Global equities were broadly positive in Q2-2024 though the pace of gains was slower than in the previous quarter and the relatively strong index gains, particularly in the U.S., were driven almost exclusively by a narrow subset of mega cap stocks. Government bonds were mixed as U.S. Treasury yields seesawed – rising as the Federal Reserve remained committed to its “higher for longer” narrative and then declining as investors started to anticipate lower U.S. GDP growth in the second half of the year.
In the second quarter, large cap technology stocks, particularly those companies that are able to monetize AI products and services, reasserted their year-to-date outperformance. As a result, market breadth deteriorated during the quarter and market concentration (the percentage of total market capitalization represented by the largest companies) reached the highest in more than 40 years. Mega cap tech stocks far outpaced index returns, with NVIDIA (NVDA) rising 36.5%, Apple (AAPL) 25.0% and Google parent Alphabet (GOOG) 21.9%. Only five of the 11 S&P 500 sectors rose in Q2-2024 and the dispersion between the top performing Information Technology sector (+ 14.6%) and the bottom performing Materials sector (-4.1%) was unusually wide. Unsurprisingly, momentum and growth style factors contributed the most to the S&P 500’s quarterly gains.
U.S. economic data showed clear signs of waning growth momentum, further disinflation and greater labor market slack. The latter two are acknowledged prerequisites for Fed rate cuts, and slowing growth would likely add impetus to Fed action. Final Q1-2024 GDP growth was revised down to 1.4%, a sharp deceleration from 3.4% growth in Q4-2023. While the latest “FedNOW” estimate for Q2-2024 growth is 2.0%, recent employment figures and manufacturer and service sector activity data suggests that this too will be revised down and that the economy will continue to slow into the second half of the year. Federal Reserve policymakers are therefore likely to reverse course from their recent interest rate projections (the so-called “dot plot”) which forecast only one 25 bp rate cut in December. Market implied probabilities for a September rate cut are over 85% and expectations are high for a second cut in December.
While slowing growth is positive for continued disinflation, the flip side is higher unemployment which will put further stress on consumer spending, particularly for those in the bottom 80% of income earners. Pandemic era savings have been fully depleted for most of this cohort and prices for both essential and discretionary products remain well above pre-pandemic levels despite the decline in the consumer price index (CPI) over the last two years from its peak of 9.1% in June 2022 to 3.0% in June 2024. As a result, monthly personal spending growth slowed from 0.7% in March to 0.2% in May. The pressure on consumers and the resulting changes in behavior are unlikely to abate with one or two rate cuts if economic growth continues to slow. The impact of a weaker consumer is already being felt by a wide range of companies in the Consumer Staples and Consumer Discretionary sectors where recent results highlighted a key challenge facing corporate America: how to preserve margins in an environment of lower sales volumes when price increases are no longer tenable? Fast food companies are already engaged in a price war to bring consumers back to their restaurants and recent results from several major consumer packaged goods companies showed accelerating volumes declines. We expect this trend to continue in coming quarters and spread to other sectors which will put downward pressure on corporate earnings.
Internationally, China’s economy sputtered, weighed down by the real estate sector, unsustainably high local government debt and weak consumer sentiment. Although the government has steadily increased economic support and introduced many measures to spur consumer spending, investors are still awaiting much larger and broader stimulus measures. This could be forthcoming at this month’s high-level meeting of the Communist Party’s Central Committee. The Japanese Yen continued to weaken to multi-decade lows against the U.S. Dollar in the second quarter despite several Bank of Japan interventions. The long anticipated next rate hike failed to materialize. The Bank of Japan is now expected to raise rates at its end of July meeting. Breaking longstanding convention, the European Central Bank (ECB) moved ahead of the Fed and in June cut its benchmark rate by 25 bps to 3.75%, citing improved inflation dynamics. European equities were among the top international performers in the second quarter as inflation declined and some growth indicators improved. Emerging Markets also performed well on the back of strong technology sector earnings in Taiwan and South Korea, strong prices in select commodities, and the prospect of a weaker USD.
