The economy is better than feared

by Badgley Phelps | May 13, 2024

Outlook: 2nd Quarter 2024

Economy

The economy has settled into a steady growth trajectory relative to the boom/bust pattern we experienced in the pandemic. The recent trend has been much closer to the long-term average with growth of 2.5 percent last year and an expected increase of approximately 2.25 percent this year. In terms of inflation, it has declined from its high but remains well above the Federal Reserve’s target. Given the solid pace of growth and persistent inflationary pressure, our central bank has held its policy rate steady. 

The sustained economic growth and persistent inflation have changed the outlook for the Federal Reserve’s policy and, by extension, short-term interest rates. Futures markets are now pricing in one to two rate cuts this year, which is slightly less than the most recent guidance from our central bank. This represents a dramatic change in the outlook as consensus expectations early in the first quarter called for six rate cuts this year.

Inflation

Inflation is well below the 9.1 percent peak reached in June of 2022. However, it remains above the Federal Reserve’s target with the Consumer Price Index coming in at 3.5 percent in March. A review of the underlying components shows that housing prices and rent expenses are some of the primary drivers of inflation. Excluding the impact of shelter, the Consumer Price Index increased only 2.3 percent, suggesting that price pressures are contained in many other parts of the economy.

As we progress through the year, inflation is expected to decline gradually given an eventual moderation in the price increases for shelter as well as the Federal Reserve’s emphasis on keeping inflation contained. The central bank’s policy rate is almost two percentage points above the rate of inflation, and they are reducing liquidity in the financial system by shrinking their balance sheet. These policies, collectively, are intended to slow the pace of growth and reduce the inflationary pressure in the economy.

U.S. dollar

The U.S. dollar has fallen from its post pandemic high but remains elevated. Expectations for an eventual pivot in the Federal Reserve’s policy have led to a decline from the recent peak, but our currency remains at a historically high level. Solid economic growth and relatively high interest rates are supporting the dollar, and we expect these dynamics to continue in the coming quarters.

Asset class

Cash/Money Market Instruments

Given strong economic data in the past few months, expectations for the timing and magnitude of interest rate cuts by the Federal Reserve have changed dramatically. Earlier in the year, the futures market had priced in as many as six, 25-basis-point, cuts to the federal funds target rate. That number has declined to one, implying a year-end policy rate of approximately five percent. Our central bank has become data-dependent in making policy decisions and we anticipate it will continue to move cautiously. Unless circumstances or untenable data force its hand, we believe the Federal Reserve will be slow to cut rates, particularly with national elections later this year.

Intermediate Government/Credit Bonds

Interest rates increased earlier this year as strong economic data pushed out expectations for central bank rate cuts. Though the timing remains uncertain, the prospect of eventual rate cuts and lower inflation suggests the possibility of lower yields in the second half of the year. In this environment, intermediate-term bonds offer a good compromise of locking in today’s higher yields while mitigating the interest rate risk of longer-term debt.

Within the investment-grade bond universe, we prefer high-quality corporate bonds balanced with a mix of government debt securities. The economy has been resilient, and the outlook for corporate bonds remains positive despite credit spreads that are at historically low levels. Government bonds are additive as they offer excellent liquidity and diversification.

Tax-Exempt Municipal Bonds

Like most other fixed income investments, municipal bond yields have increased significantly since late 2021 and are now close to the highest levels in the last 15 years. Although yields are down from their recent highs, they remain an attractive option for investors in higher tax brackets who are looking for more conservative income options. The fundamental picture remains strong, with healthy balance sheets across most municipalities. In fact, many issuers are sitting on adequate reserves and have increased their rainy-day funds over the past several years.

U.S. Equity

The S&P 500 Index generated a strong gain in the first quarter with a total return of approximately ten percent. Consistent with last year’s trend, stocks in the growth segment were the best performers led by companies in the Artificial Intelligence (AI) industry. To be specific, the gains were highest in companies that provide the infrastructure needed for AI which includes semiconductor companies and providers of cloud services. While the growth segment generated the best returns, the gains were broadly based with strong gains across the value and small/mid cap styles.

In the coming quarters, we will be watching for an inflection in earnings growth. Profits, in aggregate, plateaued in the last two years, but in 2024 they are projected to return to an upward trajectory and rise approximately eight to ten percent. That provides a positive backdrop for equities. However, the market may struggle to generate unusually strong performance from current levels given today’s high equity valuations. Currently, the market is trading at a multiple of approximately 20x forward earnings, which represents a premium to the long-term average of 16x.

We are also watching for greater symmetry in the returns of each market segment relative to last year. The economy has settled into a steady, and sustainable, growth trajectory with greater stability in supply and demand patterns. Given the return to a more balanced economy, and expectations for a return to earnings growth, we expect less dispersion in returns relative to the extremes we experienced in 2023.

