Newsletter
Dear Client,
Entering 2024, investors expected the Federal Reserve to cut its benchmark policy rate six to seven times beginning as early as March. However, the outlook for a “Goldilocks” scenario that would permit the Fed to quickly ease did not materialize, given inflation remaining sticky, the resilience of the U.S. economy, and a stronger-than-expected labor market. Despite this profound shift in interest rate expectations, the S&P 500 returned 15% in the first half of 2024 and continues to notch new all-time highs. The leadership within equities has been historically narrow though, with the median stock in the index returning just under 4% over the same period. The divergence can largely be attributed to artificial intelligence, which has thrust several technology stocks to market capitalizations over $3 trillion each.
The bond market, on the other hand, has not enjoyed the same performance as stocks, with the Bloomberg U.S. Aggregate Bond Index posting a loss of 0.71% through the end of June. Rates shifted higher across most of the curve in 2024, with the 2-Year yield +0.50% to 4.75% and the 10-Year yield +0.52% to 4.40%. July 5th marked the 2-year anniversary of the 2s10s curve being inverted. While an inverted curve has historically been a signal of a looming recession, U.S. economic activity continued to surprise to the upside, elongating the cycle. In rates markets, there are conflicting forces between a slowing economy arguing for lower rates versus the structural forces putting upside pressure on inflation and rates (namely runaway fiscal spending and deglobalization).
Credit has been extraordinarily resilient. The FOMC has maintained its target fed funds interest rate range between 5.25% and 5.50% since July 2023, its highest target range since 2001. The corporate market has shrugged off fears that higher central bank rates will cripple companies when they are forced to refinance the debt they issued during the ultra-low interest rate environment of the pandemic era. New issue demand has been voracious, and the market value of all U.S. corporate investment grade bonds outstanding has increased from $3 trillion in 2010, to $9 trillion today.
While 2024 economic activity has been stronger than expected versus the start of the year, the more recent data has started coming in below expectations. Most notably, signals from the U.S. labor market from the government’s latest monthly jobs report showed a slowdown across most metrics. With an unemployment rate now above 4%, the Fed must increasingly consider labor market conditions in its policy decisions and can no longer focus solely on inflation.
Election years have generally been good for the U.S. stock market, and thus far, 2024 is no exception. This has been the best start to an election year on record. Elections in Mexico, India, and Europe however wreaked havoc on global stock markets this year. Domestically, U.S. investors should brace for volatility between now and November as market participants navigate an environment of uncertainty surrounding geopolitics, inflation, and interest rates. Market positioning is very long, the volatility index or VIX is near multi-year lows, and credit spreads are exceptionally tight. The current setup could prove troublesome for equity markets for the balance of the summer. As equities marched higher despite the hawkish repricing of Fed futures, investors were implicitly hitching their wagon to continued growth acceleration into 2025. That may not materialize if the broader economy continues to decelerate.
If the Fed begins to cut rates later in the year as they have indicated, the reason for the cuts will be crucial in determining the speed and magnitude of easing going forward. If the Fed eases reactively as a response to weakening growth, instead of easing preemptively, they risk looking like they are falling behind the curve. Given the potential for volatility, we are focusing on companies with meaningful cash flows and strong profit margins. We remain on the lookout for any compelling opportunities that potential market dislocation may provide.
Regards,
Edge Wealth Management
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