Navigating Uncertain Markets: Insights from the First Quarter of 2024
The first quarter of 2024 is now firmly in the rearview mirror. By all measures, the 1st quarter vastly outperformed expectations, both from an economic and a market perspective. Numerous US equity benchmarks reached new all-time highs and the market rally continued its broadening out to other areas other than large cap growth. In our opinion, one of the more impressive aspects of the 1st quarter rally was that it happened despite the expectation of Fed cuts decreasing from 6-7 quarter point rate cuts to 2-3 quarter point rate cuts in 2024. This decrease did not surprise us but the fact that the market rallied in the face of it was certainly against consensus. What exactly propelled the market to such new heights?
Well, even though the Federal Reserve is seen as more hawkish today than it was when the year started, the Fed is still seen as supportive. As Chair Powell suggested in March, the "hotter" inflation data has not altered the Fed's view and his commentary conveys as much. Powell stated, "if the economy evolves as projected, the median participant projects that the appropriate level of the federal funds rate will be 4.6 percent at the end of this year, 3.9 percent at the end of 2025, and 3.1 percent at the end of 2026, still above the medium— median longer-term funds rate. These projections are not a Committee decision or plan; if the economy does not evolve as projected, the path for policy will adjust as appropriate to foster our maximum-employment and price-stability goals." In our opinion, this language used by Jay Powell has provided the market with some foundational resiliency in the face of any perceived headwinds.
Another underappreciated reason why the markets may have been able to shrug off the fact that Fed rate cuts are getting pushed back is that markets tend to be more correlated with longer-term rates as opposed to the Fed Funds rates. In his April 8th market commentary, Global Investment Strategist for ProShares, Simeon Hyman makes a strong case that the “liberation” of the 10-Year Treasury Yield from the Fed Funds rate may have benefitted equity markets so far this year.
Long-Term Correlation to Fed Funds Effective Rate
Source: Bloomberg. Quarterly data from 1957-2007.
What Hyman is saying is that “while Quantitative Easing may have made it appear that longer-term interest rates were linked to the Fed Funds rates, as the chart above shows, longer-term rates have, in fact, exhibited little correlation to the Fed Funds rates over time (Source: Bloomberg). And it is longer-term interest rates that tend to drive stock prices.” In summary, even if shorter-term rates are expected to remain higher for longer, longer-term rates are still relatively low and not correlated with shorter-term rates, so those have provided a strong foundation for equity prices to remain buoyant.
Another area where a lot of strength was seen was in corporate earnings. In fact, according to FactSet Research Systems, calendar year 2024 earnings are expected to grow by 11%, and calendar year 2025 earnings are expected to grow by 13%. Also surprising to the upside was Q4 GDP in that it expanded 3.4% versus the initial 2% consensus. The labor market has also proved to be more resilient than expected. According to the US Labor Department, despite unemployment creeping up from 3.7% to 3.9%, it is still the longest stretch (2+ years) of sub-4.0% unemployment since the late 1960s. These areas clearly point to the fundamentals of the market (corporate earnings, economic growth, employment rates, etc.) being very robust.
As it relates to inflation, we think our partners at Charles Schwab put it well when they said, "There is an old adage about Federal Reserve rate cycles: the Fed takes the escalator up and the elevator down. Because of the impact higher rates have of the economy, the Fed is usually more methodical when hiking rates. On the other hand, the Fed has historically been more aggressive when cutting rates, especially when combatting recessions. This time is different." We wholeheartedly agree with this sentiment because, as we see it, the many positive economic and market data being released on a weekly basis give the Fed the ability to be selective about lowering rates.
Vanguard economist, Ryan Zalla, put it astutely when he said, “shelter inflation [i.e., rents, housing] is critical to core inflation reaching the Fed’s target. If shelter inflation were to return to its pre-pandemic average of around 2.5%, core CPI would be approximately 2%. For shelter inflation to moderate, labor market conditions will have to materially weaken, or housing supply will have to increase. Meaningful changes in either appear unlikely to materialize.” Housing demand remains high, the labor market continues to be strong, and homeowners are still reluctant to move because that means they would have to voluntarily give up their low mortgage rate for a much higher rate.
More recently, the week of April 15th saw broad market indices pullback by more than 5% for the first time in about half a year. As investors, we must keep in mind that these pullbacks are common: The S&P 500 has experienced an average of three pullbacks of 5% or more every year since 1929, a Bank of America analysis showed. At Wolf Group Capital Advisors, we view pullbacks of this nature as not only common, but we also expect them and, on some level, view them as somewhat healthy.
In our view, investing in equity markets is not for everyone. There is volatility in investing, and because one is willing to accept this volatility, they are typically rewarded with what is known as an equity risk premium. The equity risk premium is the amount of return above the risk-free rate that an equity investor can expect to earn over the long term for holding onto equity investments. The issue is that equity returns are not linear and can even go negative for relatively long periods of time. Many individuals struggle with this concept and feel as though the market is working against them or cannot be trusted, so they stick with the security of cash. Unfortunately, we know this tends to be hazardous to your wealth:
Below, we show the returns of a $100 investment across major asset classes—from U.S. stocks to gold—between 1970 and 2023:
To put investment returns in perspective, this graphic shows the growth of $100 by asset class over the long term, based on data from Aswath Damodaran at NYU Stern.
As we look forward to the rest of calendar year 2024, as always, there are reasons to be positive and reasons for apprehension. On the opportunistic side, there are reasons to believe that the quality factor will continue to be rewarded. Companies with strong free cash flow and manageable debt that are growing earnings should continue to command a premium in the market. An argument can be made that fixed income now deserves even more consideration in portfolios, especially on the shorter end and longer end of the yield curve. The current shape of the yield curve would argue that a barbell approach would give a bond investor the most bang for his or her buck.
Reasons to be cautious continue to include geopolitical concerns as well as worries about the many global elections taking place this year. Additionally, an unexpected shift in Fed policy or runaway inflation could damage financial asset returns. Weakness in commercial real estate is also something that deserves additional monitoring. Despite the ever-present underlying uncertainty inherent in investing, we view the reasons for staying invested as carrying more weight than the reasons for being out of the market. After all, we saw a historic 5-month gain from November through March (in excess of 20%!) across many of the major equity indices. This could not have been predicted in late October of 2023 when many investors were looking to cash and short-term bonds to help stabilize their portfolios after the 3-month downturn that occurred between August and October of 2023.
Sincerely,
Charles Verruggio
Chief Investment Officer
Learn more about Charles Verruggio here, and our investment management strategy here.
About Wolf Group Capital Advisors
At Wolf Group Capital Advisors, a comprehensive wealth management firm and Registered Investment Advisor (RIA) based in the Washington, D.C. metropolitan area, nothing is more important than the fiduciary responsibility we have in managing your wealth. Taking the utmost care, we focus on providing advice tailored to your specific circumstances. With more than two decades advising U.S. expatriates and non-US citizens employed by international organizations, we are qualified in investment strategies addressing global issues. Empathy and curiosity—combined with our experience in life planning and investment management—enable you to explore a wider set of possibilities that can lead to a fulfilling life you’ve worked hard to attain.
Disclosure:
The information presented is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third-party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way whatsoever. This presentation may not be construed as investment, tax or legal advice and does not give investment recommendations. Any opinion included in this report constitutes our judgment as of the date of this report and is subject to change without notice.
Additional information, including management fees and expenses, is provided on our Form ADV Part 2 available upon request or at the SEC’s Investment Adviser Public Disclosure website. Past performance is not a guarantee of future results.
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