International Equity

International equities participated in the first quarter’s rally despite pockets of economic weakness. The breadth of the rally is impressive given the relative weakness in many foreign economies. Growth in Japan and Europe has been soft, while China’s economy has been hampered by stress in their real estate sector. The soft economic conditions have led to somewhat weak demand for commodities and that has negatively impacted the emerging markets, many of which are suppliers of oil, food, and other natural resources.

As we progress through the year, we expect foreign economies to experience modest improvement while also being positively impacted by the sustained growth in the U.S. This should provide a positive tailwind to equities. Valuations are also attractive in foreign economies, providing a wider safety margin relative to domestic markets. However, sustained strength in the U.S. dollar and ongoing military disputes may limit the upside and lead to bouts of volatility as we progress through the year. 

Commodity

After a difficult year in 2023, commodities generally increased in the first quarter. Last year, the decline in inflation was channeled through the commodity markets resulting in losses for many of this segment’s constituents. However, that pattern reversed in the first quarter with oil, agricultural commodities, precious metals, and copper increasing in value. The gains were not dramatic, but there was a notable reversal in the trend.

We have a favorable view of commodities. Growth in the U.S. has been stronger than anticipated and there is potential for foreign economies to follow suit, placing upward pressure on demand. In addition, supply constraints and heightened geopolitical risks provide the potential for energy prices to rise. Gold has rallied and rising government debt worldwide continues to provide support for precious metals.

Potential opportunities & risks

Opportunities

The emergence of new technologies such as artificial intelligence—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes such as the growth of artificial intelligence, Big Data, quantum technologies, and cloud computing.

A productivity boom—According to some estimates, technology was pulled forward two to three years during the pandemic. That development coupled with a persistent shortage of labor is leading companies to invest in new technologies with the goal of boosting productivity, automating processes, and adapting to today’s constrained labor markets.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.

Risks

Inflation—Given the unparalleled amount of fiscal and monetary stimulus in previous years, persistent federal budget deficits coupled with high government debt, the wars in Ukraine and the Middle East, reduced investment in production capacity for some commodities, the trend towards deglobalization, and a shortage of labor, there is a risk that inflation may remain above the average of the last thirty years.

Rising Government DebtSovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt has increased approximately 55 percent since the end of 2019 and that trend shows no sign of reversing course with persistent budget deficits. While the short-term implications of higher debt levels are manageable, the long-term impact may be substantial as rising interest costs burden taxpayers.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring the wars in Ukraine and the Middle East along with the relationship between the West and China.

Deglobalization—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions, upward pressure on inflation, and a rising cost structure for some industries.

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans, and competitive practices.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.

 

Originally posted on May 7, 2024

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The economy is better than feared

by Badgley Phelps | May 13, 2024

Outlook: 2nd Quarter 2024

Economy

The economy has settled into a steady growth trajectory relative to the boom/bust pattern we experienced in the pandemic. The recent trend has been much closer to the long-term average with growth of 2.5 percent last year and an expected increase of approximately 2.25 percent this year. In terms of inflation, it has declined from its high but remains well above the Federal Reserve’s target. Given the solid pace of growth and persistent inflationary pressure, our central bank has held its policy rate steady. 

The sustained economic growth and persistent inflation have changed the outlook for the Federal Reserve’s policy and, by extension, short-term interest rates. Futures markets are now pricing in one to two rate cuts this year, which is slightly less than the most recent guidance from our central bank. This represents a dramatic change in the outlook as consensus expectations early in the first quarter called for six rate cuts this year.

Inflation

Inflation is well below the 9.1 percent peak reached in June of 2022. However, it remains above the Federal Reserve’s target with the Consumer Price Index coming in at 3.5 percent in March. A review of the underlying components shows that housing prices and rent expenses are some of the primary drivers of inflation. Excluding the impact of shelter, the Consumer Price Index increased only 2.3 percent, suggesting that price pressures are contained in many other parts of the economy.

As we progress through the year, inflation is expected to decline gradually given an eventual moderation in the price increases for shelter as well as the Federal Reserve’s emphasis on keeping inflation contained. The central bank’s policy rate is almost two percentage points above the rate of inflation, and they are reducing liquidity in the financial system by shrinking their balance sheet. These policies, collectively, are intended to slow the pace of growth and reduce the inflationary pressure in the economy.

U.S. dollar

The U.S. dollar has fallen from its post pandemic high but remains elevated. Expectations for an eventual pivot in the Federal Reserve’s policy have led to a decline from the recent peak, but our currency remains at a historically high level. Solid economic growth and relatively high interest rates are supporting the dollar, and we expect these dynamics to continue in the coming quarters.

Asset class

Cash/Money Market Instruments

Given strong economic data in the past few months, expectations for the timing and magnitude of interest rate cuts by the Federal Reserve have changed dramatically. Earlier in the year, the futures market had priced in as many as six, 25-basis-point, cuts to the federal funds target rate. That number has declined to one, implying a year-end policy rate of approximately five percent. Our central bank has become data-dependent in making policy decisions and we anticipate it will continue to move cautiously. Unless circumstances or untenable data force its hand, we believe the Federal Reserve will be slow to cut rates, particularly with national elections later this year.

