Markets had a challenging start to the quarter. US stocks fell in April, declining over 5% from the March highs as stickier inflation and a strong jobs report caused the markets to push out Federal Reserve rate cut expectations.
Treasury bonds declined in value as yields rose.
However, by mid-May, the major indexes were back in the green, buoyed by large cap technology and—once again—optimism around artificial intelligence (AI). With the economy softening and the Fed still on hold, investors were drawn to the largest companies with big moats, large balance sheets, revenue growth and strong secular tailwinds.
Technology and communication services stocks saw the best gains in Q2 while defensive stocks like utilities also fared well.
With the timing of rate cuts moving further out, cyclical stocks fell, with the biggest losses coming from the basic material sector. Energy and industrials also fell after posting double-digit gains in the first quarter.
With interest rates staying higher for longer, real estate stocks and small caps continued to tread water.
This bifurcation between tech and everything else saw the market-cap weighted S&P 500 up 3.9% over the quarter, closing at a record high nine times, while the equal weight index fell by 3.1% over the quarter.
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Moss Adams Wealth Advisors Market View
Here are our key takeaways on the economy and markets:
- The trajectory of inflation has been uneven; however we believe the trend of disinflation remains intact and the Fed will cut rates later this year, likely in September.
- Though moderating, continued economic growth and labor market trends support our softer landing scenario base case.
- The resilience in jobs has been in the labor-intensive services sector, which we expect to hold up through the end of the year.
- Over the mid- to longer term, we are constructive on both stocks and bonds as the economy normalizes and deflationary trends continue.
- Key risks to equities include a Fed policy error where the central bank stays too tight for too long, a reversal upward in inflation and long-term yields, or escalation of global macro stresses.
- Labor market resiliency is key to our soft-landing narrative.
Healthy but Moderating Economy
The US economy is on solid footing mid-year. The labor market has rebalanced to pre- pandemic levels—strong but no longer overheated enough to generate significant inflation.
Core personal consumption expenditures (PCE), the Fed’s preferred gauge of inflation, has moderated to 2.6%.
The economic expansion, which began in mid-2020, is now in its fourth year and is showing some signs of slowing. Real GDP fell from 4.9% annualized in Q3 of 2023 to just 1.3% in Q1 of 2024. The Atlanta Fed GDP Now estimate for the second quarter is 1.5%.
One explanation for the softening in the economy has been the consumer. An extended period of inflation above trend has taken its toll and consumer sentiment has surprised to the downside despite reasonably good economic data.
Corporate Spending and the Consumer
While the data is mixed, the US consumer has remained mostly resilient even as excess savings from the pandemic have dwindled. Looking forward however, it’s unclear whether real wage growth and stock market gains can push the consumer to maintain the same levels of spending. Credit card debt has been rising and could rise further. May data showed consumer spending came in weaker than expected while personal income was higher.
On the corporate side, investment spending has remained robust focused on developing advanced infrastructure around intellectual property and margin enhancing technologies, such as AI.
Resilience in Labor
Labor markets have enjoyed a relatively benign softening trend without a major rise in the unemployment rate. Job openings continued to drop from their peak and labor-force participation rates remained high, providing hints of disinflationary dynamics.
The US unemployment rate has remained at or below 4.1% for the last 10 quarters. That’s the longest it has been this low since the late 60’s.
Wage growth remained positive, albeit slowing from 4.6% in April of 2023 to 4.1% this year. Still, wages in excess of inflation—real wages—should continue to support the consumer.
Inflation Trending Lower
While we believe the disinflationary trends of 2023 are intact, the path to the Fed’s 2% target has been uneven this year. Energy prices recently have rebounded, shelter inflation declines have slowed and things like auto insurance have increased.
Even as the widely quoted consumer price index (CPI) has remained stubbornly above 3%, we take comfort in the core PCE Price Index which fell in May to 2.6%, its lowest level since March 2021, and very near the Fed’s target of 2%.
Markets Decrease Expectations for Interest Rate Cut
Market expectations for the Federal Reserve’s next move have shifted in 2024. The Fed has kept interest rates steady at a target range of 5.25%-5.50% for nearly two years, and investors have been anxiously awaiting evidence that the Fed could cut rates soon.
Bond futures at the beginning of the year were pricing in six or seven cuts in 2024, but stronger-than-expected inflation data forced investors to adjust that estimate. Now markets are anticipating just one or two cuts this year.
Bond Market Performance
Bond markets recovered in the second quarter, boosted by improving inflation data late in the quarter. The yield on the 10-year Treasury note fell more than 0.30 percentage points from its April peak, ending the quarter at 4.37%.
Stock and Bond Market Volatility
Stock market volatility saw a minor increase from the first quarter but remained low compared to historical trends.
The instability in the bond market remained higher than its five-year average and experienced a minor increase from Q1, as investors adjusted their predictions for interest rate reductions from the Fed.
Outside the US
Economies around the world are beginning to diverge from each other. The US is once again acting as the global growth engine, while Europe and China are lagging.
India has been a surprise driver of global growth while Japan continues to show signs of economic tailwinds.
Recap and Looking Forward
Stocks managed to climb a wall of macro worries in Q2, even as concerns over a softening economy and reduced expectations for Fed rate cuts splashed cold water on the more cyclical areas of the market.
The better PCE and some softening labor data toward the end of the quarter combined with strong earnings, particularly in technology, led the market cap-weighted S&P 500 to new highs.
The AI trade showed no signs of slowing, and tech stocks continued to dominate. Bond markets also ended the quarter in positive territory, as investors gained confidence that inflation was improving.
For the remainder of the year, we expect continued growth though at a moderating pace, which is exactly what the Fed wants. Benign inflation numbers and economic data over the coming months should be sufficient to allow the Fed to cut rates before year-end, giving a much-needed boost to stocks sensitive to interest rates and allowing the market rally to broaden.
We believe the historical signal of a strong start to the year, combined with what is likely to be peak interest rates, continued modest economic expansion, and positive earnings guidance, bodes well for risk assets for the balance of 2024.
Where We See Opportunities
There’s an opportunity cost in holding too much cash, and investors should put long-term money in long-term assets.
US and global economies continue to grow as inflation wanes. Broadly, central banks around the world are in easing mode which bodes well for stocks and bonds.
Secular tailwinds should continue to be supportive, such as the prospects for AI, both for the companies who produce the infrastructure as well as for the companies who will benefit from its potential productivity enhancements.
We believe risk appetite can broaden out beyond tech as more sectors adopt AI, and as market confidence is buoyed by declining interest rates later this year.
Outside of public assets, alternatives still offer investors an opportunity to enhance portfolio performance through alpha, diversification, and income.
- With central bank rate cuts kicking off in many parts of the world, the expected decline in borrowing costs should create a tailwind for high quality private real estate due to their sensitivity to interest rates.
- Private infrastructure’s low downside capture can help buffer portfolios during periods of volatility. Additionally, we are bullish on infrastructure energy assets as AI’s rapid expansion is creating immense demand. Data centers and AI technologies need consistent and reliable power.
- Yields on private credit remain attractive; however, elevated macro uncertainty suggests that choosing private credit funds with robust asset management capabilities remains critical.
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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For more information about the economic landscape and what it means for investors, reach out to your Moss Adams professional.