FOURTH QUARTER 2023 INVESTMENT COMMENTARY
MARKET RECAP
In the first three months of 2024, the U.S. economy remained resilient despite short-term interest rates sitting near 20-year highs. Noteworthy in the quarter was the continuing robustness in the labor market, stronger-than-anticipated corporate earnings, and a convergence of market participants’ aggressive forecast of rate cuts with the Fed’s own projections. Retail sales pulled back, but the trend remains positive.
These factors provided a supportive backdrop for stocks. The S&P 500 Index continued to reach new highs throughout the quarter, gaining 10.6% in the three-month period. Large-cap U.S. stocks (S&P 500 Index) outperformed small-cap U.S. stocks (Russell 2000 Index), and growth stocks (Russell 1000 Growth) again beat value stocks (Russell 1000 Value).
Developed International and emerging-market stocks also posted gains but did not keep pace with the U.S. market. Developed International stocks (MSCI EAFE) gained 5.8%, while emerging-market stocks (MSCI EM Index) posted a 2.4% return.
Bond returns were mixed as the benchmark 10-year Treasury yield rose from 3.88% to 4.20%, with market expectations for rate cuts tempered in terms of timing and magnitude. In this rising-yield environment, the more interest-rate sensitive Bloomberg U.S. Aggregate Bond Index declined 0.8%. Credit performed relatively well in the quarter, as high-yield bonds (ICE BofA High Yield Index) were up nearly 1.5%.
INVESTMENT OUTLOOK AND PORTFOLIO POSITIONING
The U.S. economy has continued to prove resilient despite the Fed maintaining a higher level of interest rates for longer than most expected. A main driver of this better-than-expected economic growth has been the continued strength of the U.S. consumer. The combination of robust job gains and steady real income growth has allowed consumers to continue spending despite higher rates. The strong consumer has also benefited corporate earnings. And after a decade of near-zero interest rates, companies are generally well positioned financially with balance sheets that are healthier than they have been in past tightening cycles.
Inflation (CPI) has declined meaningfully over the past year, falling from 6% to just over 3%, though still above the Fed’s long-term target of 2%. Our expectation is that inflation will continue to trend lower over time, due in large part to shelter costs, which we expect to moderate.
With the steady decline in inflation, we believe Fed policy has crept into borderline restrictive territory. The chart above shows the Yield Curve (10-year minus 1-year maturity, gray line), alongside the real fed funds rate (i.e., fed funds rate net of inflation, yellow line). Going back to 1960, an inverted curve combined with a sharply higher real fed funds rate has preceded a recession (light gray bar).
In the most recent cycle, however, we can see that while the yield curve has been inverted since July 2022, Fed policy has been very accommodative for most of that time, i.e., the real Fed Funds rates were sharply negative when the curve first inverted. It’s only more recently that Fed policy has started to move toward restrictive levels due to the combination of a higher fed funds rate and falling inflation.
Simply put - to the extent that inflation continues to fall, and the Fed keeps rates unchanged, monetary policy will become proportionately more restrictive, and could reach a level that significantly slows the economy.
Economic growth in and of itself does not cause inflation, and ongoing modest economic growth is not a reason for the Fed to avoid cutting rates. However, persistent growth of around 2% does make it difficult to foresee aggressive rate cuts, and we’ve seen this reflected in the market’s expectations for the Fed Funds rate during the quarter. In the chart above, we see that at the beginning of the year, the market was anticipating six to seven rate cuts (shown in gray). But as of the end of March, the market’s expectations (show in yellow) have tempered, and the consensus is for three rate cuts bringing the top end of the Fed Funds range to 4.75% at the end of 2024.
We are currently in line with consensus expectations that the Fed will cut by 25bps in June, with two more cuts later in the year. With inflation still running slightly hot, the Fed has to balance cutting too early and potentially causing a second wave of inflation, versus waiting too long and putting pressure on the consumer and the economy. What the Fed ultimately decides will depend on the economic data that unfolds.
For now, U.S. economic data seems supportive of growth, not contraction. If the Fed is able to engineer a “soft landing” of the U.S. economy with inflation converging to 2% and growth continuing, they can incrementally lower rates and ensure that policy does not become too restrictive. If a recession does occur later this year, the Fed will have the ability to swiftly and meaningfully cut rates given current levels.
