For the first time in what feels like a long time, the Federal Reserve (Fed) and the market largely seem to agree on the current path of the economy, interest rates and inflation. US economic growth is expected to continue, albeit closer to the 2% trend growth rate experienced over the last 25 years. Inflation is expected to trend towards the Fed’s 2% target into 2025, and in response, short-term interest rates should reset to more sustainable levels. As expectations for this “soft landing” have materialized, financial markets have rallied, volatility has dampened, and our client portfolios have benefitted given our view that a strong US economy would be able to withstand higher interest rates.
The US economy grew +2.8% versus a year ago in the first quarter of 2024, and we believe it is on track to grow 2.0-2.5% for the full year 2024. The US economy has shown more resilience than most people expected when the Fed started raising interest rates in March 2022. Household consumption, which comprises over two-thirds of GDP, has been the main driving factor. Households have benefitted from a healthy labor market, with low unemployment and improving labor participation rates. Government spending has continued, thanks to several recent spending bills. And higher equity and real estate prices have consumers feeling more confident in their ability to spend, otherwise known as the “wealth effect”. However, the lagged effects of higher interest rates are starting to slow overall growth. Higher borrowing costs are hurting over-levered consumers and companies with delinquencies and default rates starting to tick higher. We are cognizant that decelerating growth typically makes the economy more susceptible to unexpected “shocks,” but expect any slowdown to be mild given the absence of financial excesses in the economy. May’s core PCE index, the Fed’s preferred measure of inflation, measured 2.6% versus a year ago. We expect inflation to continue to gradually lessen as shelter and some of the other stickier components moderate. But the next few months may be bumpy as low 2023 inflation readings make the year-over-year comparisons tougher. This will make Jerome Powell and the Fed’s decisions on interest rate policy that much harder. But for now, financial markets are riding a strong economy that bodes well for continued consumer spending and future corporate earnings.
Against this economic backdrop, US Large Cap Equities, as measured by the S&P 500 Index, returned +4% in the second quarter of 2024 and are +15% for the year. Valuations are not cheap on the surface, as the index has traded at 21x forward earnings for much of the year. But when looking beyond the “Magnificent 7” companies which continue to command premium multiples, valuations of most index constituents are reasonable. Additionally, corporate earnings have been more resilient than expected and the outlook is bright. The S&P 500 is expected to deliver $277 of earnings per share in 2025 and $309 in 2026, representing ~13% annual growth above 2024’s consensus expectation of $242. If these estimates are achieved, then the market is trading in line with historical averages. We are concerned about the index’s concentration, particularly to the seven “magnificent” companies, and we do believe that high valuations and growth expectations may lead to disappointments and devaluations. But these seven companies accounted for over 60% of the S&P 500’s total return in both 2023 and the first half of 2024. While many investors undoubtedly benefitted from owning shares in these great companies, there were many who did not. One of the advantages of market capitalization indexing, in addition to low cost and tax efficiency, is owning the entire market and not missing the “winners”. We have long been proponents of indexing, particularly in US Equities, and the last several years have re-affirmed this approach. US Mid Cap Equities (S&P 400 Index) and US Small Cap Equities (S&P 600) declined 3% in the second quarter, giving up their earlier gains. At 14-15x forward earnings multiples, these asset classes remain historically cheap on an absolute and relative basis. We remain Neutral weight to US Large, Mid and Small Cap Equities in our asset allocation models.
Non-US Equities have been under the shadow of their large US counterparts for some time but have quietly had a solid start to 2024. Non-US Developed Markets Equities, as measured by the MSCI EAFE Index, have returned +11% year-to-date and Emerging Market Equities, as measured by the MSCI EM Index, returned +8% year-to-date. Inflation data has been better than expected, allowing central banks including the ECB to lower interest rates. Corporate earnings have stabilized, and prospects are improving on the back of encouraging economic data. Companies have continued to pay out earnings in the form of investor friendly dividends, bolstering these markets’ dividend yields. Despite these positive returns and positive developments, valuations remain well below historical averages. The MSCI EAFE index now trades at 13x forward earnings and the MSCI EM index trades at 12x forward earnings. Uncertainty of broader global growth and geo-political tensions make the path forward less clear, particularly with recent elections roiling many of these countries of late. But we believe long-term investors are being adequately compensated for these risks with current valuations. We remain Neutral weight to Non-US Developed Market Equities and slightly Overweight to Non-US Emerging Market Equities.
The Federal Reserve has held short-term interest rates steady at 5.25 – 5.50% since July 2023 as it takes a ‘trust but verify’ approach to the recent slowing of inflation. We believe the Fed’s inflation estimates are reasonable (2.6% in 2024 and 2.3% in 2025), but we would not be surprised if the first rate cut isn’t until 2025. This reflects our belief that the economy remains strong and inflation numbers may jump up (and down) throughout the back half of the year. We believe Chairman Powell does not want to lower interest rates too quickly, particularly after getting caught so far behind inflation three years ago. In response to the constantly changing expectations around growth and inflation, long-term interest rates have been volatile. Since October 2023, the 10 year Treasury has ebbed and flowed between 3.9% and 5.0%, ultimately finishing the second quarter at 4.3%. Despite the volatility, we continued to purchase high quality bonds at attractive yields to lock in income for client portfolios. We remain Overweight US Investment Grade Bonds. Non-Investment Grade Bonds, as measured by the Barclays High Yield Index, returned +3% in the first half of 2024 after a +14% return in 2023. Credit spreads over Treasuries – the premium charged by investors to hold Non-Investment Grade bonds – have narrowed considerably and are well below their long-term averages. We remain Neutral to Strategic (Non-Investment Grade) Bonds and have slowly increased the credit quality within our portfolios.
We would not be surprised to see more volatility in the second half of 2024, whether from central bank policy, the election, or something else unexpected. The S&P 500 is up nearly 60% since the end of the bear market in October 2022 and is up 30% since its last 5% decline in October 2023 (such declines typically happen three times a year). Historically, we are overdue for a market decline. The potential for heightened volatility has many investors wooed by the high interest rates and perceived safety of holding cash. While cash may provide a feeling of protection, there is a real opportunity cost from giving up potentially attractive returns in longer term fixed income and equities. We believe this cost – reinvestment risk – is even greater today. As interest rates have risen and valuations normalized, investors can own fixed income while still generating reasonable rates of return. The Federal Reserve will eventually have to lower interest rates to stimulate the economy, and when that time comes, history tells us there may not be much time to react. Instead, we come back to a core principle of investing: focus on long-term objectives and do not get too discouraged (or elated) by violent short-term swings in global financial markets. Good long-term investing is not about making great decisions, but about consistently making good decisions. Our team has continued to focus on the “blocking and tackling” of successful long-term investing over the last few months: rebalancing portfolios to target allocations, extending fixed income duration and increasing income, and managing cash balances effectively.