Intermediate Government/Credit Bonds

Interest rates increased earlier this year as strong economic data pushed out expectations for central bank rate cuts. Though the timing remains uncertain, the prospect of eventual rate cuts and lower inflation suggests the possibility of lower yields in the second half of the year. In this environment, intermediate-term bonds offer a good compromise of locking in today’s higher yields while mitigating the interest rate risk of longer-term debt.

Within the investment-grade bond universe, we prefer high-quality corporate bonds balanced with a mix of government debt securities. The economy has been resilient, and the outlook for corporate bonds remains positive despite credit spreads that are at historically low levels. Government bonds are additive as they offer excellent liquidity and diversification.

Tax-Exempt Municipal Bonds

Like most other fixed income investments, municipal bond yields have increased significantly since late 2021 and are now close to the highest levels in the last 15 years. Although yields are down from their recent highs, they remain an attractive option for investors in higher tax brackets who are looking for more conservative income options. The fundamental picture remains strong, with healthy balance sheets across most municipalities. In fact, many issuers are sitting on adequate reserves and have increased their rainy-day funds over the past several years.

U.S. Equity

The S&P 500 Index generated a strong gain in the first quarter with a total return of approximately ten percent. Consistent with last year’s trend, stocks in the growth segment were the best performers led by companies in the Artificial Intelligence (AI) industry. To be specific, the gains were highest in companies that provide the infrastructure needed for AI which includes semiconductor companies and providers of cloud services. While the growth segment generated the best returns, the gains were broadly based with strong gains across the value and small/mid cap styles.

In the coming quarters, we will be watching for an inflection in earnings growth. Profits, in aggregate, plateaued in the last two years, but in 2024 they are projected to return to an upward trajectory and rise approximately eight to ten percent. That provides a positive backdrop for equities. However, the market may struggle to generate unusually strong performance from current levels given today’s high equity valuations. Currently, the market is trading at a multiple of approximately 20x forward earnings, which represents a premium to the long-term average of 16x.

We are also watching for greater symmetry in the returns of each market segment relative to last year. The economy has settled into a steady, and sustainable, growth trajectory with greater stability in supply and demand patterns. Given the return to a more balanced economy, and expectations for a return to earnings growth, we expect less dispersion in returns relative to the extremes we experienced in 2023.

International Equity

International equities participated in the first quarter’s rally despite pockets of economic weakness. The breadth of the rally is impressive given the relative weakness in many foreign economies. Growth in Japan and Europe has been soft, while China’s economy has been hampered by stress in their real estate sector. The soft economic conditions have led to somewhat weak demand for commodities and that has negatively impacted the emerging markets, many of which are suppliers of oil, food, and other natural resources.

As we progress through the year, we expect foreign economies to experience modest improvement while also being positively impacted by the sustained growth in the U.S. This should provide a positive tailwind to equities. Valuations are also attractive in foreign economies, providing a wider safety margin relative to domestic markets. However, sustained strength in the U.S. dollar and ongoing military disputes may limit the upside and lead to bouts of volatility as we progress through the year. 

Commodity

After a difficult year in 2023, commodities generally increased in the first quarter. Last year, the decline in inflation was channeled through the commodity markets resulting in losses for many of this segment’s constituents. However, that pattern reversed in the first quarter with oil, agricultural commodities, precious metals, and copper increasing in value. The gains were not dramatic, but there was a notable reversal in the trend.

We have a favorable view of commodities. Growth in the U.S. has been stronger than anticipated and there is potential for foreign economies to follow suit, placing upward pressure on demand. In addition, supply constraints and heightened geopolitical risks provide the potential for energy prices to rise. Gold has rallied and rising government debt worldwide continues to provide support for precious metals.

Potential opportunities & risks

Opportunities

The emergence of new technologies such as artificial intelligence—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes such as the growth of artificial intelligence, Big Data, quantum technologies, and cloud computing.

A productivity boom—According to some estimates, technology was pulled forward two to three years during the pandemic. That development coupled with a persistent shortage of labor is leading companies to invest in new technologies with the goal of boosting productivity, automating processes, and adapting to today’s constrained labor markets.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.

Risks

Inflation—Given the unparalleled amount of fiscal and monetary stimulus in previous years, persistent federal budget deficits coupled with high government debt, the wars in Ukraine and the Middle East, reduced investment in production capacity for some commodities, the trend towards deglobalization, and a shortage of labor, there is a risk that inflation may remain above the average of the last thirty years.

Rising Government DebtSovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt has increased approximately 55 percent since the end of 2019 and that trend shows no sign of reversing course with persistent budget deficits. While the short-term implications of higher debt levels are manageable, the long-term impact may be substantial as rising interest costs burden taxpayers.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring the wars in Ukraine and the Middle East along with the relationship between the West and China.

Deglobalization—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions, upward pressure on inflation, and a rising cost structure for some industries.

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans, and competitive practices.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.

 

Originally posted on May 7, 2024

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