The first quarter of 2024 continued the positive trends we experienced in the last quarter of 2023. Inflation continued to moderate, allowing the Federal Reserve to transition from raising short-term interest rates to potentially lowering them later this year. The US economy continues to flex its muscles, strengthened by a healthy consumer and labor market. This, in turn, has improved the outlook for corporate earnings. After several volatile years for investors, financial markets have enjoyed these tailwinds, with a smooth and comfortable ride upward the last few months. That said, we do think we are overdue for increased market volatility. The S&P 500 has risen nearly 30% since its last 5% decline in October of 2023 (such declines typically happen three times a year). This volatility is the price one pays to benefit from the equity premium provided by stocks over the long term.
The US economy, as measured by GDP, grew 3.1% in 2023 (page 8). While 3% may seem “normal” at the surface, it is hard to underscore how impressive this growth was amidst restrictive short-term interest rates. Remember, just a year ago, a recession was all but “guaranteed.” The US consumer, which drives over two-thirds of GDP growth, has shown resilience in their willingness and ability to spend. Consumers have shifted their spending preferences from big ticket items during the pandemic (cars, appliances, renovations) to experiences (travel, hotel, and dining). This transition is a benefit of a diversified and resilient economy. Higher equity and real estate prices have also propelled wealth creation, with an estimated $5+ trillion dollars added in the first quarter after $12 trillion last year (page 18). But as excess savings post-pandemic are reduced, economists’ attention is now on the health of the labor market. On the surface, the labor market seems healthy. Unemployment remains below 4% (page 10), with nearly 800,000 jobs created in the last three months (page 12). Additionally, real wage gains and immigration have helped age 18-64 labor force participation rates surpass pre-Covid levels (page 13). However, job openings and full-time employment have steadily declined. Whether this is a sign of workers preferring more flexible arrangements or broader weakness is one of the many questions Jerome Powell and the Fed will have to wrestle with in the coming months. There is still work to be done until a successful soft-landing can be declared. But financial markets have responded positively to the prospect of a wider and extended runway thanks to a strong economy with more workers.
Against this backdrop, global equity markets continued their rebound in the first quarter of 2024. US Large Cap Equities, as measured by the S&P 500 Index, returned +10.5%, reaching 22 record highs along the way (page 22). With the index now trading at 21x forward earnings, valuations certainly do not appear cheap. But when looking beyond the “Magnificent 7” companies which continue to command premium multiples, valuations are reasonable, if not attractive (page 36). Corporate earnings overall have been more resilient than expected (page 24). Current consensus estimates for 2024 ($244 per share) and 2025 ($276) imply an 11-12% growth rate above 2023 (page 25). If these estimates are achieved, and we believe they can be, then the market is trading in line with historical averages. We are also encouraged by the improved market breadth (10 of the 11 sectors were positive) and dispersion (the S&P 500 was +10% despite TSLA down 30% and AAPL down 11%) in the first quarter. We remain Neutral weight US Large Cap Equities in our asset allocation models. US Mid Cap Equities, as measured by the S&P 400 Index, kept pace with their large counterparts in the first quarter, while US Small Cap Equities, as measured by the S&P 600 Index, continued to lag. Smaller businesses are historically more sensitive to slowdowns in economic activity and to higher interest rates (given shorter-term debt profiles). 2024 small cap earnings estimates have declined 10% over the last 18 months and now reflect a modest 3% growth above 2023. While US Small Cap valuations remain historically attractive at 15x forward earnings, the path of future earnings remains unclear (page 23). We remain Neutral weight.
Non–US Developed Equities, as measured by the MSCI EAFE Index, returned +6% in the first quarter and Non–US Emerging Equities, as measured by the MSCI EM Index, returned +3%. Many international economies continue to face a variety of challenges and uneven recoveries, which have put a damper on the outlook for corporate earnings. And unlike in 2023, global currencies weakened against the US Dollar in the first quarter, creating yet another headwind. However, inflation continues to decelerate which should allow many central banks across both developed and emerging economies to pivot towards easier monetary policy as the year progresses. It now seems likely that the ECB and Bank of England will reduce rates faster than the Fed, a very unexpected outcome at the start of the year (page 37). Further, valuations remain historically and relatively attractive at 12-14x forward earnings with a 3% dividend yield. We remain Neutral weight to Non–US Developed Equities and slightly Overweight to Non–US Emerging Equities.
The Federal Reserve has held short-term interest rates steady at 5.25 – 5.50% since July 2023 as it continues to evaluate the effects of its policy tightening on the economy and inflation. Core PCE, the Fed’s preferred measure of inflation, increased 2.8% in February versus a year ago. Inflation has trended downwards over the past 20 months, but there has been a notable deceleration in the rate of this decline. We believe the Fed’s inflation estimates are reasonable (2.6% in 2024 and 2.2% in 2025) and leave the door open for lower rates in the second half of the year (page 26). Until that time, every month’s inflation report will garner a lot of attention. The cardinal sin of central banking is to lower interest rates too quickly, and then to have to reverse course due to more persistent inflation. Chairman Powell undoubtedly feels this pressure, particularly after getting caught so far behind inflation three years ago. Longer-term interest rates have steadily risen in 2024, with the 10-year Treasury climbing to 4.2% as of quarter-end and surpassing 4.5% in April. Despite the volatility, we continue to take advantage of the opportunity offered by these rising rates, purchasing high quality Treasury, Municipal and Corporate bonds at attractive yields to lock in income in client portfolios (page 28). We remain overweight US Investment Grade Bonds in our models. Attractive yields can still be found in lower quality bonds, but historically tight credit spreads make these bonds more susceptible to losses if the economy falters (page 29). We remain Neutral weight to Strategic Bonds.
If we look back to early 2023, most market pundits were sure the US economy would be entering a recession in response to the Fed’s aggressive monetary tightening. Fast-forward to January 2024, despite a strong US economy, the consensus was that the Fed would lower interest rate seven times in 2024 as the economy would inevitably slow (page 38). And today, there is debate if the Fed will lower rates at all in 2024. If there is one thing we have learned over the years, it is to never underestimate the ability for the consensus view to be wrong (just as it was in 2023). We do believe 2024 will be more volatile for financial markets. Whether volatility in the near-term stems from inflation, interest rates, or geo-political events, we cannot be sure. But for diversified and disciplined long-term investors, who judiciously rebalance their portfolios consistent with their long-term goals, volatility creates opportunities.
