ARQ Wealth Advisors – Q2 2024 Commentary: Tale of Two Markets
Authored by Richard Siegel, CFP® and Justin Rivera, CFA, CFP®
Last quarter’s commentary, “High For Longer” theme, has come to fruition. Jerome Powell and his staff of more than 400 Ph.D. economists are frozen. The Fed is in a major predicament; leave the Fed Funds Rate at 5.5% and risk eventually putting the U.S. economy into a recession, or lower the rate too soon and risk a re-acceleration of inflation. Either way, the likelihood of making any major changes to U.S. monetary policy just before a Presidential election remains unlikely. That said, markets are currently pricing in one or two Fed rate cuts by year-end.
In the meantime, we’ve witnessed a parabolic move in a few stocks, which have driven the major of the return of the S&P 500 benchmark index on a year-to-date basis. This is somewhat reminiscent of the tech bubble of the late-nineties, but with better earnings growth to almost justify the recent price-action. We view the construction of S&P 500 as problematic. It is a capitalization weighted index and at current levels, it is more of a large cap growth, momentum fund. Shockingly, Vanguard just reported that their 500 index ETF is no longer meeting the definition of “diversified” under the ’40 Act. This is the most concentrated the index has been in several decades.
At present, we view the following dynamics as positive for equity markets:
- Strong corporate earnings growth
- Decent economic growth
- Strength in the first half of a calendar year usually translates into 2nd half strength
- Q3 and Q4 are typically strong in Presidential election years
We view the following as negatives for the stock market
- A weakening job market
- Geopolitical risks (Russia/Ukraine, Israel/Gaza, Iran/China threats)
- A policy error by the Fed
- Expensive valuations
Of great interest is the effect of the election outcome on the economy and the markets. Based on the known policies of both candidates, we can expect…..
Economic Overview
The U.S. economy has demonstrated significant resilience despite widespread predictions of an impending recession. However, we continue to see signs of weakening in several critical areas. Inflation is coming down, the job market is softening, and GDP estimates are being revised downward. While these indicators suggest a cooling economy, it does not necessarily mean a recession is imminent. Instead, a soft landing—where economic growth slows but avoids a severe downturn—seems increasingly probable.
Although inflation has been a significant concern over the past few years, recent data indicates a downward trend. As you can see in the chart (right), as of May 2024 the Headline CPI has come down to 3.3% from its high of 9.1% in 2022 and Core PCE (Fed’s preferred inflation measure) is coming in at 2.6%. We reported previously that rising consumer debt and elevated interest rates were expected to weigh on consumer spending (and consequently inflation), and we are seeing that come to fruition. Additionally, delinquencies on auto loans and credit card debt have been rising, surpassing pre-pandemic levels. This financial strain among lower and middle-income groups is likely to continue to contribute to slower growth in overall consumer spending, a critical component of the U.S. economy.
The labor market has shown signs of softening with data revealing that the ratio of job openings to available workers has come back down to levels not seen since pre-pandemic 2019 (chart on right). Although job openings remain higher than in 2019, the number of job quits has returned to 2018 levels, disregarding the sharp drop during COVID, indicating that workers are not seeing significant opportunities to increase wages by switching jobs anymore.
As we move into the second half of 2024, GDP growth has slowed, which reflects the broader trend of a cooling economy. Revised estimates indicate that while growth continues, it is at a reduced pace, with the Atlanta Fed estimating real GDP growth of 1.5% as of July 3rd, down from over 4% in their May forecasts. This deceleration is not necessarily a net negative scenario, as it can help prevent the economy from overheating and can contribute to a more sustainable long-term growth trajectory.
The Federal Reserve’s actions regarding interest rates remain a pivotal aspect of the economic outlook. Currently, only one or two rate cuts are expected by year-end. The Fed’s cautious approach is understandable given they are aiming to avoid backtracking on rate cuts and to maintain credibility throughout their rate cutting schedule. However, delaying cuts too long may hinder the desired soft landing. If the Fed remains overly restrictive, it could exacerbate economic slowing and risk missing the opportunity to stabilize the economy effectively.
Equity Markets Overview
U.S. Large-Cap dominance continued in Q2 2024, further exacerbating the narrow market performance we have seen over the past couple of years. Goldman Sachs recently reported that this is the narrowest leadership for stock performance since the Great Depression. The increasing concentration of the S&P 500, where the top 10 stocks account for almost 38% of the index (right), is continually raising concerns regarding what a decoupling period may look like. On top of the data itself, large-cap company “insiders,” executives and other individuals with the most intimate knowledge of these companies, are selling more than they are buying at an alarming rate (below). This trend contrasts sharply with the more balanced insider activity seen in small-cap stocks, which could signal a lack of confidence in sustained high valuations by the very people who know these large-cap companies better than anyone.
The broadening out of earnings growth within the S&P 500 companies is another critical factor to monitor. We are seeing signs that the Magnificent 7 companies forecasted earnings growth are becoming more in line with the rest of the companies in the S&P 500 by the end of the year (right). Not shown in the chart is that forecasts suggest small-caps and emerging markets earnings growth will actually surpass that of the Magnificent 7. This is something you would expect to see in a decoupling phase from narrow leadership to a more balanced market environment.
We are not only seeing concentration within the U.S. market, but also relative to international stocks as well. The concentration of U.S. equities in global indices has never been more extreme. As shown in the chart (left), the U.S. now accounts for 64% of the MSCI All Country World Index. Historically, periods of such high concentration have often been followed by periods of international outperformance versus domestic equities. This pattern suggests that staying globally diversified in stocks is a prudent strategy moving forward.
Bond Market Overview
Bonds continued their struggle to breakout into positive territory over the past three months. Fixed income returns are reliant on interest rate stability and/or rates pulling back to lower levels. With better than expected economic data and stickier inflation metrics early on in the year, the benchmark 10-year Treasury yield moved higher, putting pressure on bond prices. On a year-to-date basis, the U.S. Aggregate Bond Index delivered a – 0.71% return. Based on our defensive positioning with a bias toward lower duration bonds, medium-grade credit quality and significant exposure to non-traditional investments, our clients’ portfolios have returned 1.41% in the bond/non-traditional category for the first half of 2024.
On a go-forward basis, we continue to be quite positive on fixed income. Investment grade bond yields remain attractive in the 5-7% range and there is significant upside price potential if the 10-year Treasury pulls back on weaker economic data. Although, the “higher for longer” theme has played out, the likelihood of the Fed slowly lowering the Fed funds rate has increased in recent months as progress has been made on inflation and jobs data. Assuming the Fed lowers twice this year, traditional fixed income yields will have a significant yield advantage over money markets and CDs.
It is notable that over the past few years, the correlation between stocks and bonds has surged, reminiscent of the 1960’s – 1980’s. We’ve become accustomed to bonds providing a ballast to the volatility of stock prices in recent decades, but this strategy has been somewhat reduced, with stocks and bonds moving together about 50%-60% of the time. This dynamic needs to be respected in an asset allocation construct. We have worked to lower overall portfolio volatility by reducing exposure to intermediate and long-duration government bonds and increasing exposure to low risk alternative investments which are true diversifiers to core bond and stock investments.
The back half of 2024 will bring very intriguing capital markets activity, sparked by inflation and jobs data, the Fed’s messaging, possibly the first rate cuts in over three years, and of course the uncertainty around the upcoming Presidential election. As always, we will resist the urge to act on short-term trends and a flavor of the month investing mentality. It is widely established that yielding to fear and greed typically results in negative outcomes. Ultimately, market returns are derived from fundamentals (economic growth, monetary policy, corporate profits, and valuations).
