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 second quarter of 2024 saw potential market problems emerge with an Artificial Intelligence (AI) led tech rally showing signs of cooling, a disappointing first quarter GDP reading at 1.4% annualized growth, and slowing progress against inflation pushing expected Fed interest rate cuts further down the road. The Fed kept rates unchanged within the 5.25-5.50% range and signaled they remain focused on fighting inflation. Futures markets now expect one 0.25% interest rate cut before the end of the year, down from an expectation of 6 cuts to start 2024. Unemployment is still very healthy at 4.1% but has trended up since a 3.7% reading in January to its highest level since November of 2021.
Despite these developments, most indexes still finished the quarter in positive territory, led by a continuing AI themed rally in a few big-name tech stocks. The following charts show that individual stock contribution to the current rally remained poor in breadth. The chart on the left shows that although approximately 90% of the index constituents increased in price, only about 50% of them increased above their 50-day moving averages, which basically means only about 50% of the index was driving the rally. This is not a sign of a broadly healthy rally in individual stock performance. The chart on the right is even more concerning, illustrating that for 2024 through June 30, more than half of the Earnings Per Share of the S&P 500 came from only the top 10 largest companies:
Current Investment Strategy
We made some significant strategy changes during the past quarter. Most importantly, we rebalanced portfolios back to their long-term equity targets, resulting in 5-10% equity weighting increases. In doing so, we eliminated several bond positions that were originally added specifically to protect against the effects of rising interest rates, reflecting our belief that the current cycle of rising interest rates is mainly over, and the next move from the Fed is likely to be a rate cut. We held several floating-rate bond positions whose performance is positively correlated with interest rates, unlike traditional fixed income investments that are negatively correlated with interest rates. We had also held interest rate hedged bond positions which bought insurance to hedge against the negative effects of rising rates on an existing bond portfolio. All these types of bond positions were sold in the 2nd quarter as we rebalanced portfolios and readied them for a neutral-to-falling rate environment. However, we have aimed to keep portfolios relatively low in interest rate sensitivity (short in duration) should rates begin to rise again (an outcome we foresee as highly unlikely).
After rebalancing, we added two new equity sector positions in the industrial/infrastructure areas. These sectors were added for the following reasons: an expected increase in domestic construction (both real estate and infrastructure), current record high defense spending, and expected future infrastructure spending by the government. Both Harris and Trump campaigns have signaled a preference for increased infrastructure spending.
Investment moves this past quarter had a unified theme of increasing portfolio risk and return potential, as our current forecasting is that the U.S. economy is increasingly likely to achieve a “soft landing” from a long period of high inflation and rising interest rates. The 2nd quarter advanced estimate of GDP growth was 2.8%, which is a healthy improvement from the solid 1st quarter GDP of 1.4%. The following chart shows the history of the U.S Leading Economic Indicators index (LEI) over the last 60 years relative to recessions and recoveries. The LEI attempts to forecast future economic performance, and the most recent reading shows the LEI trending up and supporting the case for avoiding a recession and moving straight to recovery.
Future Asset Allocation Changes and Considerations
To reiterate, our investment committee is currently uniform in the belief that the U.S. economy will achieve a “soft landing” and avoid a recession over the next 6 months. As such, we have increased equity allocations and changed our bond strategy to expect a flat or falling interest rate environment. However, this outcome is not guaranteed, and concerns about the future remain. For one, the bond market yield curve remains inverted and has been for nearly 2 years. This has historically been the best indicator of a coming recession, but it does not have a perfect prediction track record, so the current inversion may well be a false alarm. Should economic conditions change, we will aim to reduce risk accordingly.
As far as potential investment moves in the current quarter, we are considering a slight shift within equity weightings from U.S. equity to European international equity. The European Central Bank cut rates last quarter from 4% to 3.75%, their first rate cut since 2019. Falling rates and more attractively valued equity markets than the U.S. are causing us to consider increasing equity allocations to Europe, but as the global economic and political situation is currently uncertain, we may wait until after the presidential election later this year to make such a move.
The presidential election season does have the potential to add uncertainly and volatility to the markets as the election date draws nearer, but we would like to stress the point that historically, U.S. elections do NOT drastically change market performance and at this early date, the best approach is to the stay the course with a diversified investment approach and not to make drastic changes to strategy based solely on potential political outcomes. The chart below illustrates this investment approach, making clear that staying invested regardless of which political party holds the Presidency is by far the best course of action.
Key Investment Takeaways
- In the 2nd quarter, we moved from defensive to more aggressive strategies in both stocks and bonds
- Stock and bond markets rallied in the 2nd quarter on expectations of interest rate cuts and strong GDP growth
- High interest rates make cash and fixed income investments relatively attractive
- Inflation has declined significantly to 3% trailing year, and the Fed is likely to cut rates in 2024
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
