US stocks surged in the first quarter of 2024 with the S&P 500 climbing over 10%, the largest first quarter gain since 2019. The widely followed index finally hit a record high after two years in January, as momentum from late 2023 continued into the new year.
Enthusiasm around artificial intelligence (AI) continued to boost technology stocks, in particular semiconductor companies. However, unlike last year, the rally broadened out to the more cyclical areas of the market.
The strongest sectors included communication services, industrials, materials, energy, and financials. The broadening, driven by strong economic data, resilient corporate earnings, and expectations for rate cuts propelled the S&P 500 to new record highs 22 times during the quarter.
Moss Adams Wealth Advisors Market View
Here are our key takeaways on the economy and markets:
- Though progress on inflation stalled in Q1, the Federal Reserve is done with rate hikes and the next move will be a cut, likely in summer 2024
- The gradual, although bumpy, trend of disinflation remains intact
- Economic strength and labor market trends support the softer landing scenario for the US economy, and that’s our base case
- The resilience in jobs has been in the labor-intensive services sector of the economy, which is expected to hold up in the first half of 2024
- Over the mid- to long-term, we’re constructive on both stocks and bonds as the economy normalizes and deflationary tailwinds continue
- Key risks to equities include a Fed policy error—staying too tight for too long, a reversal upward in inflation and long-term yields, or escalation of global macro stresses including tensions with China, the ongoing Russia-Ukraine war, and conflict in the Middle East
- Labor market resiliency is key to our soft-landing narrative
Rate Cut Expectations and the Fed
Optimism was high heading into the new year with inflation having made significant progress toward the Fed’s target in 2023. Heading into Q1, the bond market was pricing in a total of five interest rate cuts this year, with the first expected to be in March.
However, the economy was stronger than expected, which is good news, but inflation turned out to be stickier than expected, which was not good news. This means Fed rate cuts have been pushed out to at least June 2024, with the market now pricing in just three rate cuts at best for 2024.
Still, in our view, the number of rate cuts isn’t as important as the fact that the Fed is able and willing to cut rates if needed or when they see more progress on inflation.
At the Fed’s March open market meeting, the committee left rates unchanged as was expected and upgraded its economic outlook. The statement reiterated the Fed needs greater confidence that inflation is returning to target before easing.
The highly watched dot plot continued to show the majority of the Federal Open Market Committee (FOMC) members expecting as many as three rate cuts in 2024; however, the number of expected rate cuts in 2025 was reduced from four to three, highlighting that policy easing is likely to be gradual.
Investors quickly adjusted to the idea of fewer rate cuts and longer-term interest rates moved higher, causing fixed rate bonds to decline in price. Even with the uptick in interest rates, equities charged higher setting multiple new highs, underscoring the strength in the economy and attractive fundamentals for corporate earnings.
With market expectations and Fed messaging now looking aligned for rate cut expectations, it will take a significant change in the economic outlook, particularly inflation trends, to significantly move rates meaningfully one way or the other in the near term.
Fixed Income
Interest-rate volatility increased in Q1 as strong economic data, stubborn inflation, and reduced rate-cut expectations pushed yields higher, stalling the bond rally seen in late 2023.
For the longer term, we expect bonds to resume their rally as inflation and rates decline later this year, albeit at a much slower rate. Within the credit segment, we continue to favor high quality bonds.
Inflation
Headline inflation has declined significantly since mid-2022.
The Personal Consumption Expenditures (PCE) price index, which is the Fed’s preferred inflation measure, fell from a peak of 7.1% year-over-year growth in June 2022, to just 2.4% as of February 2024, putting it very near the Fed’s target of 2%.
While progress in the Consumer Price Index (CPI), which has some methodological differences from PCE, has been dramatic, moving from 8.9% at the peak to 3.2% year-over-year as of February, improvements for this indicator have stalled. The CPI has stubbornly hovered around 3.2% since October, sparking concern that it won’t have further meaningful decline.
We believe there were seasonal factors elevating the CPI readings in Q1 and the disinflationary forces we saw in 2023 are still intact.
Core goods prices trended lower in 2023, as supply chain distortions related to the pandemic and Russia’s invasion of Ukraine continued to fade.
Even with the recent conflict in the Middle East, supply chains are still in good shape, and goods prices should remain well behaved. Within the more volatile components, energy prices have risen in recent months while food prices continue to ease.
Overall, the disinflationary trend established in 2023 should continue into 2024. While the ride down may take slightly longer than anticipated, the Fed should feel reasonably confident that inflation can fall to close to their 2% target later this year.
A Soft Landing Is Our Base Case
Our base case is that inflation will return to normal in 2024, even as real gross domestic product (GDP) growth remains positive.
Over the past year, inflation has fallen significantly, even as real GDP growth has accelerated, defying predictions that an economic slump or recession would be needed to resolve entrenched inflation.
The most recent measure of real GDP quarter-over-quarter of 3.4% was higher than the long-term average of 3.19%, so quite strong even as inflation trends improved.
While the lagged effects of higher for longer interest rates will likely slow GDP growth in 2024, we believe the trend will continue to be positive—meaning no recession—as inflation recedes toward the 2% target.
Employment
While the labor market has normalized from its post-pandemic boom, the US economy still added 250,000 jobs per month in 2023 and sustained this pace into early 2024.
The unemployment rate has remained at or below 4% since December 2022—the longest streak of low unemployment since the late 1960s.
Despite fears of an economic slowdown, strong growth in the US labor supply has allowed employers to steadily hire workers and narrow the gap between supply and demand.
After falling sharply during the pandemic, labor supply in the US staged an impressive recovery over the last two years, largely due to increased immigration.
Labor market resiliency is key to our soft-landing narrative.
Looking Forward
A positive January for US stocks is typically a prelude to a positive year, with that correlation holding true 80% of the time since 1928.
In our view, 2024 looks set to be another year of economic expansion supported by:
- A resilient consumer buoyed by a tight labor market and rising real wages
- Business spending focused on developing advanced infrastructure around intellectual property and margin enhancing technologies, such as AI
Tailwinds from federal government initiatives supporting infrastructure spending. We believe the historical signal of a strong start, combined with what’s likely to be peak interest rates, economic expansion, and positive earnings guidance, bodes well for risk assets for the balance of 2024.
Potential Opportunities
Cash has built up in money market funds over the past two years as the Federal Reserve raised short-term interest rates to the most attractive levels in over a decade. With central banks around the world indicating their intention to cut rates, there’s an opportunity cost to holding too much cash. Money intended for the long term should be invested in longer-duration assets.
Economies around the world continue to grow as inflation wanes and secular tailwinds should continue to support long-term assets such as stocks and bonds.
The potential for AI, both for the companies who produce the infrastructure as well as for the companies who will benefit from its potential productivity enhancements is expected to be wide ranging.
We believe the market rally can broaden beyond technology as more sectors adopt AI, and as market confidence is buoyed by recent Fed messaging and falling inflation. Some portions of the market are richly valued versus history, so diversification is key.
In addition to publicly traded assets, private investment opportunities can provide diversification through different and less correlated sources of return, while lowering overall volatility of a portfolio. We see opportunities in private equity, credit, and real assets.
While it’s impossible to predict what will happen to markets in the short term, markets have historically done well following a peak in inflation, the conclusion of a Fed tightening cycle, and a trough in consumer confidence.
We’re constructive on both stocks and bonds as the economy normalizes and deflationary tailwinds continue.
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