2Q 2024 Market Commentary

Economic Overview

By Dr. Mark Pyles

We often speak on these pages of the three legs of the economic stool, referring to economic growth, price levels (inflation), and the labor market. While it is certainly true that each of these elements is a critical standalone concern, it is equally true that they are very interrelated. More so, each leg is significantly driven by the actions of consumers. To put this into context, while Gross Domestic Product (GDP) can be broken down into four primary pieces, two-thirds is from personal consumption expenditures; and these expenditures are, in turn, most often driven by consumer attitudes towards the current and future economic realities being faced.

With this as a backdrop and given the uncertainty surrounding the state of the consumer coming out of one of the most unprecedented exogenous shock periods of human history, an updated examination of the current headwinds and tailwinds facing consumers is warranted. Let’s first review recent history from the consumer’s perspective. Prior to the world going on lockdown in early 2020, the U.S. economy was on reasonably solid footing. The unemployment rate had trended down from 5.7% at the beginning of 2015 to 3.6% at the end of December 2019, while the rate of real GDP growth averaged 2.5% quarter-over-quarter (QoQ) annualized and headline Consumer Price Inflation (CPI) only averaged 1.6% year-over-year (YoY) for the same period. Further, real average hourly earnings (the rate of average hourly increase in earnings minus headline CPI) was positive for all but three of the 60 months. Thus, most U.S. consumers were employed and seeing their spending power increase, which allowed economic growth through robust consumption.

Of course, COVID then forced us to consume in a completely different way. In fact, during the first and second quarters of 2020, we were forced to nearly stop consuming services entirely. At the same time, it has been well-documented that an unprecedented $3 trillion in stimulus money was fed into the economy, including to a large percentage of consumers that were then able to maintain their earnings power throughout the pandemic. This led to a surge in savings rates, where savings as a percentage of disposable income averaged 17% from March 2020 through April 2021, compared to just 6.2% for the previous five years. Consumers were also able to pay down debt, with the amount of outstanding revolving debt shrinking by nearly 12% (or $130B). Ultimately, while the humanitarian tragedy of COVID can never be overstated, the personal financial impact was ironically positive for a wide range of consumers during the period.

At the core, consumers desire consumption, and will do so in whatever avenues are available to them and within their means. During the heart of the pandemic, we had little choice but to splurge on goods, both things practical (e.g., washers and dryers) and those that were hoped to ease the misery of the situation (e.g., large screen TVs or barbeque grills). As we know, the ugly side of this spending was the creation of significant supply chain pressures and a basic imbalance of supply and demand such that goods inflation was significantly elevated. Eventually, we were allowed to go back out into the world, and responded by spending aggressively on services, largely to make up for lost time. This naturally then led to a supply/demand imbalance in core services, driving inflation in that component to an average of 5.8% YoY from the beginning of 2022 through the most recent May print.

These inflationary pressures resulted in the Federal Open Market Committee (FOMC, or “Fed”) raising the Fed Funds rate an aggressive 5.25% from March 2022 through July 2023. Whether from the resulting increase in financial restriction or some combination of other factors, headline CPI has declined from over 9% in mid-2022 to 3.3% for the most recent May reading. But consumers faced 25 straight months (from April 2021 through May 2023) where inflation by this metric was over 4% YoY. And throughout, consumers continued to spend. Personal consumption within GDP reports averaged robust growth of over 3.3% from Q2 2021 through Q2 2023, with personal spending increasing every month (except two) over that period. This was accomplished, at least in part, by using savings to support the higher prices and still high demand. The average savings rate now stands at only 3.9%, significantly below historical levels. We have also started adding debt again, with the amount of revolving debt outstanding measured at $1.34 trillion as of the end of April, compared to $1.10 trillion just prior to COVID, and $970 million at the COVID lows.

This is all leading to the inevitable question: what is the current state of the U.S. consumer?

On the one hand, it is relatively easy to paint a pessimistic picture. Consumers have spent down their savings and ran up debt to maintain spending behaviors in the face of higher prices and could be feeling the pinch. This notion would be supported by a large range of consumer surveys, such as the University of Michigan Sentiment Index, which currently sits significantly below pre-COVID levels. One also can simply listen to any number of consumer-sensitive firms on recent earnings calls pointing out that their customers are being more selective in their purchase decisions. Adding to the potential worry is that inflation seems relatively stuck at current levels, leaving the Fed in a quandary over when and how much to cut rates. This has extended affordability pressures, particularly in the sensitive area of housing, where the average mortgage rate has increased from approximately 3.2% at the end of 2021 to the current level in excess of 7.2%.

