Overview: Settling in for a Soft Landing
In our April 9 Outlook, we identified two major trends that support a further advance in US stocks: a gradual decline in inflation pressures and a resilient economy heading toward a soft landing. We reaffirm this positive forecast: annualized core PCE inflation will continue its downward trend from the current 2.8% rate to about 2.0% by the end of the year. In response, the Federal Reserve will commence interest rate cuts. We also anticipate the labor market and consumer spending to remain strong enough to avoid a contraction and provide for robust corporate profit gains.
US Economy: A Tale of Two Consumers
The US economy continues to expand. The Atlanta Fed’s GDPNow model forecasts 1.7% GDP growth for the second quarter, slightly above the first quarter’s 1.4%. We expect GDP to pick up slightly in the second half of the year, resulting in a solid 2.3% for 2024. Future growth will benefit from a reduction in inflation and interest rates. Easing borrowing costs will give consumers relief from relentless inflation anxiety and, in particular, boost the housing and auto markets. The promise of a more stable long-term economic future would also strengthen CEO confidence to increase capital expenditure and pursue mergers, acquisitions, and initial public offerings.
The US consumer provides the foundation for future growth. Despite higher borrowing costs, we expect consumer spending, driven by a strong labor market and real wage gains, to hold steady. We think total nonfarm payroll employment, which increased by 206,000 in June, will continue to expand and the unemployment rate will remain close to its current 4.1%. Nevertheless, we acknowledge that there are pockets of weakness in consumer spending. The Conference Board Consumer Confidence Index dipped in June to 100.4 from 102.0 in May and has been trending lower for three of the past four months. Similarly, the University of Michigan Index of Consumer Sentiment fell 1.3% in June after plummeting 13.0% in May. Most problematic is the economic drag of consumers who are struggling with the four-year cumulative increase in inflation, especially in living essentials such as housing, transportation, and food. Many renters and new homeowners are burdened with sky-high mortgages and rent. They are in sharp contrast to the many homeowners who are thriving with refinanced sub-3.0% fixed mortgages and real wage gains.
US Stock Market: Concentrated Gains
The S&P 500 Index has enjoyed strong performance in the first half of 2024, though the second quarter brought increased volatility, including a 5% pullback in April. This year’s positive returns should hold up if estimates for corporate profits meet expectations: aggregate S&P 500 earnings are projected to log a double-digit gain in 2024, including an impressive acceleration to 17.6% in the fourth quarter (Factset Earnings Insight, June 12, 2024). Profits at these elevated levels should more than justify higher than average P/E ratios. However, a closer look at the market’s internal dynamics reveals an unusual market, with concentrated gains among the “Magnificent 7” stocks. Outsized performance in the first half extends to those companies with exposure to Artificial Intelligence (AI). We recommend that investors consider holding at least some AI securities in their portfolios. While this high growth sector exhibits some bubble-like characteristics, we believe it is transitioning into a “prove it” phase: companies that can demonstrate tangible benefits and market share gains are likely to continue outperforming, whereas those that disappoint will struggle to maintain investor enthusiasm. This dynamic suggests a selective approach to AI-related investments is warranted. Narrow market leadership often has a short shelf-life, but a negative ending is not a foregone conclusion. A broadening rally that rewards companies in diverse industries for their earnings and revenue progress would increase the prospect of a multi-year bull market.
The recent performance of major US market benchmarks indicates the extent to which the S&P 500 and the technology heavy NASDAQ Composite are not representative of US stocks as a whole. The gap between the S&P 500, in which the Magnificent 7 stocks account for about 30% of performance, and the S&P 500 equal weighted stocks is also noteworthy. Investors needed to be concentrated in a few large cap stocks, and technology stocks in particular, to have enjoyed outperformance. Investors with diversified exposure to the full range of US stocks have likely underperformed.
| Recent Performance of US Market Indices | |||
|---|---|---|---|
| Index | 6 Month | 12 Month | P/E Ratio (NTM) |
| NASDAQ | 18.1% | 28.6% | 28.3 |
| S&P 500 | 14.5% | 22.7% | 21.2 |
| S&P MidCap 400 | 5.3% | 11.7% | 15.0 |
| S&P 500 Equal Weight | 4.1% | 9.6% | 16.3 |
| Dow Jones Industrials | 3.8% | 13.7% | 17.9 |
| Russell 2000 | 1.0% | 8.4% | 24.5 |
| S&P SmallCap 600 | -1.6% | 6.6% | 14.0 |
International Market: Opportunities Amid Recovery
International markets present a mixed landscape. China’s recovery remains fragile, facing headwinds from both domestic economic challenges and global trade dynamics. Unlike the S&P 500 and NASDAQ, international stock markets have not experienced an outsized performance driven by AI investments. This discrepancy creates a more attractive entry point for value-focused investors. A positive development is the synchronized monetary policy stimulus being implemented by some major international central banks: for example, Canada and the European Union have already embarked on an interest rate cutting cycle, which should boost economic activity and sentiment. An interesting observation has been the outperformance of emerging markets compared with developed markets year to date, as measured by the iShares EEM and EFA exchange traded funds. We are watching this closely, as this scenario has sometimes preceded a sustainable rally in international stocks.
Bond Market: Policy Shift on the Horizon
Interest rates remain elevated due to the Fed’s current restrictive policy. However, with rate cuts anticipated in the near future, we expect benchmark yields to fall modestly and to remain lower throughout the easing policy cycle. High yields on money market instruments will likely drop swiftly, potentially raising demand for fixed-income securities and equities. Bond investors or those with balanced portfolios should consider fully investing their allocations before the first Fed cut to capitalize on the current higher yields. Given the lack of reward for extending duration, our preferred strategy is to focus on short- to moderate-duration bonds with a laddered approach. This strategy should help investors manage interest rate risk while optimizing returns in a shifting rate environment.