Economic Flash: Why Market Leadership Could Shift in 2024

March 2024

US Economy: A few signs of weakness.

The latest estimate for U.S. GDP in Q4 didn’t meaningfully change the economic picture, with a minor downward revision in inventory restocking leaving a still robust, consumption-driven 3.2% rate of growth. Important fundamental data within manufacturing and the labor market continue to project strength while consumer confidence (106.7), retail sales (-0.8%) and durable goods orders (-6.1%) have slipped in the past month.

US Stocks: Onward & upward

U.S. large cap stocks notched the latest entry in a four-month winning streak built around continued belief that the Federal Reserve will cut interest rates later in 2024 as well as better-than-expected corporate earnings and guidance. Undiminished optimism for AI kept the technology (+6.3%) and consumer discretionary (+8.7%) sectors in the lead, but most segments including small-cap stocks (+5.7%) participated in the gains.

Foreign Stocks: China rebound.

Foreign equities lagged their U.S. counterparts in aggregate, although performance was highly differentiated by country and region. The outlook for Europe (+1.6%) dimmed somewhat amid higher-than-expected inflation and muted expectations for growth. On the flip side of the coin, Chinese stocks (+8.4%) surged as the government cracked down on short selling and bought equities amid expectations for much-needed economic stimulus.

Fixed Income: Inflation still an issue.

Bond investors drove up the yield on 10-Year U.S. Treasury bonds for the second consecutive month (to 4.28%) and remain less sanguine than stock bulls for a good reason: U.S. inflation is holding at around 3% (CPI), significantly higher than the Fed’s 2% target. The Fed funds rate remained unchanged in Feb. and financial market derivatives are now pricing in fewer than four rate cuts in 2024 vs. the six expected at the beginning of the year.

Real Assets: Lukewarm results.

Real asset returns in February were slightly better or in line with bonds. Outcomes were distinctly different depending on the segment, which is typical of a category with an array of structures and markets. Traditional infrastructure (-0.1%) was the relative “winner” receiving a boost from the rally in equity markets. Meanwhile, renewable energy infrastructure (-4%-5%) continued to face headwinds from higher interest rates and input costs.

Alternatives: The edge of hedging.

Hedge funds were popular following the 2008 global financial crisis but their overall returns disappointed some investors in the boom years that followed. While hedge funds shouldn’t be expected to keep up with equities in the short term, they should improve a portfolio’s risk-return profile to deliver better long-term results. Recently, hedge fund managers have been taking advantage of trading tailwinds – rising interest rates and volatility – to generate attractive returns.

Source of data: Bloomberg

Equities Total Return

U.S. Large Cap 5.3% 7.1% 30.4%
U.S. Small Cap 5.7% 1.5% 10.0%
U.S. Growth 6.9% 9.2% 44.0%
U.S. Value 3.7% 3.5% 13.5%
Int’l Developed 1.8% 2.4% 14.4%
Emerging Markets 4.8% (0.1%) 8.7%

Fixed Income Total Return

U.S. Agg. Bond (1.4%) (1.7%) 3.3%
TIPS (1.1%) (0.9%) 2.5%
U.S. High Yield 0.3% 0.3% 11.0%
Int’l Developed (0.6%) (1.4%) 2.3%
Emerging Markets 0.5% 1.3% 7.7%
Intermediate Munis 0.1% (0.2%) 4.1%
Munis Broad Mkt 0.0% (0.2%) 5.7%

Non-Traditional Assets Total Return

Commodities (1.5%) (1.1%) (3.9%)
REITs 1.9% (3.0%) 4.3%
Infrastructure 0.0% (3.1%) 1.9%
Hedge Funds
Absolute Return 0.6% 1.1% 4.1%
Overall HF Market 0.8% 1.3% 3.1%
Managed Futures 4.6% 6.0% 0.9%

Economic Indicators

FEB-24 AUG-23 FEB-23
Equity Volatility 13.4 13.6 20.7
Implied Inflation 2.3% 2.2% 2.4%
Gold Spot $/OZ $2044.3 $1940.2 $1826.9
Oil ($/BBL) $83.6 $86.9 $83.9
U.S. Dollar Index 121.4 120.6 121.4

Glossary of Indices

Our Take

A key question as we approach the end of the first quarter: Why has the U.S. stock market been on a tear when underlying economic fundamentals indicate a balanced set of scales that overall lean a tad pessimistic?  

While consumer spending has been robust in recent quarters, the excess savings built up by U.S. households during the height of Covid has been mostly drawn down. Ongoing increases in spending levels seem unlikely given higher prices and tighter, more expensive credit for both businesses and individuals.  

We are seeing signs of strain: Auto and credit card delinquencies and Chapter 11 bankruptcies are now at levels last seen during the 2008 global financial crisis. The number of U.S. job openings has been falling steadily, which is typically a precursor to a higher level of layoffs and eventual belt-tightening by consumers. Moreover, we are about to navigate through a series of consequential elections both in the U.S. and abroad. 

So Why the Optimism? 

  1. AI technology and its potential to lower operating costs, boost productivity and create breakthroughs in many different fields, from biotech to government. The euphoria surrounding AI is ongoing, lifting the stocks of a handful of public tech companies uniquely positioned to deliver (or not) on the AI promise, including Alphabet, Amazon and Nvidia to name a few of the “Magnificent 7”. To be fair, many of the tech titans have reported strong earnings growth recently. But beyond the AI tailwind, most U.S. equities over the last year have not seen exceptional returns.
  2. The expectation that the Fed will be able to cut interest rates later this year, reigniting growth before the U.S. economy loses steam. This has led to recent gains in sectors outside big tech, extending the rally into small-cap stocks and industrials.  

Curbing all that enthusiasm, we are well aware that equity valuations are elevated and borderline expensive for the Magnificent 7.  “Pricing in perfection” is the phrase investors use when valuations reach a level that makes the path to future gains very narrow based on fundamental data.  

We are not market forecasters, but it does seem a number of things could derail whatever perfection is priced in. Chief among these is whether the Fed will actually cut interest rates later this year to blunt the impact of one of the most aggressive tightening cycles in history. Should the data start to show that progress is waning on bringing down U.S. inflation to the Fed’s 2% target, the Fed has indicated they will again inflict “some pain,” which likely means postponing rate cuts. Currently, U.S. inflation is running at around 3%. 

What Now 

If there is one takeaway from this edition of the Flash Report it is this: The financial markets are not a homogenous mass, meaning that at any one time, new opportunities are being created in a variety of sectors and asset classes.  

For example, the Magnificent 7 that have been powering the S&P 500 are not the market. Market leadership could rotate this year to the “Fabulous 493” should economic growth slow and enthusiasm for AI drop off. Elsewhere, the ongoing rally in U.S. equities has not been shared by the U.S. bond market or foreign equity markets.

Each of these two asset classes — fixed income and foreign equities — offer diversification as well as yield (for bonds) and the potential for added return given current valuations. In the case of bonds, while we can’t say when the Fed will cut rates, we can safely say that they will eventually, and when they do it will reward investors who have maintained defensive, longer-maturity exposures. Lastly, where applicable, it may be prudent for portfolios with private market investments to consider whether cash for upcoming capital calls can be parked in fixed income vehicles or money markets with competitive yields.