Global Market Review and Outlook

Continued Economic Expansion, Progress on Inflation, Greater Political Uncertainty

• The cyclical economic expansion continues but momentum is beginning to wane, and this has become most apparent among lower-income consumers. Conversely, the longer-term secular outlook looks increasingly positive and growth expectations from both the Fed and the market have increased.
• Further progress on inflation and the probability of further upward movement in the unemployment rate present a good backdrop for the Fed to start lowering interest rates to help ensure that it delivers the expected soft landing.
• The geopolitical landscape looks to be radically changed when compared to the outlook from the start of the quarter, perhaps more so in Europe than the U.S. Electorates are not happy with the lack of growth in Europe and are looking for change, whereas U.S. voters are increasingly wary about the competence of 81-year-old President Joe Biden.
• The stock market continues to be dominated by a small handful of large-capitalization tech stocks, and other growth areas of the market with strong growth narratives and attractive valuations continue to be ignored as investors feel they cannot risk not participating in the Mag 7 rally.

In tennis, perfection is impossible. ... In the 1,526 singles matches I played in my career, I won almost 80% of those matches. ... Now, I have a question for all of you ... what percentage of the POINTS do you think I won in those matches? Only 54%. In other words, even top-ranked tennis players win barely more than half of the points they play. When you lose every second point, on average, you learn not to dwell on every shot.

ROGER FEDERER, Dartmouth College Commencement Address, June 9, 2024

Growth Still Positive but Momentum Slowing, Inflation Lower, Rate Cuts on the Way

This economic cycle chugged through its 50th consecutive month of expansion this past June, putting it into its late-middle age relative to the average 64.2-month duration of past economic cycles since 1945, though it is relatively old compared to cycles going back to 1854 (41.4 months). And while reports of this cycle’s death have so far been greatly exaggerated, higher interest rates are increasingly starting to bite, and momentum has notably eased over the last quarter.

While areas such as the manufacturing and housing sectors have arguably already been in recession for almost two years now, this weakness has been more than offset by the strength of the U.S. consumer. That strength has been underpinned by a solid labor market and household balance sheets that are low in debt, while interest rates on that low debt have been locked in for longer. It is also possible that we are seeing what some have been starting to call reverse hysteresis. After the GFC and the massive layoff that followed, the labor market effectively became stuck in a state of hysteresis, whereby the longer workers were unemployed, the longer they remained unemployed—with lost skills, contacts, and confidence making reemployment that much more difficult. This time around, with a structurally tighter labor market due to slower population growth, retiring boomers, and reshoring, workers are finding themselves in high demand and are being redeployed relatively quickly upon workplace separation, thus maintaining market momentum.

We are seeing some emerging weakness, however, in the lower-income cohort of the U.S. consumer, those who have been benefiting the least from strength in both the stock market and residential real estate. This is also the cohort that has been least able to take out longer-duration debt, has run through their pandemic-related savings, has been the most adversely impacted by higher inflation, and is also being more heavily penalized by the rise in the cost of auto loans (6.2%) and credit card rates (22%). And while this was also the group that saw the largest relative rise in wages over the last few years in real terms, that positive real wage growth has now fizzled. As a result we have seen subprime auto loan delinquencies rise to their highest rate since at least 2000, while surveys of income growth expectations for one year ahead for lower-income consumers have also moved sharply lower.

As a result, companies continue to tell us that consumers are pushing back on price, trading down to private labels or substituting to other cheaper alternatives, and more generally becoming much more discerning around what constitutes value. This was a clear message we heard from many of the consumer-related companies of the total approximately 260 firms that presented at William Blair’s 44th Annual Growth Stock Conference this past June.

We continue to see emerging signs of near-term cyclical softening; however, the path of longer-term structural growth in the U.S. is starting to notably improve. This positive development is likely being driven by a number of macro mega trends, including, but by no means exclusive to: generative AI, decarbonization and the electrification of the economy, a rising demand for energy and water, reshoring and infrastructure investment, and in healthcare the ramifications of a greater use of GLP-1s (glucagon-like peptide 1 agonists, or new diabetes and weight-loss medication that have been extremely effective in weight reduction and have now been used by roughly 12% of all Americans)—all of which are topics examined by William Blair’s equity research analysts in their coverage of relevant companies.

Perhaps most important for the economy (and the Fed) has been the renewed decline in the rate of inflation. The first quarter represented a disappointing bump in the road heading back to 2% inflation, though the second quarter brought confirmation that inflation is still on a downward trajectory. Looking toward the second half of the year, disinflationary gains start to face tougher annual rates of change comparisons, though should continue to show progress on 3- and 6-month annualized rates of change. This, in conjunction with what are likely to be further modest increases in the unemployment rate—which has already risen from 3.4% to 4.1% over the last 13 months—should be enough to finally warrant a major pivot by the Fed toward lowering interest rates in the coming months.

