Index YTD 1Q 1Y
S&P 500 U.S. Large Cap 10.56% 10.56% 29.88%
DJIA U.S. Large Cap 6.14 6.14 22.18
Russell 3000 U.S. All Cap 10.02 10.02 29.29
Russell 2000 U.S. Small Cap 5.18 5.18 19.71
MSCI EAFE Developed International 5.78 5.78 15.32
MSCI EM Emerging Markets 2.37 2.37 8.15
Bloomberg U.S. HY U.S. High Yield 1.48 1.48 11.15
Bloomberg U.S. Agg U.S. Core Bond -0.78 -0.78 1.70
Bloomberg Muni U.S. Muni Bond -0.39 -0.39 3.13
MSCI U.S. REIT GR U.S. Real Estate -0.32 -0.32 10.37

Total Returns
Source: Factset

The new year got off to a strong start, with the S&P 500 returning 10.5% in the first quarter, surpassing the previous all-time high the bellwether index reached in 2022. This market strength came at a time of mixed inflation readings, increased uncertainty about the future path of interest rates, and pronounced geopolitical tensions. Election dynamics are in full force, and it is worth noting that the last time the S&P index fell in a re-election year was in 1940. Sitting presidents like to prime the economy as the election approaches, and since 1944 (13 instances) the average return for the S&P 500 in a re-election year has been 16%.

U.S. megacap companies, and growth stocks in particular, continue to lead performance across global markets. The “Magnificent 7” stocks, which have gotten so much acclaim, have been disproportionate beneficiaries of ongoing digital transformation and artificial intelligence (AI) related tailwinds. While the stocks have traded less monolithically this year, the recent exceptional market returns of these companies have been supported by outsized profit growth. Forward profit estimates are still robust for this group, but the gap appears to be narrowing versus the rest of the market. Diversification across market segments (large, mid-, small) and styles (growth, core, value) remains an important tool to control risk and take advantage of a broadening investment opportunity set, which we believe lies ahead.

With so much focus on AI, we wanted to touch on the subject. We are believers that AI is going to have substantial impacts on efficiencies (margins) and productivity (growth) over the long run, mostly in very positive ways. At a time when the United States’ working population is shrinking because of the retirement of the baby boomer generation, combined with an onshoring of manufacturing, the layering in of AI is likely to ease these pressures. It could also serve as an inflation dampener as productivity enhancements may lead to cheaper goods and services. The U.S. is leading the way in AI development and technologies, positioning our country as a primary beneficiary. The applications for AI are real, from driverless Ubers in San Francisco to more effective fraud detection at financial services companies, but at this early stage, uses of AI are far from fully vetted or broadly adopted by companies. However, the transformative power of this innovative technology is widely recognized, and investors have been making bets on which companies will be AI winners and losers. We are invested in many companies that we expect to benefit from the application of AI and will continue to seek additional high-quality investment opportunities that fit this theme in a rapidly shifting competitive landscape.

In addition to the lift from excitement around AI, the buoyancy of U.S. equity markets is likely the result of economic conditions that are more positive than anticipated. Expectations have migrated from a near certainty of recession for much of last year, to recent optimism that a sustained decline in growth can be avoided altogether. Going into 2024, real GDP was expected to increase by a meager 1.3% for all of 2024, but with better data points to start the year, that estimate has swiftly risen to 2.2%. Bolstering improving GDP growth forecasts, corporate S&P earnings are expected to grow a solid 10% in both 2024 and 2025. Perhaps most importantly, a sturdy labor market with employment at a healthy 3.8% is helping the consumer to keep spending, perpetuating the growth flywheel. While layoffs are certainly taking place, job openings remain plentiful. As always, there are offsetting trends. High interest rates have been a headwind for large-ticket purchases like homes and vehicles. In addition, despite the strong labor market, savings are down, and credit card and auto loan default rates are migrating upward.

Inflation has increased more quickly than wage growth, which helps explain weak consumer sentiment in the face of full employment. While inflation has trended down significantly and forcefully since the 9.1% high CPI reading in June 2022, more recent readings are proving that the final leg back to 2% inflation may be more difficult. Going into 2024, the market was expecting at least six interest rate cuts this year; now the expectation is for just one or two. Higher interest rates have a multifold of implications, from pressure on equity valuations, to compression of corporate profit margins, and higher payments on the federal deficit, which crowd out discretionary spending. With the federal debt now at 122% of annual GDP (up from about 60% in the mid-2000s, and the highest prior reading of 120% just after WWII), interest payments now constitute close to 15% of the total federal budget, almost double the percentage of spend just a couple of years ago. It is particularly noteworthy that in exceptionally strong economic times, the U.S. deficit is at all-time highs. This could limit fiscal policy options when the next inevitable crisis arises.

Sticky inflation has impacted bond yields, and since the beginning of the year the 10-year Treasury yield has gone from 3.9% to 4.2% at the end of the first quarter. While higher interest rates make it more difficult for borrowers and pressure prices of existing bonds, investors benefit from the ability to lend money at higher rates. In addition, with higher interest rates on bonds than we have seen in many years, bonds are competing with equities for marginal investment dollars. We see a good risk/reward profile in bonds for our clients in both municipal bonds and government and corporate bonds.

With so much discord across our country and the world, it can be hard to feel positive about the future. It is important to be mindful that politics and geopolitics are not the capital markets. The financial market pendulum swings between fear and greed, and along the way opportunities present themselves. We seek to prudently take advantage of these opportunities by focusing on long-term trends while being mindful of client objectives. We appreciate your trust and support, and value our relationship.

Happy spring, and we hope to see you soon!