Turning to our portfolio positioning, after a broad review of portfolio exposures in recent quarters, which involved a deep dive on emerging markets (particularly China), we are eliminating the overweight allocation to emerging-market stocks and returning portfolios equity exposure to their neutral strategic allocations across the U.S., developed international, and emerging-markets stocks.
The proceeds from the overweight allocation to emerging markets will flow back into their original funding source, U.S. stocks and developed international stocks. The amount going back into U.S. stocks will be invested in more-reasonably priced value and blend stocks; we are not adding to U.S. Large Cap Growth due to the strong absolute and relative returns for growth stocks over the past year and a half. In total, we believe this move marginally reduces the portfolios’ overall equity risk, as U.S. stocks would likely outperform the historically more volatile emerging markets in a downturn.
Speaking of inflation, it has come down meaningfully from its June 2022 high of 9.1%, thanks in part to the Federal Reserve’s rapid rate hikes. The chart below illustrates year-over-year inflation data, which recently declined to 3.7%, and suggests the Fed’s policy has been working and with time inflation could continue to fall.
Very briefly, our rationale for a return to our neutral weighting for emerging-markets equities centers on China, which comprises roughly a quarter of the MSCI Emerging-Market Equity Index. Given the level of cyclical and structural headwinds China’s economy faces, we lack the level of conviction necessary for a “fat pitch” tactical overweight in Emerging Markets despite China’s historic undervaluation. Meanwhile, outside of China, the broader EM index has performed well (India, Taiwan, Brazil, etc.). At just shy of 16x trailing earnings, emerging-market stocks appear fairly valued relative to their 30-year average.
Fixed-income portfolio positioning as not changed much since year-end. We believe that inflation is under control for now, and that short-term interest rates have peaked and will likely decline slightly over the course of the year. For corporate bonds, we do not foresee a near-term risk of a spike in default rates given the still-attractive corporate fundamentals. In this environment, we continue to take advantage of the inverted yield curve, emphasizing shorter-term higher-yielding securities with yields in the 6.5% to 7% range, while also maintaining some exposure to longer-term bonds with yields around 4.5% to 5%, which can also provide protection in the event of a stock-market downturn. And if long-term rates climb, we’ll look at adding exposure to capture these yields while adding defensive ballast to portfolios.
CLOSING THOUGHTS
The U.S. economy currently appears to be in decent shape. The stock market continues to hit new highs with ongoing economic growth. There continues to be a high level of concentration in the “Magnificent Seven” stocks, which comprise about a quarter of the value of the S&P 500. In our view, this creates relative opportunity in the remaining 493 stocks in the S&P 500, which have not seen valuations so stretched. The possibility of a recession isn’t off the table by any means, but if it does happen, the timing is likely pushed back until late this year or 2025.
As we look ahead, we anticipate there will be pockets of choppiness given headline risks related to Fed policy, geopolitical events such as the ongoing wars in Europe and the Middle East, and the upcoming U.S. presidential election (election years have historically been more volatile for the equity markets). In anticipation, we are prepared to be opportunistic and take advantage of any attractive risk/reward opportunities that arise.
Thank you for your continued trust and confidence.
- The Owen Legacy Group
Note: For discretionary use by investment professionals. This document is provided by iM Global Partner Fund Management, LLC (“iMGPFM”) for informational purposes only and no statement is to be construed as a solicitation or offer to buy or sell a security, or the rendering of personalized investment advice. There is no agreement or understanding that iMGPFM will provide individual advice to any investor or advisory client in receipt of this document. Certain information constitutes “forward-looking statements” and due to various risks and uncertainties actual events or results may differ from those projected. Some information contained in this report may be derived from sources that we believe to be reliable; however, we do not guarantee the accuracy or timeliness of such information. Investing involves risk, including the potential loss of principal. Any reference to a market index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indexes are unmanaged vehicles that do not account for the deduction of fees and expenses generally associated with investable products. A list of all recommendations made by iMGPFM within the immediately preceding one year is available upon request at no charge. For additional information about iMGPFM, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the SEC’s Investment Adviser Public Disclosure website (adviserinfo.sec.gov) and may otherwise be made available upon written request.