Strong Start to the Year
Markets continued higher in the first quarter, boosted by the Federal Reserve’s policy shift signaling that the next move in interest rates would be downward. With the economy and labor markets demonstrating greater resilience, consensus expectations of a recession or mild slowdown have now been largely replaced by a no-landing scenario.
From a structural standpoint, large-cap growth and tech led the market for the quarter. However, there was a notable shift in March as the rally broadened to include stocks across all sectors and those with smaller and mid-size market caps. While the Magnificent 7 contributed almost 40% of the S&P 500’s 10.6% year-to-date gain, cracks started to show in this esteemed group as both Apple and Tesla declined in the quarter. The momentum in Artificial Intelligence (AI) related companies carried through into 2024, led by the usual suspects and some newer entrants.
While we continue to identify compelling investment opportunities in the equity market, we believe that much of the good news is already reflected in current prices, making it harder to see where the incremental upside comes from, even with continued positive economic news. We offer additional insight on why our expectations for the balance of the year have moderated in our commentary below.
After relatively flat to negative returns from fixed income to start the year, we are more constructive on return opportunities now that interest rates have bounced off the lows of last quarter. For more details on our Fixed Income views, click the update found here.
1st QUARTER OBSERVATIONS:
Interest Rates
The Yield Curve remains inverted and while its predictive signaling of a recession seems increasingly at risk, it still falls within the historical time frame where it can happen. More probable is the backdrop of a resilient economy enabling interest rates to remain higher for longer. Seasoned investors will recognize that current rates are not particularly high by historical standards and should not be seen as an impediment for positive investment results or further economic growth.
Inflation
We support the higher for longer view on inflation as well. The growth rate of inflation has slowed meaningfully and we can expect apartment rents to eventually roll over as well. But there are signs that inflationary pressures are building elsewhere, particularly in the case of energy and a number of other global commodities. Additionally, near and intermediate-term pressures on input costs driven by wages, transportation, and sourcing still persist. An important offset is the opportunity for future productivity gains with the expected benefits from AI eventually expanding to all companies. For now, however, we reiterate a belief we have held for some time – the cost of doing business is going higher.
The Consumer
Some 70% of the economy is driven by the consumer. History suggests that the steep hike in interest rates last year would have produced a consumer-led recession. However, it did not, and that is no longer the consensus expectation. One explanation is that the consumer (and businesses) are not as rate sensitive as in times past. The prolonged period of historically low interest rates enabled borrowers to lock in cheap debt, protecting them from higher current rates. Additionally, the pandemic and related stimuli, coupled with the significant number of Baby Boomers who left the labor market in recent years, have provided ample savings and job opportunities to ease or delay the consumer’s sensitivity to the broad increase in interest rates.
Government Deficits
Dysfunction and partisanship remain the order of the day as the federal budget deficit continues to grow. The threat of a government shutdown remains ever present. Almost two hundred billion dollars of Employee Retention Credit dollars could still be paid out on top of hundreds of billions of dollars in CHIPS Act funds that are still left to be dispersed. While this outlook will provide additional market liquidity, it is difficult to see how our Government can effectively reverse the course of this growing overhang on society. As to when this unsustainable reality actually weighs on investment returns remains unknown.
Politics
Many important elections will be taking place around the world this year and perhaps none more important than the U.S. Presidential election. Historical precedent suggests that markets perform well in election years and 2024 is certainly off to a good start. That said, the uncertainties that go along with a divided electorate and the possibility of a contested outcome, along with the general dissatisfaction of the candidates, could lead to more market volatility than usual. Additionally, we acknowledge the possibility that the slate of expected candidates could look different on election day.
Geopolitics
Always an overhang risk to markets, the geopolitical picture focusing on China, Russia, and Israel, with Iran and Korea lurking in the background, continues to be more complex with a rising volume of rhetoric. For now, the impact on markets is the existential reality of event risk and the more direct possibility of commodity price and sourcing disruptions, adding pressure to the price of goods.
Artificial Intelligence
OpenAI unveiled ChatGPT less than 18 months ago. The hype that accompanied this release did not do justice for how it has transcended everything we thought we knew about AI. Still in the early stages, there is an active debate about how transformative this technology will eventually become to our ways of doing business. The promise of productivity enhancements and new discoveries across all sectors is expanding. Disruptions to the workforce are inevitable, but so is the creation of new opportunities. From the market’s perspective, we expect the benefits of AI to eventually work their way down the food chain from the enablers to the users. While we could see the possible impact these tools could have on business productivity, we did not fully appreciate how quickly and the degree to which the markets would embrace these new capabilities.
Energy
After coming off their highs last fall, oil prices have been on the rise again since mid-December. Given the various geopolitical risks, better economic growth leading to increased demand, and the slower uptake of alternative sources, this is another area where we believe risk is underappreciated. We believe diversity of source and supply is part of a long-term solution, but new supply from non-fossil alternatives (wind, solar, nuclear, hydrogen, etc.) is simply not coming online at a fast-enough pace.
Outlook
The markets have had a terrific run over the past five months. Our instincts tell us that a near-term pullback should not come as a surprise, though making short-term market calls are not usually accurate or necessarily important. Just more a resetting of expectations given that markets already embody a better economic environment than most had been anticipating. We are also mindful of the possibility that there may be no rate cuts this year if the economy continues to perform strongly and inflation levels out. Markets have handled the shift to expecting fewer cuts well, but they may not be prepared for the consequences of keeping the overnight cost of money at 5.3% for the full year.
That said, we are encouraged by the continued resilience of the consumer and the ability of U.S. businesses to grow earnings and not just from raising prices. Additionally, the broadening recognition of investors to appreciate opportunities in small and mid-cap stocks has been long in coming.
We remain vigilant in our process and pursuit in identifying those investments that are financially strong and consistent cash flow generators, regardless of the environment.
