At a Glance

Inflation & Labor Data: Headline and core PCE inflation data increased in October to 2.3% and 2.8%, respectively (vs. 2.1% and 2.7% the month prior). The PCE increases were in line with expectations but introduce concerns that inflation will remain sticky. After September’s noisy labor report, the October report, published on December 6, will be widely anticipated. The unemployment rate remains at 4.1%.

U.S. Election: Since the election on November 6, markets have been assessing potential policy changes and cabinet appointees from President-Elect Trump, ushering in a “Trump Trade.”

Fed & Monetary Policy: The Fed continued their easing cycle by cutting interest rates another 25-bps in November. Inflation and labor market data remain hyper-important as the Fed continues to be data dependent. There is one final FOMC meeting in 2024 in December, which will likely witness another rate cut and an update to the Fed’s Summary of Economic Projections, providing insights into the possible monetary policy activity for 2025 and beyond.

Equity Markets: Equity markets continued their year-to-date run-up in November, with major equity indices continuing to notch record highs. The S&P 500 reached its 53rd all time high (ATH) in 2024 on November 29.

Asset Class Performance

The “Trump Trade” took full effect in November, as news of President Trump’s re-election reverberated through global markets. Emerging markets were hit the hardest, a direct result of Trump’s tariff threats and a surging U.S. Dollar. Conversely, U.S. equities fared the best, led by small cap stocks, which stand to benefit from expected Trump policies, including de-regulation and greater reliance on domestic companies.

Source: YCharts. Asset class performance is presented using total returns for an index proxy that best represents the respective broad asset class. U.S. Bonds (Bloomberg U.S. Aggregate Bond TR), U.S. High Yield (Bloomberg U.S. Corporate High Yield TR), International Bonds (Bloomberg Global Aggregate ex-USD TR), U.S. Large Cap (S&P 500 TR), U.S. Small Cap (Russell 2000 TR), Developed International (MSCI EAFE TR), Emerging Markets (MSCI EM TR), and Real Estate (Dow Jones U.S. Real Estate TR). 

Markets & Macroeconomics

Elections and Rate Cuts and Earnings, Oh My!

Markets digested a lot of information in the month of November, including the results of the U.S. election, another Fed interest rate cut, and a slew of 3Q earnings reports. While markets experienced volatility intra-month, they ended the month solidly up, with major indices like the S&P 500 and Russell 2000 turning in their best monthly results of the year, gaining 5.7% and 11.0%, respectively, in November.

The results of the U.S. election in early November brought news of another Trump Administration and a “red sweep” across Congress. Markets reacted positively to this outcome, with small caps as measured by the Russell 2000 up nearly 8% from November 4, the day before the election, through November 6, the day after the election. The market enthusiasm in small caps was primarily due to Trump’s promise of “deregulation,” which has the potential to positively impact smaller companies more than larger ones. Market participants also started positioning around Trump’s stance on tariffs, immigration, and other potential policy decisions. Cryptocurrency is another asset class benefiting from Trump’s re-election, illustrated by Bitcoin’s run-up of over 140% in 2024. Fervor related to the so-called “Trump Trade” waned over the course of the month as much uncertainty remains around the extent of Trump’s policies.

Exhibit 1: Equity Markets Pre- and Post-Election

One day after the Presidential election results were declared, on November 7, the Federal Reserve cut interest rates by 25 bps, continuing their policy easing. The Fed has continued to reiterate its “data dependent” approach, particularly as it concerns inflation and labor data. Whether the policies outlined in the Trump agenda have the potential to impact the course of monetary policy is of no concern to the Fed – they remain independent from politics and focused on a broad set of data to determine their policy trajectory, not speculation of potential fiscal policy changes. The Fed meets one more time in 2024 in December, where they will publish a new set of economic projections, providing important data on what to expect in 2025.

Source: YCharts

Finally, 3Q earnings season is drawing to a close, with over 95% of companies having reported already. Earnings have now grown for five quarters in a row, and expectations for 4Q are expected to double the growth seen in 3Q, with broader contributions from companies outside the Magnificent Seven expected. Year-over-year earnings growth was led by the Health Care and Communication Services sectors, meanwhile the Energy sector was the most challenged in 3Q. As company earnings continue to grow, so too do major equity indices, with the S&P 500 and Dow Jones indices notching multiple all-time highs over the course of the month. The S&P 500 now has 53 all-time highs in 2024. Equity markets remain slightly overvalued, making it important to not just consider large cap stocks, but diversify across asset classes and sectors.