However, we can also paint a more optimistic picture of the consumer, which starts with the labor market; impressively resilient with an average of 391,000 jobs added per month according to nonfarm payrolls since January 2021. While the data is noisy, and some recent prints suggest softening, consumers are still relatively confident in keeping their jobs and/or being able to find another. We are also in a reelection year, which often provides fiscal support as elected officials seek to solidify their candidacy. And while the long-predicted rate cuts by the Fed have yet to materialize as quickly or as numerously as we would have expected, the next move in rates is still almost certainly lower. This will provide support for the areas of the economy such as small firms and stretched consumers that may be struggling. Finally, perhaps the one thing that can support sentiment, and in turn drive action, above all is a robust financial market backdrop, such as that currently being experienced in large-cap equities. Heavily related, consumers have seen a collective increase in household net worth of a mind-boggling $17 trillion from the end of September 2023 through March 2024.

Ultimately, a well-known anecdote is that one should never bet against the American consumer when it comes to just that… consuming. However, it is also true that prudence often wins out in times of financial stress. We feel we are experiencing healthy doses of this prudence at present and are likely to continue to do so in coming months. This puts additional pressure on the labor market and will force tough decisions by the Fed in upcoming FOMC meetings as they balance the fight against inflation with the stress on the consumer in this restrictive financial environment. At present, we still feel it most likely that the path forward is simply slower and bumpier, not backwards. But the current consumption prudence has our attention and, in turn, motivates us to also remain prudent in our investment approach.

The Stock Market

By Walter Todd

As the calendar turns the page to July and the third quarter of 2024, I find myself feeling a bit like Bill Murray’s character in the movie Groundhog Day, released in 1993. This is a great film if you have not seen it, where Bill’s character, Phil Connors, wakes up every day reliving the same day (February 2) over and over again. He is stuck in a time loop and no matter what he does, he cannot change the events of the day and wakes up every morning to the same song on his alarm clock. This seems to be the case with the performance of the stock market over the past 18 months and the lack of broader participation we have seen. But instead of watching to see if the Groundhog, Punxsutawney Phil, sees his shadow, we are watching to see what Nvidia’s stock price does and what CEO Jensen Huang will say. Such was the case again in the most recent three-month period ended June 30, 2024, and year-to-date. There are more details below on the breakdown for performance. Similar to Phil Connors, I cannot say with certainty when this time loop will break, but it will and that is when we have to “watch out for that first step. It’s a doozy.”

The second quarter started on a downward slide, with stocks (S&P 500) falling over 5% through April 19 as rates moved higher. From that point forward, equities (at least the top of the S&P 500) finished strong, with the market-cap weighted index moving nearly 10% off the lows and finishing up +4.3%, including dividends. As hinted, this recovery was not broad-based with the Equal-weight S&P 500 Index ending the quarter lower by -2.6%. YTD, the S&P 500 has outperformed its more democratic brother (the equal-weight) by over 1000 basis points (or 10%). To put a finer point on it, YTD only 25% of stocks in the S&P 500 have outperformed the index, the lowest level in past 50 years. Looking beyond the U.S. large-cap space, small-cap stocks (as measured by the S&P 600) were also negative for the period at -3.1%. Outside the U.S., International stocks were mixed with Developed International Markets basically flat at -0.2% for the quarter (as measured by the EAFE Index) while Emerging Markets (EM) posted a +5.0% return for the quarter (measured by the MSCI Emerging Market Index). EM stocks were led by rebounds in China and continued strength in India. Putting the U.S. and International Markets together, the MSCI All-Country World Index (ACWI) finished up by +3.0% for the three-month period and is up 11.6% YTD. Similar to the U.S., however, the ACWI Equal-weight Index did not fair as well, falling -0.9% for the quarter and rising just 1.1% YTD.

During the most recent quarter, the market narrowed further from a sector perspective, with only 5 of 11 sectors positive for the period and only 3 of 11 outperforming the broader market (S&P 500). Sector leadership went back to the future with Technology (+13.8%) and Communication Services (+9.4%) leading the pack once again. These sectors were joined in the green by Utilities (+4.7%), Consumer Staples (+1.4%) and Consumer Discretionary (+0.7%) – with the latter mostly attributable to Amazon. Financials, Energy, Industrials and Materials brought up the rear, falling between 2% to 5%. Healthcare and Real Estate were in the middle, down less than 2% each. For the YTD period, we have more sectors in the green, 10 out of 11, but just 2 out of 11 outperforming the market – you guessed it, Technology (+28.2%) and Communication Services (+26.7%). Energy (+10.9%) and Financials (+10.2%) are also up double digits. Real Estate is the lone negative sector YTD, down 2.5%.