While the Fed may want to wait until November (i.e., after the election) before lowering interest rates to avoid the appearance of any election bias, there already seems to be enough evidence to justify a cut in September and likely another in December. Futures market participants are currently forecasting almost 95% certainty of a September rate cut and pricing in a terminal easing rate only to 3.7%; this still looks a little high relative to the neutral estimate of 2.75% and would be consistent with a very soft landing. It is notable that more interest rate sensitive economies, such as Canada, Sweden, and the EU—where debt duration is shorter—have already started to lower interest rates this past quarter.

End of the Political Line—All Change, Please

In the U.S., President Joe Biden called for an unexpectedly early debate in his race with Donald Trump for reelection, and much like what happened with Macron and Sunak (discussed below), this move backfired; a very poor debate only heightened the electorates’ already elevated concerns about the president’s physical and cognitive abilities to represent them as leader of the Union. As we come to write this quarterly letter, President Biden has in fact handed the baton over the Vice President Harris to be the Democratic nominee. As far as financial markets are concerned, a Trump win is likely to mean higher tariffs, a renewal of the 2017 tax cuts, a weaker dollar, and more deregulation, all potentially inflationary, particularly if accompanied by coopting the Fed, as the WSJ suggested as a possibility.

Who Will Win the 2024 Presidential Election?

PredictIt Market Odds

This past quarter also brought with it a fairly sudden and radical change across the political economy. Both the U.K. Prime Minister Rishi Sunak and the French President Emanuel Macron called unexpectedly early snap elections, in which both were roundly defeated and will now be leaving office. The U.K. moved from center right to center left, and many traditional Tory voters split off to the further right Reform Party. The shift in the U.K. was not a referendum on Brexit nor should it be viewed as a major mandate to turn left; rather, it was a “let’s get rid of this tired old government who is tapped out of ideas and riddled with infighting, and give the other side a go.”

The French election was a turn-up for the books. After having seen a sharp move to the right in the European elections, Macron challenged his voters to put up or shut up, with the result that round one of his snap election shifted to the extreme right—though when it came to round 2 most of the parties to the left of the far right colluded to stop it from taking power. The result was a surprise win for the far left, with the hard right coming in second. The upshot here is that this remains a very divided and dissatisfied electorate.

Market Focus—Still a One-Track Mind

Stock market breadth continued to be relatively tight, with the Magnificent 7, or specifically just Nvidia, still dominating the index. The Magnificent 7 stocks increased by 16.8% in the quarter, whereas the aggregate S&P 500 index rose by 3.9%, against a decline of 3.1% for the equally weighted index. Interestingly, while these stocks have mostly been the largest contributors to aggregate performance, aside from Nvidia, they have not necessarily been the best-performing stocks in the quarter—with four other stocks outperforming Apple and then another four outperforming Alphabet.

There is no doubt that this has been a tough market for most stocks besides these 7, but we do not believe that these are the only stocks with any value in the market. Rather, we believe this represents a tremendous opportunity for investors to diversify portfolios and acquire some attractive companies with very attractive businesses at very attractive prices.

In reference to Roger Federer’s quote at the start of this letter, which was delivered at the commencement ceremony for Dartmouth College students earlier this year—which Federer claims was only the second time in his life he has set foot on a university campus—the quote could just as easily have been delivered by any one of the world’s best investors in reference to their trading legacy. Historically, many of these investors tell us exactly that—only around 54% of their trades end up being winners, with the remaining 46% being losers. Yet, it is those cumulative wins that allow them to outperform the investment herd over time. The message we take away is don’t dwell on each and every investment decision—even the greats make plenty of bad shots. Rather, remember your gameplan for capital and focus on the next goal in front of you.

S&P 500 vs. Magnificent 7

(Indices Rebased to 100, 28 December 2023)

Russell 2000 NTM P/E Relative S&P 500 NTM P/E

Also encouraging this quarter and boding well for the market, the performance of analysts’ earnings expectations relative to the normal progression for those expectations for the same quarter over the last two decades is 4.2% above the historical average (exhibit 4). Importantly, earnings growth going forward is also forecasted to be represented across the market more broadly than the past many quarters which had been very concentrated in earnings from the Mag 7 cohort.

These many moving pieces of earnings, inflation, the Fed, and now the looming election, are sure to be a major focus of investors over the remaining months of 2024. We look forward to our conversations and meetings together as review all the market dynamics and most importantly, any updates and changes inregards to your investment perspective, goals and objectives.

As always, thank you for your continued trust and confidence.

1935 Wealth Management Team

Asset Class Performance Table

Source: FactSet