The Bottom Line: November was an eventful month, with the U.S. election, an interest rate cut, and the 3Q earnings season keeping markets busy. As the “Trump Trade” took effect, we saw markets end the month higher, as illustrated by the number of all-time highs by major U.S. equity indices. The Fed continues its easing policy which may come into conflict with Trump’s fiscal agenda in 2025.

Looking Ahead

Wrapping Up 2024

With 2024 drawing to a close, there are still a few events left that have the potential to drive market activity in the final month of the year: the December Federal Open Markets Committee (FOMC) meeting, including the publication of the Fed’s latest economic projections, and, of course, Santa Claus!

Every quarter, the Federal Reserve updates their projections for future GDP growth, unemployment, inflation, and interest rates in a publication titled the Summary of Economic Projections, the “SEP” or “Dot Plot” for short. Updates to the Dot Plot inform market participants about the trajectory of interest rates, both in the short- and long-term, and this trajectory can shift course as economic data changes. Throughout 2024, the Fed has been extremely “data dependent” with monetary policy, meaning their decisions have been heavily influenced by monthly macroeconomic data points, particularly inflation and unemployment data. This data has guided the Fed in their decision-making and has resulted in changes to their economic projections, as illustrated in Exhibit 2 below, which shows the March, June, and September SEP or Dot Plot projections. What we learned from these projections is that the latest Dot Plot in September showed interest rates elevated at a higher level in the long-term (2027 and beyond) than previous projections in March and June, indicating a slower pace of rate reductions. The December Dot Plot, which will be published on December 18, will provide important clarity on whether the Fed’s thinking has changed based on the latest macroeconomic data. We could also see an additional rate cut at the December FOMC meeting.

Exhibit 2: Changing Fed Funds Projections

Source: The Federal Reserve

As markets assess the Fed and the direction of monetary policy, they may also get to experience the magic of Santa Claus this December. The “Santa Claus Rally” is a technical market phenomenon explaining why equity markets advance in the final week of the year. This phenomenon is illustrated in Exhibit 3 below, where four out of the past five years saw equity market gains in the last week of December. There are numerous reasons why this phenomenon can occur, with one major explanation being the lower institutional trading volume during the holidays. Some believe a Santa Claus Rally can help set expectations for market performance in the coming year; however, skeptics believe it to be a self-fulfilling prophecy. Either way, wrapping up 2024 could see continued growth in equity markets, and depending on the commentary and decisions from the Fed, may introduce short-term volatility to close out the year.

The Bottom Line: 2024 is wrapping up and two events have the potential to keep markets busy through year-end: the last FOMC meeting, where an interest rate cut is largely expected, in addition to updates to economic projections, and a potential for a Santa Claus Rally, which could drive equity markets even higher to end the year.

Exhibit 3: S&P 500 Recent December Returns

Source: YCharts

Capital Markets Themes

What Worked, What Didn’t

•Small Caps Take Off: Small cap stocks, as measured by the Russell 2000 Index, were up nearly 11% in November, spurred by the “Trump Trade” and policy implications that would stand to benefit smaller domestic companies.

•Growth vs. Value Equity: While growth equities have largely outperformed value equities in 2024 due to the tech- and AI-boom, these two styles performed roughly in-line with one another in November, illustrating how equity market participation may be starting to broaden outside of tech.

Source: YCharts. Data call-out figures represent total monthly returns

On Alternatives

The Outlook for Private Credit

The private credit market is around $1.7 trillion in size and has grown nearly two-fold in the past 10 years. Most of this growth has been in the direct lending sector of the market, which represents close to 50% of the entire private credit market, illustrated in Exhibit 4 below. Direct lending is a form of private lending to small- or medium-sized companies without the use of an intermediary, typically in the higher quality, or senior, portion of the company’s capital structure.

Exhibit 4: Private Credit AUM

Source: Preqin. Data as of 6/30/2024

Direct lending, and private credit as a whole, is predominately floating rate, meaning that the underlying debt instrument is tied to a rate, typically the secured overnight financing rate (SOFR), that can fluctuate over its life, i.e., the rate “floats.” SOFR is an interest rate that is directly tied to the federal funds rate, meaning that as the fed funds rate increased in 2022 and 2023, so did SOFR, and, subsequently, the yields for private credit. Conversely, this means the opposite also holds true in the current environment: as the Fed cuts interest rates, the yields across private credit are expected to decline, albeit at a delayed cadence to rate cuts.

