2024 Q2 Outlook
April 23 , 2024

Q1 Review

The first quarter was an excellent one for stocks. The S&P 500 index rode a resilient U.S. economy, rising corporate profits, and anticipation of rate cuts from the Federal Reserve (Fed). March was the fifth straight winning month, and the best first quarter since 2019.

Despite the volatility experienced so far in April, history suggests staying the course. Since 1950, the S&P 500 has risen 93% of the time in the 12 months following a five-month streak, with an average gain of over 12%. Moreover, down years are rare after strong first quarters.

The year began with continued outperformance from US mega-cap growth stocks. However, as data increasingly showed a pickup in economic growth and inflation, we saw a rotation in March away from technology, and a broadening of the rally into more cyclical sectors and value stocks. We anticipate this will continue as investors grapple with the realization that interest rates may stay “higher for longer.”

Economic Update

Economic Update

US economic conditions remain favorable for solid growth, accompanied by an improving global backdrop, as evidenced by the global PMI manufacturing index rising above 50. This is driving up prices for industrial and energy commodities, a significant point given the recent stability of the US dollar. On the margin, higher input prices are expected to contribute to inflationary pressures domestically and internationally.

Consumer spending in the US continues to grow steadily, supported by robust income gains and residual savings accumulated during the pandemic. Notably, employment metrics remain favorable, albeit slightly below the peak levels observed earlier in the decade. Credit spreads are historically narrow, and consistent with a positive earnings and economic environment.

Inflation and the Fed

The sustained strength in US core CPI, as highlighted by the latest March data, emphasizes that the rise in inflation over the past few months is not merely a temporary blip, as Fed Chair Powell had anticipated. This development clouds the Fed's intentions to significantly ease monetary policy this year.

The forward market, which initially priced in six rate cuts for the year in January, is now expecting only two cuts following the release of the March CPI data. Long-term bond yields have gradually increased throughout the year, aligning with the firmer inflation data and positive economic reports.

The Federal Reserve finds itself in a challenging position due to its committed stance towards multiple policy rate cuts this year. Despite this, the prevailing sentiment among most investors and the Fed is that the recent inflationary trends are temporary aberrations. There's a widespread belief that inflation will significantly decrease in the future, reverting to the low levels seen before the pandemic. However, we disagree with this consensus view and believe that inflation will persistently stay well above the Fed’s target, likely ranging between 3-4%, rather than around 2%.

Ultimately, the current economic and inflationary landscape does not support the need for U.S. rate cuts, especially considering the consistent strength of indicators that have reliably signaled U.S. conditions in recent years. Furthermore, the global economy has shown resilience, with weaker economies not faltering despite significant monetary tightening last year, indicating that overall conditions never reached a truly restrictive level.

Market Projections for 2024

Looking ahead, the market landscape in 2024 is expected to be shaped by several factors. The economy's response to the lagged effects of the Federal Reserve's tighter monetary policy and the shift away from historically low interest rates will be crucial. Investors will closely monitor how these changes impact various economic segments, especially those already showing signs of weakness.

For equities, the focus will likely shift towards companies with strong fundamentals. Businesses boasting robust free cash flow, substantial cash reserves, high interest coverage, and consistent revenue growth will be in the spotlight. These "quality" factors are anticipated to become increasingly important as the cost of debt servicing rises, affecting corporate profitability.

The potential for lower interest rates in 2024 seems straightforward, yet the journey towards this outcome is expected to be fraught with challenges. Bond yields are projected to decrease, aligning with anticipated declines in inflation and a slowdown in economic growth. However, the market's reaction to Federal Reserve policy decisions will likely continue to induce volatility.

In 2023, the 10-year Treasury yield experienced substantial fluctuation, reflecting the market's response to shifting economic indicators and policy decisions. Bond yields, which move inversely to prices, typically rise during periods of economic strength, and fall when growth appears to be slowing. The expectation is that both short- and long-term yields have reached their peak for the current cycle and will continue to decrease, assuming inflation continues to diminish in 2024. This could provide a tailwind for bond investors, enhancing returns beyond attractive current yields

<sup>Equity Markets</sup><br/>Review and Outlook<br/>

Equity Markets
Review and Outlook

Stocks thrived in a "Goldilocks" environment that began in the fourth quarter of 2023, following the Federal Reserve's shift to a more accommodative stance, which boosted both growth expectations and reduced bond yields. However, in the first quarter of this year, as investors adjusted their economic and earnings projections and scaled back expectations for rate cuts, bond yields began to rise. Despite this, stocks continued to perform well through the end of the quarter, mainly because the upward revision in growth expectations outpaced the increase in bond yields. This was partly due to the confidence among bond investors and the Federal Reserve that inflation would continue to retreat, irrespective of robust economic growth, thereby allowing for multiple rate cuts by the central bank. While the Goldilocks environment persisted, it evolved from a period of sluggish growth and significant Fed rate reductions to one of solid growth and only minor Fed rate adjustments

However, now that bond investors and central banks are beginning to realize their excessive complacency on the outlook for consumer price inflation, it appears this Goldilocks period for stocks may have ended. This should result in a more volatile trading environment, where selectivity becomes crucial. Our factor-based approach for selecting stocks allows us to continually screen for companies that exhibit characteristics (or factors) which have led to outperformance over time.

We’ve made subtle shifts in our equity portfolios to take advantage of the current economic environment. Our expectation for a recession over the near term is low, but it is uncertain whether growth will continue to accelerate over the second half of the year. As such, we’ve targeted the two factor exposures that historically have performed the best with low recession probability: momentum and value. The result of these shifts has tilted our strategies more towards companies demonstrating continued growth but at a reasonable price.

Impact of Higher Bond Yields

Although the recent increase in bond yields has been moderate compared to the dramatic increases seen in recent years, its timing holds significance for equity markets. Conditions in the equity markets had become notably overextended for the first time in several years. The rise in bond yields is exerting downward pressure on price-to-earnings (P/E) ratios, particularly in markets and sectors where valuations and sentiment have become excessively stretched, primarily observed in the U.S.

Thus, equities might remain under pressure in the short term until investors are reassured that bond market volatility will ease. This should eventually occur as market and Fed expectations surrounding rates become more closely aligned. Stabilization in bond markets can pave the way for a return to risk-taking behavior, supported by the ongoing positive corporate earnings outlook and growing indications of improved economic activity worldwide. While such a backdrop may prevent interest rates from moving significantly lower, bonds can still play their traditional role of providing income and diversification in portfolios.

Conclusion

The strong start to the year for stocks, despite some emerging challenges, illustrates the resilience of the global economy and equity markets. With a favorable economic outlook and robust corporate earnings, investors should remain optimistic about the potential for continued growth. Although the path forward may feature increased volatility and shifts in market dynamics, particularly with inflation and interest rates, our active approach to managing portfolios can help navigate through uncertainties and capitalize on opportunities that arise.

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