Summary
Inflation and economic growth both showed continued but slowing momentum in the second quarter of the year. U.S. equity markets built on a strong start in the first quarter as investors continued to believe in the soft-landing scenario for the economy and the potential for the Federal Reserve (Fed) to start a rate cutting cycle in the latter half of the year. Market participant concerns are shifting from inflation to growth.
The Economy
First quarter Gross Domestic Product (GDP) was positive but still showed a slowdown in activity. The rise was supported by consumer spending, fixed investment, and state and local government spending. The strong U.S. dollar and wealth effects from consumers’ improved balance sheets contributed to an increase in imports and travel. The Transportation Security Administration (TSA) broke the record for passenger screenings on June 23rd for both domestic and international travel. Despite Main Street’s better balance sheet, consumers have shown some softness recently as consumer confidence dipped a bit following several months of rising credit card and auto loan default rates.
While the Fed’s preferred indicator, the Personal Consumption Expenditures (PCE) index, showed a 2.6% year-over-year increase, there was no increase month-over-month from April to May. The Core index, which excludes food and energy, was up 0.1% month-over-month and 2.6% year-over-year. Both readings remain above the Fed’s 2% inflation target, although significantly lower than the peak of 7.1% in June 2022. This reading confirmed the May Consumer Price Index (CPI) report, which was unchanged month-over-month, but increased 3.3% year-over-year.
The labor market continues to garner a high level of attention as much of the data shows some cooling from a very tight labor market. The four-week moving average of Initial Jobless Claims rose to its highest level since September 2023. The four-week moving average for Continuing Claims reached its highest level since December 2021. The Job Openings and Labor Turnover Survey (JOLTS) showed that layoffs in April remained at its lowest level since August 2020. The nonfarm payrolls report showed that the U.S. added 272,000 jobs in May. Small employers posted about 50% more job openings in April than they averaged in 2019, while larger firms had 14% fewer openings. The unemployment rate rose slightly to 4% in May, the highest it’s been since January 2022, but remains low by historical standards. This may be partially driven by a rebound in immigration. The labor force participation rate remains near its post-pandemic high while the rate for prime age workers (age 24-54) rose to its highest level since 2002.
Interest rates ended the quarter flat as expectations for Fed cuts in July fell, especially in April when the Consumer Price Index showed continued but not drastic slowing at an annual rate of 3.4%. Expectations for a cut at the September Fed meeting have risen along with concerns about economic growth. The 2–10-year US Treasury yield curve inversion widened slightly over the quarter, extending the longest lasting inversion in history to nearly two years (July 6th).
The level of long-term rates, record high prices, and expectations for rate cuts have begun to pressure home sales. Existing home sales declined 2.8% year-over-year. Housing starts and new building permit issuance declined from the previous quarter. Housing inventory remains low, despite a modest rise during the quarter.
Globally, some Central Banks in developed countries have begun cutting rates to address growth concerns. Switzerland, Sweden, Canada, and the Eurozone all modestly cut rates in the quarter. Struggling with a weakened Yen, Japan raised rates to slightly positive (0.0-0.05%) after eight years of negative rates.
Markets
U.S. equities continued their upward trajectory following a very strong first quarter, driven primarily by the largest stocks in the S&P 500 once again. Performance by size diverged significantly with mid- and small-cap stocks losing nearly as much as large caps gained. In large caps, the Russell 1000 Growth index (8.3%) outperformed the Value index (-2.2%) by more than 1000 basis points (bps) for the quarter, still not near the December 2021 high of nearly 1600 bps. The Magnificent 7 continues to lead, with the Information Technology (13.6%) and Communications Services (9.1%) sectors posting large quarterly gains. While all other sectors except for utilities posted losses for the quarter, all sectors except for the Real Estate sector are still solidly positive for the year. Internationally, Emerging Market equities (5%) strongly outperformed Developed Market equities (-0.4%) for the quarter, pushing it past DM equities for the year (7.5% vs 5.3%, respectively).
Earnings growth drove equities in the quarter as 1Q2024 reports showed significant progress. S&P 500 earnings showed a year-over-year increase of 5.9%. It was particularly pronounced for companies doing business overseas, as companies with less than 50% of their revenues coming from the U.S. showed an increase of 13.2% year-over-year. Revenues in S&P 500 companies grew by 4.3%, led by U.S. generated revenue. The earnings growth rate for the 2nd quarter is expected to be 8.8%, the highest growth rate since 1Q2022.
Broad fixed income indices were essentially flat for the quarter and the year as the market has ridden steady coupon yields while moderating expectations for rate cuts. Retail money market balances grew to new highs as investors continue to wait out the Fed.
Looking Forward
As we move into the second half of the year, much of the news cycle will be occupied by election news and analysis, as more than half the global population will go to the polls this year. Growing political instability and softening confidence in government will likely contribute to volatility globally. In the U.S., a major issue, government debt, could remain unresolved for some time as a consensus solution may be elusive to a heavily divided government. If rates remain elevated, government debt service could be a heavier drag on GDP and fiscal resources.
Economic growth, inflation, and the labor market are all expected to continue to soften through to the end of the year. In response, market participants expect some rate easing in the fall. The FOMC’s Dot-Plot indicates that participants expect lower rates in 2025 and 2026 with a long run rate near 2.5-3%.
Despite economic and geopolitical concerns, the equity markets have continued to climb the wall of worry on the strength of the consumer and corporate America’s ability to deliver earnings. Also, the growing awareness of Artificial Intelligence and its potential applications have driven some of the largest components of equity indices.
Between the global election calendar, the continued competition between growth and inflation, the potential for the labor market and the consumer to reach an inflection point, and the strong positive returns we’ve already posted, markets have the potential for some increase in volatility, especially if some of the biggest names in the market begin to falter. As other equity sizes and styles have already experienced an increase in downside volatility, the spotlight on the largest growth companies will be more intense.