Illustrated in Exhibit 5, private credit has recently enjoyed elevated yields of close to 12%, measured by the private credit benchmark, the Cliffwater Direct Lending Index (“CDLI”). Compared to the public credit alternative, short-term Treasury bills, private credit offers a yield advantage of nearly 6%. This yield advantage helps explain why private credit has seen such strong inflows in recent years.

While declining interest rates typically lead to lower yields for private credit, they also reduce the interest burden on companies, particularly the smaller companies that direct lending targets. Smaller-sized companies are more sensitive to interest rates, meaning they benefit more when rates fall. This creates a double-edged sword in
the private credit market: lower rates mean lower yields, but they also ease the burden on borrowers, potentially reducing default risks and overall investment risk.

Although investors may not see yields of 11% or higher moving forward, private credit still offers elevated yields and other advantages, such as diversification from traditional fixed income – a key
benefit that has become even more important in the falling rate environment.

Exhibit 5: Private vs. Public Credit Yields

Source: Cliffwater

The Bottom Line: The outlook for private credit is changing, driven by falling interest rates which will reduce yields within the asset class over time. Falling rates should also reduce the interest burden on companies targeted by direct lending. Private credit still offers advantages against traditional fixed income, including higher yields and diversification benefits, which remain paramount in the current environment.

Asset Class Performance Quilt

Markets are ever-changing, making diversification across asset classes and sectors a critical component to portfolio construction. As illustrated below, a Balanced 60/40 portfolio provides greater consistency of returns and less volatility over time.

Source: YCharts. Asset class performance is presented using market returns from an exchange-traded fund (ETF) proxy that best represents its respective broad asset class. Returns shown are net of fund fees for and do not necessarily represent performance of specific mutual funds and/or exchange-traded funds recommended by Centura Wealth Advisory. The performance of those funds may be substantially different than the performance of broad asset classes and to proxy ETFs represented here. U.S. Bonds (iShares Core U.S. Aggregate Bond ETF); High Yield Bonds (iShares iBoxx $ High Yield Corp Bond ETF); Intl Bonds (Invesco International Corporate Bond ETF); Large Growth (iShares Russell 1000 Growth ETF); Large Value (iShares Russell 1000 Value ETF); Mid Growth (iShares Russell Mid-Cap Growth ETF); Mid Value (iShares Russell Mid-Cap Value ETF); Small Growth (iShares Russell 2000 Growth ETF); Small Value (iShares Russell 2000 Value ETF); Intl Equity (iShares Core MSCI EAFE ETF); Emg Markets (iShares MSCI Emerging Markets ETF); and Real Estate (iShares US Real Estate ETF). The return displayed as “60/40 Allocation” is a weighted average of the ETF proxies shown as represented by: 40% U.S. Bonds, 12% International Stock, and 48% Large Blend.

Disclosure: CCG Wealth Management LLC (“Centura Wealth Advisory”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Centura and its representatives are properly licensed or exempt from licensure. Insurance products are implemented through CCG Insurance Services, LLC (“Centura Insurance Solutions”). Centura Wealth Advisory and Centura Insurance Solutions are affiliated. For current Centura Wealth Advisory information, please visit the Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov by searching with Centura Wealth Advisory’s CRD #296985.

Markets in the summer months are historically sleepy as individuals go on vacation and gear up for a new school year, but the third quarter brought anything but sleep to investors worldwide. Equities were marred with bouts of negative activity throughout the quarter – markets experienced a historic 180% surge in the VIX to an intraday high of 65.7 on August 5, yet, despite the volatility, both stocks and bonds pushed higher to end Q3. The market’s resilience caused the month of September to post its first gain in five years. While initially overreacting to adverse events, markets quickly put them in the rearview mirror as the S&P 500 witnessed the best nine-month start to a year since 1997, which also coincided with the best start to an election year ever, all while registering its 42nd all-time high of the year. The busy quarter witnessed the following:

1. Yen Carry Trade – On the heels of the Bank of Japan’s rate increase announcement, global hedge funds that capitalized on the arbitrage opportunity presented by zero long-term rates in Japan for years, realized the music was about to stop in early August. Quickly unwinding their trades, Japan’s Nikkei stock market experienced the largest single day loss dating back to “Black Monday” in 1987, resulting in a single-day decline of 12.4% on August 5.
2. Softening Labor Market – The Bureau of Labor Statistics announced an 818,000 revision lower for the prior 12-months jobs added through March of 2024. The labor reports for June, July, and August confirmed softening with the revised additions of 118,000, 61,000, and 142,000, respectively.  Every month in the quarter came in below expectations, as the unemployment rate continued to rise – ending at 4.2% through August.
3. Assassination Attempts – Former President Trump survived two assassination attempts in the quarter as the Presidential race picks up steam, further adding to the market’s anxiety amid election uncertainty.
4. Candidate Swap – President Biden dropped out of the Presidential race, paving the way for Vice President Kamala Harris to grab his bid. Since Harris’s party nomination, Democrats have seen a sharp reversal of fortunes, and now hold a slight advantage in the polls as of 10/1.

5. Fed Rate Cut – In line with traders’ expectations — though surprising to many economists and investors — the Fed aggressively cut rates in September for the first time since 2019, front-loading their easing cycle with a 0.50% reduction in their overnight borrowing rate. This led many to question the Fed’s perception of the economy and whether the central bank could manufacture a soft landing and avoid a recession.
6. Port Strike – As of 12:01 am Eastern Standard Time on October 1, a union labor strike forced ports on the Eastern US and Gulf Coasts to shut down, threatening the economy. JPMorgan Chase & Co. anticipate the closures will result in economic losses between $3.8 billion to $4.5 billion per day, and will likely cause supply chain disruptions and perhaps transitory inflation. Oxford Economics projects a week-long strike would take about a month to clear the shipping congestion.
7. Israel-Iran – Iran fired nearly 200 missiles into Israel escalating tensions in the Middle East. Israel cited it would retaliate, and this pledge caused Gold (GLD) prices to reach record highs, a U.S. stock market sell off, losses in Crude oil (USO), and a gain in defense sectors.

In face of the strife and a broadening out in earnings growth, the Fed signaled the start of its easing cycle in July, pointing markets to their first rate cut at the September FOMC meeting. While markets experienced hurdles throughout the quarter, economic growth, fueled by resilient consumer spending, continued to surprise to the upside, and investors chose to focus on these positives, causing both the S&P 500 and bonds, as measured by the Bloomberg U.S. Aggregate Index, to advance more than 5% over the quarter. This solid performance in the face of market angst and during a historically slow period demonstrated that investors’ animal spirits are alive and well.  

Market Recap 

Equities – After contracting 3.62% in the second quarter, rate cut speculation supported higher returns among the profit-hungry and interest-rate sensitive small caps. The Russell 2000 led the way, up 9.27% in 3Q. Lagging their small cap counterparts, the S&P 500 witnessed a broadening out of market participation away from the Magnificent Seven on its way to a 5.89% return for the quarter, and a 22.08% advancement for the year. 
      
Bonds – Amidst moderating yet conflicting economic growth signals, bond yields fell aggressively during the quarter in anticipation of the first Fed rate cut. Entering July, the yield on the 10-year U.S. Treasury dropped sharply from 4.48% to 3.66%, leading up to the looming rate cut in mid-September. Generating fewer headlines over the quarter, the Treasury market continued to grapple with robust U.S. debt issuance and weakening demand for U.S. Treasury securities. We believe supply absorption concerns will likely continue to apply upward pressure on yields, illustrated by yields slightly reversing course to close the month of September. The 10-Year U.S. Treasury closed the quarter at 3.81%. The Bloomberg U.S. Aggregate Bond Index rose 5.20% in the quarter, erasing the negative 0.71% return in the first half of 2024, finishing up 4.45% through September 30.

 Source: YCharts. The Bloomberg US Aggregate Index was used as a proxy for Bonds; the Bloomberg US High Yield 2% Issuer Capped Index was used as a proxy for High Yield Bonds; the Russell 2000 Index was used as a proxy for Small Cap Equities; and the MSCI ACWI Ex USA Index was used as a proxy for Foreign Equities. All returns are based on total return levels as of 09/30/2024.
  
