Positives
- U.S. Federal Reserve Bank remains paused in interest rate hiking cycle; next move is likely to be a rate cut
- U.S. unemployment rate remains healthy at 3.9%, though up from 3.7% in January 2024
- Fixed income and cash offering very attractive yields (>5% on cash)
- U.S. inflation rate has declined significantly from its peak
Risks and Concerns
- Wars in the Middle East and Ukraine significantly increase already high geopolitical tension
- Equity risk premium at its lowest level in over 20 years
- CPI inflation rose at a 3.2% annual rate in February 2024, but is down greatly from its peak of 9.1% in June 2022
- Interest rates may remain higher for longer than markets hope as some inflationary pressures remain
The Quarter in Review
The first quarter of 2024 was off to a strong start in financial markets after an early confirmation that 4th quarter GDP growth was above expectations. GDP grew at a 3.4% annual rate in the 4th quarter and was 2.5% for the full year of 2023. GDP growth between 2% and 3% is generally considered ideal by most economists whereby growth, inflation, and unemployment are in a healthy balance. The economy remained strong despite high interest rates, but the downside of this strong growth is that it has fueled inflation (which has remained persistent and has not dropped as fast as markets hoped). Inflation, as measured by headline CPI (Consumer Price Index), was above expectations in February, coming in at 3.2% annualized vs. market expectations of 3.1% (as shown in the following chart):
Consumer Price Index, Change from a Year Earlier
Source: Labor Department
The Core CPI metric is the Fed’s preferred measure of inflation, and at 3.8%, was far above the Fed’s target of 2%. These disappointing inflation numbers have dashed expectations for multiple Fed interest rate cuts in 2024. The central bank controlled Federal Funds rate has been at 5.25% – 5.5% since July of 2023, a 23-year high. At the beginning of 2024, futures markets were expecting six 0.25% rate cuts by the Fed, but due to persistent inflation, the futures markets are now forecasting just one (or zero) rate cuts this year. The inflation is not only arising from strong domestic GDP growth, but also due to geopolitical tensions abroad in the Ukraine, Israel/Gaza, and now, Iran.
It is important to note that the U.S. economy has been extremely resilient in the face of persistent inflation and high interest rates, weathering both systemic stresses extremely well up to the present date. The S&P 500 Index rose 10.6% in the first quarter and the tech-heavy NASDAQ Index rose 9.3% in a sign that the market dominance of the largest “Magnificent 7” technology stocks is beginning to wane in favor of broader market participation – a good sign for the health of the overall economy. The Russell Midcap Index rose 8.5% and Russell 2000 Index (small cap stocks) rose 5% while international equity continued to lag the U.S., with the MSCI EAFE Index rising 6%. Earnings announcements for U.S. companies have been strong, with approximately 80% of companies beating earnings estimates in the current earnings season.
On a more cautionary note, the continued high interest rates have hurt the residential and commercial real estate markets and therefore the REIT investment sector has suffered as well. Unemployment has ticked up slightly to 3.9% in February from 3.7% in January, though this is still a healthy overall number.
Current Investment Strategy
We have been focused on rebalancing portfolios back to a more equity neutral position (no longer underweighting), as well as rebalancing out of our more defensive bond positions. The overall economic situation has continued to improve and despite sticky inflation, it appears that the U.S. will avoid a recession and achieve a soft landing from the Fed’s rate hiking cycle. Due to inflation, it looks as if interest rates will remain higher for longer than previously expected. The following chart shows investors revising expectations for lower interest rates over the past 3 months:
Where Traders Have Thought the Fed Would Set its Target Rate in 2024
Source: The New York Times, “Bets on Rate Cuts This Year Are Fading Away,” 4/26/2024
Despite this development, we still think the Fed’s next move is most likely a rate cut, with the period of rising interest rates most likely coming to an end. As such, we continue to rebalance out of our most defensive bond positions, which are interest rate hedged and floating rate strategies designed to protect against rising rates. These positions are being replaced by short and intermediate term maturity bond positions. As the likelihood of a recession fades, our overall strategy in the first quarter was a move away from defensive positioning in both equity and fixed income strategies.
Future Asset Allocation Changes and Considerations
Our future strategy will not only be determined by the likelihood that interest rates will be higher for longer, but also whether it appears that the U.S. economy has successfully absorbed the effects of higher rates and persistent inflation. Unless the economy begins to slow dramatically or inflation drops significantly, it is unlikely there will be any interest rate cuts from the Fed in 2024. Unemployment has been below 4% since 2022, and with core inflation well above the Fed’s stated 2% target, the Fed has little motivation to cut rates imminently. The following chart illustrates the continued low unemployment, but also highlights a worrying trend in rising credit card payment delinquencies:
State of Consumer – Mixed Signals
Source: Bloomberg, as of February 2024
Strong consumer spending driven by low unemployment has been one of the driving forces keeping our economy strong, but unfortunately, the chart shows that a rising number of consumers are clearly overspending. Another red flag is that both commercial and residential real estate markets have continued to suffer under the effects of persistent high interest rates.
Regardless, as mentioned prior, we do believe that a soft landing for the economy is the most likely outcome, and we continue to move portfolios to an overall more balanced and less defensive position. We are currently considering the addition of a new sector investment that would likely benefit from the persistent higher inflation such as an industrials, commodities, or materials sector ETF.
Key Investment Takeaways
- We are currently moving from defensive to more aggressive strategies in both stocks and bonds
- Stock and bond markets rallied in the 1st quarter on expectations of interest rate cuts and strong GDP growth
- High interest rates make cash and fixed income investments relatively attractive
- Inflation has remained persistent, but the next Federal Reserve move is still most likely a rate cut
We will continue to monitor the market risks of this rapidly changing and difficult environment, frequently adjusting to help protect and grow your investment portfolio. As always, please feel free to call or email us with any questions or concerns.
Your Capital Advantage Team