With the top ten names in the S&P 500 comprising over 36% of the index weight and accounting for nearly 73% of the return in the first half of the year, we can appreciate the inclination to simply buy these ten names and forget about it. In our opinion, this would be taking on unnecessary concentration risk to try and keep up with an index that really has nothing to do with what you are individually trying to accomplish with your money. After all, these same names were down a median of 28% in 2022 with the market down 18%, with the worst performer, META, down 64%. Looking at the YTD period, the dominant factors for both large and small stocks in market performance have been Size, Momentum and Value vs. History. This simply means that investors continue to buy what is working regardless of how expensive it is. Our equity strategies are more balanced across various factors than the narrowness exhibited over the past three and six-month and even twelve-month periods in the market. Yet, these strategies have produced solid absolute returns over these time frames. We continue to look for and find value in all corners of the market. However, it is worth noting that volatility remains subdued, as the S&P has been 340 trading days without a 2% correction, the third longest streak in the past 20 years. While July is traditionally a good month for stocks, as we move through the summer and towards the election the fall, we would not be surprised to see volatility increase.

The Bond Market

By John Wiseman

Interest rates moved higher this quarter as uncertainty over Federal Reserve policy continued and higher inflation in some countries confused the outlook for global rates. The Federal Reserve left the benchmark rate unchanged at its June meeting, but their forecast was lowered to one quarter-point cut this year instead of the three listed on their previous forecast in March. The yield on the 2-Year Treasury Note rose above 5% for a brief period in April then settled back to finish the quarter at 4.75%. Still, this was an increase of 13 basis points for the quarter, resulting in a total return of 0.86% thanks to the higher income return offsetting the loss in price return. Since the start of the year, its yield is 50 basis points higher, but the interest income offset produced a total return of 1.07%. The yield on the 10-Year Treasury Note is 4.40%, which is 20 basis points higher on the quarter and up by 52 basis points for the year. The resulting returns are -0.30% and -1.90% for the quarter and year, respectively. The yield curve, as measured by these two points, has been inverted for an unprecedented two years. The US measures of inflation have moderated and, though not yet at the Federal Reserve’s target, likely provides the ammunition for them to more explicitly signal the timing of a rate cut. For this reason, along with the high valuations of other fixed income investments, we favor government bonds. We are concerned about the government’s widening deficit, increased interest expense, and expanded debt issuance, but expect it will remain the favored global investment.

Thanks to the higher income return, the corporate bond sector has outperformed its government counterpart for the quarterly and yearly periods. Spreads – the amount of yield over Treasuries that investors are compensated for assuming company specific risk – were slightly higher for the quarter but are below the level at the start of the year. The spread of the Bloomberg Intermediate Corporate Index ended the quarter at 84 basis points. The total return of this index was 0.74% for the quarter and 1.00% for the year. Financial bonds outperformed their utility and industrial counterparts by 20 basis points in the 2nd quarter but are better by nearly 100 basis points for the year. Lower-rated bonds outperformed higher-rated ones. For example, junk bonds have outperformed investment-grade ones by more than 100 basis points for the year. We have reduced our exposure to corporate bonds given how narrow spreads are at this point in the cycle.

Municipal bonds continue to be relative laggards in the fixed income sector as issuance of these securities expanded well above the 10-year average for the sixth consecutive month.   The Bloomberg 5-Year Municipal Index ended the quarterly period with a total return of -0.42% and is lower by -0.79% for the year.  The ratio of the 5-Year Municipal to Treasury, a measure of relative value, is 68% which is the highest level of the year.  However, given the higher absolute yields, we continue to favor municipal bonds for those in higher tax brackets.

Within our strategies, we continue to make efforts to lengthen the portfolios and lock-in higher rates, but we are still shorter than the benchmarks and this slightly detracted from performance this quarter; however, this positioning remains a positive for the YTD period.  Additionally, having more exposure to the credit sector has been the biggest benefit to our strategies for the quarterly and YTD periods as higher spread income offset the move up in rates.

The information contained within has been obtained from sources believed to be reliable but cannot be guaranteed for accuracy.  The opinions expressed are subject to change from time to time and do not constitute a recommendation to purchase or sell any security nor to engage in any particular investment strategy. Investment Advisory Services are offered through Greenwood Capital Associates, LLC, an SEC-registered investment advisor.

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