With markets experiencing their own heat wave, will the summer rally sizzle or fizzle
“No man stands taller than when he stoops to help a child.”- Abraham Lincoln
It’s that time of year again, with the warmer weather and the longest of days, I find myself excited to watch the US Open and celebrate my favorite holiday with my two sons. It wasn’t long ago that Thanksgiving was the apex of the celebratory days, but then when our first little guy came into the world, it was clear that turkey and football would have to take a back seat. The thought of getting recognition for something you so personally prize is a bit ironic don’t you think…Having the privilege of working in our profession, as an advisor, provides a similar sense of purpose and enjoyment. We hope we can live up to your expectations and help support you like we do for the little people in our lives. You surely make us better. I’ll return to philosophizing a little later, but let’s dive into what’s happening out there with the economy and the markets. After a modest pull back in April due to hotter inflation reports, we have witnessed the market touching new highs seemingly every day for the last month. Yes, it’s been a few stocks that have captured everyone’s attention, but recent data has suggested the economy and inflation continue to slow and thus allowing the monetary easing conversation to return to the foreground.
As we debate what the relevant leading and lagging indicators should be compared to past models, it would seem to me that the material slowdown in inflation that we saw in the back half of 2023 was the result of cooling GDP readings. You may recall that Q’1 2023 real growth was 2.2% followed by 2.1% for Q’2 only to accelerate in Q’3 and Q’4, coming in at 4.9% and 3.4%, respectively. Like clockwork, inflation ticked up a bit in the readings from February through April this year as increased insurance premiums, higher fuel prices and some shelter costs stalled the progress. With 1st quarter 2024 GDP revised downward to 1.3% (awaiting one further revision) and the Atlanta Fed’s GDP Now tracker indicating we are growing around 3.1% in Q’2 my sense is that we will see inflation continue to abate in the back half of the year on its way to 2.0%. This may very well allow the Fed to begin the easing process in September and follow up with a second cut in December. The Fed doesn’t meet in August or October thus taking those two months off the table. Two cuts from the present 5.25-5.50% range are likely to have little real impact on the economy as the cost of capital will not have changed drastically, but it’s about the signal it sends to the market and may result in some pent-up demand in housing, restarting an existing home sales market that has been flat on its back for two years.
We are all human and our legacy (remember the theme being Father’s Day) is important, Jerome Powell is no different. When I listen to his post meeting press conferences, I can see his desire to start cutting policy. If by easing, albeit slowly, can prevent or delay the next recession and support the soft landing/ no landing narrative, he could ride off into the sunset when his term ends in 2026 thinking job well done. There is some precedent for easing while the economy is still expanding, though it’s a less common phenomenon. Given the fact that less than 6 months ago the market was pricing in 6 rate cuts, it’s fair to say that easing has been priced into the market somewhat. Real estate, the only sector down for the year, would surely rally on that news as would small caps and perhaps more cyclical industries which could propel the market cycle along. The risk/return looks interesting there, where small caps trade as a group while energy, materials and parts of the industrial space have been range bound for the last few months despite the underlying commodities they produce showing improving fundamentals.
Nvidia continues to suck up all the oxygen in the room, and now it’s a 3-horse race for the most valuable company in the world, something unimaginable as recently as a year ago where Apple and Microsoft had clear leads over the Amazons and Alphabets of the world. All things AI have created a wave of sentiment that does have some analog to 2021 or 1999, even if the companies are different and much more profitable. Much like the investments of Global Crossing, WorldCom and Lucent paved the way for extraordinary improvements in how we do business in a modern (internet) based world, AI’s real impact is likely to be realized over the decades ahead and in companies vast and wide. Here is something to keep in perspective, Apple, again the world’s largest company, generates $100BB in net income, not revenue, but bottom-line earnings. Nvidia’s net revenue is likely to be close to $100BB, yet these two companies are worth the same $3 trillion dollars, a market cap figure that would have been scoffed at as recently as 10 years ago when thinking about a company’s value 50 or 100 years into the future. While the current market darling’s gross margins of nearly 80% would make anyone green with envy, that still means they are generating 20% less than the Cupertino juggernaut in what is a highly competitive, cyclical business. Time will tell where this story goes, but my sense is that you may find more success investing in areas not in the limelight.
With the S&P 500 & Nasdaq at all-time highs, it’s easy to lose sight of what has been an otherwise solid year for stocks overseas, with a notable speed bump in the last couple of weeks. With much of the free world spending time at the polls this year, political risks may jeopardize some positive economic and market momentum abroad. It’s easy to focus on November 5th, but worth monitoring is how many of our allies look to set the direction of policy in the years ahead. In some instances, the expected outcomes have materialized albeit with modest complications (see India and Mexico) while others suggest a greater shift in the Zeitgeist may be under way. In the two most dominant economies of the Eurozone, France and Germany, massive right leaning movements have meant that populism was not simply a 2016 phenomenon. Eight years ago, we saw the Brexit referendum and the introduction of the Trump party. Populism at its face suggests that we’ll see more inflationary policies resulting in fiscal deficits to rising protectionism in the form of tariffs and domestic subsidies. This is a concerning development calling into question the existence of the Eurozone itself (the UK’s departure was easier given their reliance on the Great British Pound vs. the common Euro currency) while diminishing the prospect of “free trade” and globalization where it’s irrefutable that has been a massive successful era. We’ll see how things play out in France with snap elections later this month, while the Brits go to the polls on our Independence Day. We’ll have more to share on our market update call next month. A clear positive is that the easing cycle has begun in the developed world where the ECB and Canada most recently cut rates for the first time in years, and we expect others to follow in the months ahead. Hopefully it will not be necessary to ease more sharply if the political uncertainty causes a slowdown in economic activity or perhaps the opposite, in ceasing the easing process if rates volatility becomes problematic. Our base case remains that foreign economies should see some improvement in growth this year offsetting some of the previous slowed growth.
As by now you know it’s not all stocks, as many investors have a sizable portion of their portfolio in fixed income securities. 2024 has continued the theme of rate volatility we had seen in the last few years. The good news is that it hasn’t spilled over into equity markets like it did in 2023 (see summer correction) or 2022 (bear market in both stocks and bonds). Rates likely ended 2023 too low as overly optimistic forecasts of Fed easing were the rage, with the 10-year Treasury yielding 3.80% that didn’t seem like great compensation in a world with elevated inflation. Rates moved as high as 4.70% in late April on the back of higher inflation readings and still strong jobs numbers, but since then we have seen yields head back down to 4.20% as inflation data continues to show progress there and labor demand seems slackening as evidenced by a decline in openings and rising new unemployment claims. Rates seem more reasonable in the 4.25-4.50% range so we are close to fair value there. There has been a lot of chatter about tighter spreads being a little concerning, but with absolute yields relatively high that’s less worrisome when spreads were narrower and rates much lower. Heck, getting a 50-60% cumulative return on fixed income in the next 10 years would mean anywhere from 2-3X what you realized the 10 years from 2011-2020.
Let me close with some additional personal reflection, I know I speak for Madeline and Tom both here too. It’s funny, for many years, my colleagues would complain about a case of the “Mondays”, while the general impression was that it was the angst associated with beginning another long week at the office, I have come to realize that it’s more about having to wait another 5 days to be fully immersed in all things dad. Admittedly, I do miss their companionship from Monday through Friday, but we get the privilege of spending time with you, our other family, which does a great job to fill that void. Wishing everyone a happy Father’s Day, we wouldn’t be here without ‘em. Hope to see you next month on our quarterly webcast.