Summary
Resilience in both the U.S. economy and inflation caused market participants to recalibrate their expectations for lower policy rates from the Federal Reserve. Economic data modestly reaccelerated while inflation rose a bit more than expected, driven by services and energy prices. While the modest rise in interest rates was consistent with the change in expectations for Fed rate cuts, equity prices built upon their momentum from the fourth quarter of 2023 as investors continued to move into stocks.
The Economy
Businesses joined consumers in their optimism about a soft landing and economic growth. Consumer confidence rose to its highest level since July 2021 despite inflation data, particularly energy prices, rising slightly in the quarter. West Texas Intermediate crude oil (WTI) rose 14% to its highest level since early November. Both the Consumer Price Index (“CPI”) and the Producer Price Index (“PPI”) started the year outpacing expectations but are still below their readings in October. The Fed’s preferred inflation indicator, the Personal Consumptions Expenditures Price Index (“PCE”) also rose in February but did not exceed 4Q23 readings.
Generally, financial conditions have shown similar characteristics: slightly higher during the first quarter of 2024, but still better than early in the fourth quarter of 2023. Asset prices have increased, volatility has moderated, credit spreads have narrowed, and bank lending standards have eased. While the 30-year fixed rate mortgage rose by about a quarter of a percentage point, it remains well off the 7.80% high from October 26th, and is currently near 6.80%. Housing prices remain an issue as inventories of homes available for sale have remained low. In addition, a surge in immigration that has helped to fill open jobs, balance the labor supply, and provide more consumer support to the economy has added pressure to rental prices and other housing indicators.
The easier conditions have allowed businesses to resume investment in durable goods and services. In February, capital goods orders saw its largest monthly gain since November, following two straight months of declines, including a 6.9% decline in January. Business investment improved, even pushing a strong revision to 4th quarter 2023 GDP. For the first time in two years, the Conference Board’s US CEO Confidence survey showed more positive responses than negative responses. While they expressed optimism on the economy and interest rates, the difficulty in attracting and retaining qualified workers and geopolitical risk remain top of mind.
March was important for global Central Banks. After two years of tightening monetary policy to combat high inflation, Switzerland became the first major economy to cut interest rates. On the other side, the Bank of Japan raised rates for the first time since 2007. Other major Central Banks, such as the Bank of England and the U.S. Federal Reserve, elected to keep their policy rates steady in the first quarter but signaled that rate cuts could be on the horizon. Both the BoE and U.S. Fed have held rates steady since August 2023.
Markets
Equities continued their positive trajectory in the new year, building on the impressive nine week run to close out 2023. The S&P 500 returned more than 10%, on the back of the 15% run from October 27th to December 31st. U.S. Large Cap continued to lead, with growth-style equities leading the way among all capitalizations. The Russell 1000 Growth index outperformed the Russell 1000 Value index by more than 240 basis points (bps). At the sector level, the Communications Services sector (16%) lead the S&P 500, followed by the Energy sector (13%) and Information Technology (12%). Interest rate sensitive sectors, such as the Real Estate sector (-1%) and the Utilities sector (4%) were the worst performing sectors in the index.
S&P 500 corporate earnings continued to grow. Expectations for earnings moderated over the first quarter. However, if the estimated earnings growth rate of 3.6% comes to fruition, it will mark the third straight quarter of year-over-year earnings growth. The forward 12-month P/E ratio (20.9) remains above both the 5-year (19.1) and the 10-year (17.7) averages.
In fixed income, bond yields rose as hopes for a rate cut in March faded. The 2- to 10-year Treasury spread ended flat versus the end of 2023. Corporate yield spreads slipped slightly. With corporate balance sheets flush with cash and looking for a rate cut later this year, new corporate issuance has been soft to start the year. Cash balances continue to climb, with retail money market funds reaching nearly $1.8 trillion.
Looking Forward
At the very end of the quarter, a cargo freighter, with containers stacked 10 high above the deck, ran into the Francis Scott Key Bridge in Baltimore, MD. While Baltimore emergency services were able to stop traffic, they were unable to clear a small road construction crew working on the bridge. Our prayers go out to the families of the six crew members who did not survive.
This collision closed one of the most important shipping ports on the East Coast of the U.S., raising concerns about a new disruption to the supply chain for U.S. manufacturers and import/exporters, particularly automobiles, coal and agricultural shipments. Ships are being rerouted to ports in New York, New Jersey, Norfolk, VA, Wilmington, DE, and other ports along the Southeast Coast of the U.S. Because of the transportation infrastructure on the East Coast, many of these ports should be able to absorb much of the shipping demand but with some slowdown in throughput. There will likely be a particular impact to the local Baltimore economy and traffic around the city as the port will be closed until they clear the Patapsco River and, over the longer term, rebuild the bridge to reopen the east side of I-695. Currently, larger trucks and vehicles carrying hazardous materials that would have normally used the FSK bridge are being rerouted around the west side of the Baltimore beltway, adding to an already highly congested route. I-81, on the west side of the state, may also begin to see additional freight traffic.
The slowdown will impact an already fragile global supply chain and inflation data that seems to be just on the verge of an inflection point. With inflation data just slightly above expectations, market participants continue to recalibrate their expectations for interest rate cuts, potentially becoming more and more comfortable and adjusted to current levels for a longer period.
Expectations for multiple Fed rate cuts continue to drop with most projections targeting three rate cuts of 25 basis points starting this summer. However, continued resilience in the economy and inflation data could push back the timing and, potentially, the number of cuts, during the year.
The strong economy is encouraging. Labor demand remains solid, leading to resilience in consumer activity. Businesses are finding better conditions to make longer term investments, even though rates are still relatively high compared to recent history. Inflation remains a concern but has shown a slightly lighter touch, even if it hasn’t come down as most market participants had hoped. This last part of the inflation reduction cycle will take patience, as the ‘last mile’ always tends to be the toughest.
Moving further into the year, geopolitical risk and an impactful election cycle in both the U.S. and abroad will potentially be among the biggest contributors of volatility for all asset markets. News flow, both factual and speculative, will be difficult for investors and market participants to digest. We believe our investment principles of discipline, diversification, and focus on fundamentals will allow us to navigate these stressful times.