Economic data remains mixed, and base case expectations still call for the Fed to successfully achieve a ‘soft landing’ and avoid recession. However, as the Federal Reserve’s attention shifts from price to job stability, the path of monetary policy will likely be driven by the health of the labor market. 

Economy: The Consumer Surprises 

In contrast with the nation’s revised first quarter GDP growth of 1.6%, which was held down by softer consumer spending of 1.9%, the second quarter surprised to the upside. A lift in personal income fueled a resurgence of consumers’ penchant to spend, as spending jumped to a 2.8% pace, and an 8.3% increase in business investment helped push U.S. growth higher at a 3% annualized pace. Building on the first two quarters of 2024, as of September 27, 2024, the Atlanta Fed’s GDPNow model for Q3 has been revised from 2.9% to 3.1%, indicating a stable, albeit moderating economic growth engine. This revision reflects the sustained trends of a resilient consumer and further business investment, though an economy hindered by negative residential investment.

Unemployment    

August’s Labor Market Report registered the 44^th consecutive month of job gains. Estimates called for 161,000 jobs in August, and the market once again surprised to the downside with the addition of 142,000 jobs and further downward revisions to June and July’s reports to 118,000 and 61,000, respectively. Conversely, the unemployment rate retraced slightly to 4.2%, which is still nearly 1% higher than the 55-year low of 3.4% in April 2023. The deterioration of the labor market has quickly grabbed the attention of the Fed, as softness became evident across several pockets of the economy.  

The Bureau of Labor Statistics announced an 818,000 revision lower for the prior 12-months jobs added, through March of 2024, reflecting weaker job growth than anticipated. Since peaking in 2022, job openings (JOLTs) have continued to trend lower, bouncing around from month-to-month. For example, job openings fell to their lowest level since January of 2021 to 7.71 million in July, only to reverse course back above eight million in August, bringing the ratio of job openings to those unemployed down to 1.13:1. While the ratio of 1.13:1 is above historical levels, the ratio has fallen significantly from nearly two job openings for every job opening in 2022, indicating the labor market is showing signs of tightening. Over the course of the year, the number of open jobs has trended lower, while the number of unemployed job seekers has trended higher, as evidenced by the additional 991,000 unemployed persons from January to August.  

Since the Fed embarked on its tightening journey and increased rates, the strength and resiliency of the labor market gave them confidence to keep rates higher for longer. Ultimately, the Fed would like to see wage growth continue to trend lower from its current, elevated level of 3.83%. Given the slowing pace of hiring and the increase in unemployment figures, labor market stability has become a primary concern for the Fed. Fears surrounding further labor market weakening cast doubt on the Fed’s ability to avoid a recession and produce a soft landing. The surge in late July Unemployment Claims helped fuel the market selloff in early August that witnessed the S&P 500 enter a nearly 10% correction, although claims have since retraced. Unemployment Claims (both Initial and Continuing) are released weekly and provide the most up to date insight on the health of the labor market. As mentioned, Initial Claims have fallen from 250,000 on July 27 to 218,000 on September 21, while Continuing Claims have been range-bound between 1.73 million and 1.87 million since the start of the year. Both of these levels are nowhere near levels seen in prior periods leading up to a recession, though remain important to monitor.

Inflation 

The Fed appears to be in a position to win the war on inflation. However, we would not be surprised to see a few battles lost from month-to-month as pricing pressure moves towards the Fed’s 2% target. All inflation measures are below wage growth of 3.8%, with both of the Fed’s preferred inflation measures (PCE) coming in at 2.7% or lower. Core inflation, as measured by CPI and PCE, remains stickier: core CPI stayed at 3.2% year-over-year, while core PCE saw a slight uptick in August to 2.7%. 

Further evidence of falling price pressures should provide Federal Reserve Chair Jerome Powell the confidence to continue down the path of monetary easing, supporting further rate cuts. Threatening the falling trend in inflation measures are the recent port closures across the Eastern seaboard and the Gulf. We are paying close attention to these closures and hoping for a quick resolution. A prolonged strike could result in serious supply chain constraints, potential price increases for goods, and a slowing in economic output.  

