Economic and Market Commentary
The S&P 500 returned 10.6% during the first quarter, a level comparable with average full-year performance (see Exhibit 1). In fact, our January forecast for all of 2024 was in that range. Our forecast could still be realized if the equity market remains at its current level, but we believe there’s room for more price appreciation.
Exhibit 1
Source: Bloomberg, AAFMAA Wealth Management & Trust
Among S&P 500 sectors, Communication Services, which includes Alphabet, returned 15.8%. Energy returned 13.7%, and Information Technology returned 12.7%. Real Estate was the only negative sector with a -0.5% return, which was in line with most fixed-income returns.
On an individual stock level, NVIDIA contributed an incredible 24% of large-cap returns, and the next nine largest contributors account for another 36% (see Exhibit 2).
Exhibit 2
Fixed-income asset classes could not keep up, though below-investment-grade bank loans and high-yield corporate bonds did generate relatively strong returns. Treasury inflation-protected securities, investment grade corporate bonds, US agency mortgage-backed securities, and US Treasurys were negative primarily due to an increase in interest rates.
Equity volatility moderated towards the end of the quarter after rising for the first couple of months. Market moves were driven by investors self-referentially gaming out where inflation and unemployment might be headed, how the Fed would respond, and how investors would react.
Strong economic numbers negatively impacted the market under the belief that they would lead the Fed to cut rates later and less extensively. Market participants reduced January expectations of close to six rate cuts in 2024 to late March expectations of three cuts. As of mid-April, the market was pricing in approximately two cuts.
Rate volatility returned to pre-Quantitative Easing levels once the Fed began raising rates in 2022. However, even by those standards, recent volatility has been high. On April 10th, when higher than expected March CPI data were released, the two-year US Treasury yield rose by an exceptionally large amount – in statistical terms, more than three standard deviations based on the prior day’s market-implied volatility.
Looking ahead, the implied one-year forward yield curve is less inverted with lower short to intermediate yields. Interestingly, implied rates longer than about seven years are unchanged, suggesting little to no relief for mortgage interest rates in the foreseeable future.
The decline in inflation orchestrated by the Federal Reserve appears to have hit a wall. The March consumer price index (CPI) was 3.5%, a level that hasn’t changed very much over the past year. As a result, there has been a remarkable shift in investor sentiment. At the beginning of 2024, investors priced in a significantly earlier and larger set of rate cuts than the Fed itself projected. By mid-April, however, futures pricing implied that investors had become more conservative than the Fed, with only two 0.25% rate cuts expected by year-end.
Our analysis suggests that, with CPI stalling and the Fed holding rates steady, monetary policy appears increasingly accommodative, perhaps enough to require a rate hike rather than a rate cut. That is not necessarily a call we’re ready to make, but the fact that we and other market participants are even thinking about it is surprising.
Several months ago, we adjusted our recession probability model to include an estimate of the “true” monetary policy rate (explicitly taking into account the impact on the economy of excess financial assets that the Fed owns on its balance sheet). When we did that, our forecast of the probability of recession occurring in the next 12 months declined to below 10%. That change was consistent with an economy that has been stronger than anticipated.
In contrast, many investors have been guided by the NY Fed model, which does not take those excess assets into consideration and relies solely on the difference between 10-year UST and 3-month US T-Bill yields. We believe the Fed has significantly overestimated the probability of recession. Likewise, as stronger than anticipated economic data have come in, professional economists surveyed by Bloomberg have also recently lowered their forecasts to roughly 35% from a peak of 65% in June 2023.
Our conclusion is not only that the likelihood of recession is waning, but also that the possibility of a “no-landing” scenario (as opposed to a soft-landing scenario) has risen significantly. If the economy were to maintain its strength under such a no-landing scenario, we could indeed see one or more further rate hikes.
One last thought on the economy: while oil prices have had their ups and downs over the past two years, they’ve generally not been disruptive. Rising tension in the Middle East could change that. A sustained confrontation between Israel and Iran could lead to substantial increases in oil prices, which would have a host of negative effects, including increases in inflation. While all parties, including the US, China, and Russia, seem disincentivized to escalate, oil prices could become an important wild card.
We believe that equity risk premia and corporate bond spreads are low by historical standards but still arguably within the fair range. As a result, we would maintain our asset class allocations. Returns will likely depend on the direction of inflation expectations. The market is implying a 0.15% decrease in inflation expectations through year-end, which would be consistent with another nine percentage points or so of return for the S&P 500. We would emphasize that even small changes in market expectations can have a large impact on actual returns, so we need to continue to be vigilant.
We hope you’re enjoying your Spring.
Yours In Trust,
Paul
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© 2024 AAFMAA Wealth Management & Trust LLC. Information provided by AAFMAA Wealth Management & Trust LLC is not intended to be tax or legal advice. Nothing contained in this communication should be interpreted as such. We encourage you to seek guidance from your tax or legal advisor. Past performance does not guarantee future results. Investments are not FDIC or SIPC insured, are not deposits, nor are they insured by, issued by, or guaranteed by obligations of any government agency or any bank, and they involve risk including possible loss of principal. No information provided herein is intended as personal investment advice or financial recommendation and should not be interpreted as such. The information provided reflects the general views of AAFMAA Wealth Management and Trust LLC but may not reflect client recommendations, investment strategies, or performance. Current and future financial environments may not reflect those illustrated here. Views of AAFMAA Wealth Management & Trust LLC may change based on new information or considerations.