We believe the prospects for fixed income have improved with disinflation occurring more rapidly than expected. Additionally, the Federal Reserve is poised to pivot toward rate cuts as soon as September with both growth and inflation risks appearing more balanced than they did last quarter. The inflation shock and steep policy rate hikes over the last two years produced a generational reset higher in bond yields, which now embed a significant inflation-adjusted cushion. Starting yields, currently near the highest levels in 15 years, are comparable with improved forward returns, offering attractive income and potential downside support as inflation recedes, particularly on a risk-adjusted basis relative to other assets. We remain focused on high-quality bonds which tend to have lower volatility than stocks, providing investors with more stability against a range of economic scenarios. Within the asset class, we are seeking higher quality, more liquid, and resilient investments, and find reasonable value in industrials and financials with strong capital positions. U.S. agency mortgage securities are also attractive at current levels and represent a high-quality compliment to portfolios. Portfolio duration positioning is intended to be neutral, yet guided by client cash flow needs.
Looking ahead to the second half of the year, we see possibilities for increased volatility in equities and fixed income as earnings expectations remain very high (consensus 2024 earnings growth estimate of +11% accelerating to +14% in 2025), equity market concentration is at historical extremes, valuations are on the high end, and the bond market is increasingly focused not just on growth and the level of interest rates, but on the unsustainable path of U.S. fiscal spending and deficits. Potential turmoil around the U.S. presidential election would further increase market risk. Such an environment would also likely spur more definitive leadership rotation in U.S. equity market sectors and between domestic and international markets. These risk factors will remain in place regardless of whether the current GDP slowdown is a transitory “soft patch” or is a harbinger of a recession.
On the other hand, rate cuts finally appear to be on the horizon, and if delivered could further support positive sentiment. Despite the risks, a soft landing is still our base case, and earnings growth is expected to accelerate at a strong clip into the second half of 2024 and into 2025. In addition, earnings growth contribution is expected to broaden out beyond mega cap tech strength as we enter the fourth quarter, and thus market participation is set up to expand as well, which would be a healthy outcome for equity markets given stretched positioning in the tech mega caps.
Within the portfolio we have shifted the mix in certain sectors to favor more late-cycle beneficiaries and increased our weighting in select AI market leaders. Several longstanding portfolio themes remain intact. These include the broader use of and additional indications for GLP-1 anti-obesity drugs, significant industrial CapEx related to the green energy transition and expansion of domestic semiconductor manufacturing and data center capacity, as well as power generation and transmission systems required to fuel this growth. We remain cautious on consumer related sectors for the reasons outlined above.
Our global equity portfolio remains overweight large-cap domestic stocks relative to foreign stocks, but we have continued to raise our exposure to international markets in select portfolios and would expect to increase that further if equity market leadership definitively shifts in favor of international markets. On a style basis, we continue to favor high-quality style factors, stable growth, and a selective mix of cyclical value.
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Bruce Schoenfeld Principal Investment Analyst First American Trust |
Bruce is the Principal Investment Analyst responsible for investment research coverage of various asset classes and equity industry sectors. Bruce has more than 20 years of experience as an equity analyst and portfolio manager. He joined First American from 3P Associates, LLC, an investment and strategic management consulting firm he founded. He previously served as Director of Research at BlueStar Global Investors and as an analyst and portfolio manager focused on emerging markets for Delaware Investments, Artha Capital and Caisse de depot et placement du Quebec, Canada’s second largest pension fund.
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Jason Nerio SVP, Director of Investment Research & Strategy First American Trust |
Jason Nerio is the Director of Investment Research and Strategy at First American Trust. Mr. Nerio has more than 20 years of investment research experience. He is responsible for formulating investment strategy and serves as a leading member of the investment committee which monitors and manages the firm’s allocation strategies for over $1 billion in client assets.
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Scott Dudgeon, CFA Director, Equity Research First American Trust |
Scott Dudgeon is the Director of Equity Research at First American Trust. Mr. Dudgeon is a Chartered Financial Analyst (CFA) and has more than 25 years of investment research experience. He also serves as a leading member of the investment committee and has a proven track record for outperforming the markets for our clients. He has been with The First American Family of Companies for 16 years.
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