Fed Starts Strong Out of the Gate

The Federal Open Market Committee (FOMC) elected to lower rates by 0.50% (50 bps) at their September meeting, while leaving the size of future rate cuts open. The Fed’s decision to cut rates was largely expected. The surprise centered around the size of the Fed’s cut and the subsequent updates to their Summary of Economic Projections (SEP). This surprise was best illustrated by the Fed’s updated median projection for total rate cuts in 2024, which increased from a mere 0.25% of cuts projected in the June SEP to a total of 1.00% worth of cuts in the September SEP, signaling to markets that interest rates would be cut at a more accelerated pace than initially expected. 

Many expected the Fed to start slow with rate reductions, pointing to the health of the overall economy. A larger cut can indicate the Fed believes the economy is deteriorating quickly and that they waited too long to cut rates; however, the Fed has downplayed this rhetoric, stating that a 50 bps cut was warranted due to the strength the economy has exhibited.  

Source:  US Federal Reserve Summary of Economic Projections, September 2024

The Committee held its projection for 2025 at 1.00% (100 bps) of cuts, indicating a slower pace of change as the Fed adopts a more patient data-dependent position after front-loading their easing in the final four months of 2024. Barring any exogenous event or resurgence of inflation, we believe Powell’s plan is to settle into a predictable cadence in terms of size and timing as we transition into 2025. We believe the Federal Reserve will align further rate reductions with their quarterly meetings and updated Summary of Economic Projections to the tune of more traditional 0.25% policy changes. We fully anticipate the Fed will hit its policy target for 2024 with 100 bps of cuts. However, the question remains whether they will do so in the form of one more 0.50% or elect a more traditional policy change and reduce the terminal rate by 0.25% in November and December: we are in the latter camp.

Centura’s Outlook  

The Fed’s goal to lower inflation to its 2% mandate and avoid recession is still our base expected outcome. However, the Fed will need to monitor the state of the labor market deterioration closely if they are to fully avoid an economic contraction. 

Successfully delivering lower inflation and monetary policy normalization should bode well for equities and bonds, however, as always, there are several potential risks looming and investors should proceed carefully.  

By most measures, the S&P 500 is overvalued. According to FactSet, as of September 27, the forward 12-month Price-to-Earnings Ratio (P/E) is 21.6x, which is higher than both the 5-year and 10-year averages of 19.5x and 18.0x, respectively. Current valuations pose a risk to the market, as negative sentiment can lead to sharper selloffs. Also posing a risk to the overall market is the concentration of the Top 10 largest stocks in the S&P 500. According to JPMorgan Asset Management, the 10 largest constituents represent 35.8% of the index, as of August 31, while contributing to 28.1% of the earnings. Concentrations of this magnitude make the index vulnerable to significant changes stemming from those underlying companies, which is one of several reasons we favor global diversification across a multitude of asset classes – both public and private.

In the face of higher borrowing costs, corporate profits remain resilient, illustrated by the fourth consecutive quarter of positive earnings growth by the S&P 500, rising 5.1% in the second quarter. As of September 27, FactSet estimates third-quarter earnings to expand at a slower pace, only advancing 4.6% year-over-year. We are encouraged by the positive earnings growth trends, though the second quarter saw investors punish negative earnings surprises more than they rewarded positive beats. Relative to the five-year average, stocks that beat earnings guidance in 2Q rose less (0.9% vs. 1.0%), while those companies that missed guidance fell nearly double the 5-year average (-4.3% vs. -2.3%), indicating the market appears overvalued, and investors are overreacting to news and resetting expectations.

Source: FactSet Earnings Insight

Since 2023, the Magnificent Seven have been responsible for most of the market’s earnings growth, increasing 31%, versus the 4% contraction of the remaining 493 companies’ earnings in the S&P 500 last year. While third quarter earnings for the 493 companies are expected to be flat for 3Q, we remain optimistic by the fact that JPMorgan is expecting the remaining companies outside the Magnificent Seven to catch up and accelerate earnings throughout the remainder of the year. Both the Magnificent Seven and the S&P 500 ex-Mag Seven are expected to experience double-digit year-over-year earnings growth in the fourth quarter of 21% and 13%, respectively. A broadening of earnings growth should bode well for increased market breadth and carve a path for higher broad-based returns on equities, outside of the Magnificent Seven. 

Source: JPM Asset Management Guide to the Markets

Persistent, elevated rates will continue to cause issues for certain companies, such as small caps, though earnings are expected to grow broadly through the remainder of 2024 and 2025; the Fed’s pivot to lowering rates should alleviate some of the pressure on company financials. 

