall affordability appears to be keeping buyers on the sidelines.
Concerns over a rising federal budget deficit have become more pronounced given recent estimates by the Congressional Budget Office (CBO) alongside worries that neither the Democratic nor the Republican party would be willing or able to make a significant dent in federal spending. The CBO projected that the U.S. deficit will be $2 trillion in 2024, up from its $1.6 trillion forecast in February, and will grow to $2.8 trillion by 2034. These figures represent roughly 7% of GDP, much more than the 3.7% average over the past 50 years and much higher than the 3% maximum mandated in the euro zone. Further, these numbers assume that the tax cuts passed in 2017 will expire as planned in 2025. Notably, nearly half of the deficit is attributable to interest paid on the national debt. While so far the enormous deficit has not had a measurable impact on rates, this scenario may yet unfold as issuance needs to increase and could put upward pressure on rates as well as structural inflation.
Central banks away from the U.S. have started to cut rates as growth has slowed and inflation moderated. In June, the Bank of Canada lowered its overnight rate 25 bps to 4.75%, and the European Central Bank cut rates for the first time this cycle. The Swiss National Bank has cut rates twice this year, and other cuts have come from Brazil, Mexico, Chile, and Sweden. Japan, on the other hand, raised rates very slightly in March (to 0% – 0.1%) and was the last country to exit a negative interest rate policy. Its 10-year government bond yield rose above 1% in May for the first time since 2013 as markets anticipated further rate increases. The yen, however, closed the quarter at just over 160 to the U.S. dollar, the lowest since 1986. The yen’s weakness is due in part to the large differential in interest rates between Japan and other developed countries.
This year has also been marked by several elections that have yielded surprises and impacted markets. In India, Prime Minister Narendra Modi’s party unexpectedly lost seats to the opposition, a result that caused its stock market to tumble on concerns over Modi’s ability to pursue a business-friendly agenda. In Mexico, Claudia Sheinbaum won by a landslide to become the country’s first woman president, but the wide margin of victory raised concerns that proposed changes to the constitution would be enacted, spooking investors and raising concerns over capital outflows. Subsequently, the peso dropped sharply and the Mexican stock exchange was off roughly 6%. And in France, stock and bond markets were roiled with the far right gaining traction ahead of President Emmanuel Macron’s surprise elections, fueling worries over increased spending and a rising deficit that at about 5.5% of GDP (in 2023) is already higher than the 3% maximum set by the European Union. The European Commission recommended disciplinary action against France for its excessive deficit in June. The yield premium for French government bonds over Germany reached its highest level since 2012.
Global Equity
The S&P 500 Index hit 31 record highs over the first six months of 2024 and gained 15.3%. Second quarter results (+4.3%) were very mixed with sector performance ranging from -4.5% (Materials) to Technology (+13.8%) with 6 of the 11 S&P 500 sectors posting negative 2Q returns. Index returns were driven by a handful of stocks; the 10 largest stocks in the index returned 14% while the equal-weighted S&P 500 fell 2.6% for the quarter. Value (R1000V: -2.2%) sharply underperformed Growth (R1000G: +8.3%) and small cap (R2000: -3.3%) underperformed large (R1000: +3.6%). The Magnificent Seven comprised 33% of the S&P 500 as of quarter-end and, as a group, they climbed 33% in the first six months of the year, far exceeding the “S&P 500 ex-Mag Seven” gain of only 5%. However, there was much dispersion within this group as noted by the worst YTD return (Tesla: -20%) vs. the highest (NVIDIA: +150%).
The MSCI ACWI return (+2.9%) was attributable to only five stocks (NVIDIA, Apple, Alphabet, Microsoft, and Taiwan Semiconductor), four of which are U.S. companies. The remaining 9,000-plus stocks were down 0.1%. The MSCI ACWI ex-USA eked out only a modest gain of +1.0%. France (-7.5%) was a notable underperformer given concerns over the advancement of the far right and implications for spending and increases in an already high deficit. Japan (-4.3%) was a notable underperformer but in local terms the country was up 1.8%. The yen fell about 6% in 2Q to its weakest level since 1986. The currency is down 12.4% YTD.
Emerging markets (MSCI EM: +5.0%; Local: +6.2%) also saw mixed results. Latin America (-12.2%) fared the worst driven by poor returns in Brazil (-12.2%) and Mexico (-16.1%). Meanwhile, Emerging Asia (+7.4%) benefited from strong performance in China (+7.1%) and Taiwan (+15.1%). India (+10.2%) was also up sharply for the quarter in spite of a short-lived sell-off after the election.
Global Fixed Income
The Bloomberg US Aggregate Bond Index (+0.1%) was flat in 2Q, bringing its YTD return to -0.7%. The yield on the 10-year U.S. Treasury climbed from 4.20% to 4.36% over the quarter. Mortgages were the only sector to underperform U.S. Treasuries on a duration-adjusted basis. High yield (Bloomberg High Yield: +1.1%) and bank loans (Morningstar Leveraged Loan: +1.9%) were top performers for the broader market. Valuations, as measured by spreads, remained rich from a historical perspective across the credit spectrum as absolute yields attracted buyers less interested in relative value. Supply was robust but met with strong demand.
Global bond returns were also flat (Bloomberg Global Aggregate USD Hedged: +0.1%) while dollar strength eroded returns in unhedged terms (Bloomberg Global Aggregate Unhedged: -1.1%). Emerging market performance was similarly uninspiring with the hard currency JPM EMBI Global Diversified Index up 0.3% and the local currency JPM GBI EM Global Diversified Index down 1.6%. Brazil (-10.7%) and Mexico (-9.6%) were notable underperformers in the latter given currency weakness.
Municipal bond returns (Bloomberg Municipal: 0.0%) were also muted in 2Q. Yields rose most sharply in five- and seven-year maturities (44 bps), causing intermediate indices to underperform the broad market. The Bloomberg Muni 1–10 Year Index fell 0.4% for the quarter. Lower-rated bonds outperformed (AAA: -0.3%; BBB: +0.7%). Issuance in 2024 is more than 40% ahead of last year and the strongest in at least a decade but has been met with strong demand.
Closing Thoughts
Midway through the year there are few signs that elevated interest rates have taken a material toll on economic growth, yet most expect the economy to slow and the Fed to eventually lower the Fed Funds rate. Markets have taken the “higher for longer” mantra in stride with bonds down modestly YTD and most stock indices up, albeit with much dispersion (R1000 Growth: +20.7%; R2000 Value: -0.8%; ACWI ex USA: +5.7%). Gold reached an all-time high in May (S&P Gold Spot Price: +12.9%) and oil prices were up sharply from year-end (WTI Crude: +13.8%).
That said, higher rates have already negatively impacted some segments of the population, most notably younger and lower-income people as reflected by rising auto loan delinquencies and credit card delinquencies among those cohorts. Consumer spending and lending have also slowed. There have been some signs of labor market weakness, but a trend is not in place. Fed cuts remain elusive, as the Fed remains patient and waits for further evidence of weakness in the economy and/or more progress in tempering inflation. In the meantime, political news dominates the headlines and is likely to remain the focus of attention over the near term. As ever, we recommend adhering to a disciplined investment process that includes a well-defined long-term asset-allocation policy.
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