While equities generally produce positive returns during election years, we expect volatility will likely increase as we approach the election through October and early November. The recent political turmoil has created a great deal of market uncertainty, particularly given the differing policy initiatives of both candidates. In the face of uncertainty, we generally avoid making changes to investment portfolios in advance of an election, as the policy expectations could change greatly. Markets tend to rally once the election has concluded. We encourage clients to avoid making rash decisions and stay invested, as we are strong believers that long-term investment outcomes are improved by time in the market, rather than timing the market. We suggest investors concerned with historical market behavior leading up to, and after an election, listen to the podcast we recorded with Michael Townsend, Managing Director, Legislative and Regulatory Affairs at Charles Schwab & Company.

The stock market’s resilient momentum, a more favorable rate environment, a potential post-election rally, and expected earnings growth all serve as potential tailwinds to push equities to further highs. However, a fair amount of uncertainty and risks pose headwinds for markets. Outside of further labor market deterioration or a resurgence of inflation leading to a Fed policy misstep, significant geopolitical risks are present and could result in additional volatility, especially if there are escalations in the Middle East, Eastern Europe, or China. For instance, on October 1, Iran fired nearly 200 missiles into Israel escalating tensions in the Middle East. Israel cited it would retaliate, and, as a result, Gold (GLD) prices reached record highs, U.S. stocks sold off, Crude oil (USO) experienced losses, and investors flocked to safe haven investments and sectors.

Real estate tends to be an interest rate-sensitive asset class; as rates continue to move lower, we anticipate a pick-up in activity and a subsequent reversal of valuations over the next several years. We may not have found the bottom of the real estate market cycle quite yet, though based on improving fundamentals and discussions with our real estate partners, we may be bouncing off the bottom, from a valuation adjustment perspective. Access to nearly-free credit post-pandemic resulted in record numbers of new construction, particularly in commercial real estate sectors like multifamily and industrials. As a result of the Fed’s rate hiking cycle, those new constructions screeched to a halt as the cost to borrow and build has been unfeasible. However, 2024 is still expected to deliver more than 650,000 multifamily units, the most since 1974. Like most goods, price is determined by supply and demand, and real estate is no different. Currently, demand, or absorption, is failing to keep pace in multifamily, applying downward pressure on rents. Furthermore, new higher-quality inventory generally attracts higher rents, forcing older vintage properties to offer rent concessions to remain competitive and applying downward pressure on net operating income (NOI). On the opposite side of the ledger, expenses have outpaced income, particularly the cost of insurance and labor. 

We believe we are approaching the light at the end of the tunnel. While valuations may trend sideways over the next 12-18 months, we are optimistic that increased activity resulting from lower interest rates, combined with supply concerns evaporating as we enter 2026 and few-to no new construction starts, should bode well for private real estate in the long-term, with 2024 and 2025 vintages potentially producing strong results at disposition. We continue to remain extremely cautious and selective, focusing on select submarkets, signs of possible distress, and attractive risk-adjusted returns.

Private equity, particularly lower middle market buyouts, appears to have stabilized, potentially presenting attractive investment opportunities relative to public market alternatives. Current yield levels still present challenges for private equity valuations, though, like real estate, lower rates should lead to increased exit activity and higher valuations moving forward. With limited private equity exit opportunities since mid-2022 and our expectation for increased activity, we favor managers specializing in co-investments, GP-led secondaries, and late-stage primaries that offer the potential for superior risk-adjusted returns in this environment, a potentially quicker return of capital, and generally lower fee structures. 

Private credit is predominantly floating and tied to a base rate such as the Secured Overnight Financing Rate (SOFR) and closely linked to the Fed Funds overnight rate, as such the asset class has benefited from the Fed’s restrictive monetary policy, though we believe the asset class remains attractive. However, yields on private credit will start to come down as the Fed continues to cut rates, though with a lag to the Fed’s timing as the floating rate on private loans does not adjust immediately. Rather, there is a delay before the loan terms reset lower. Should our Fed rate path expectations prove accurate, we expect private credit to continue to produce a high level of income, particularly on a relative basis.

While the third quarter brought both hurdles and strong market performance, we remain laser-focused on long-term objectives and minimizing volatility in the short-term amidst this data-dependent backdrop. 

Thank you for your continued confidence and support. If you have questions or concerns, please contact your Centura Wealth advisor.     

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.  

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.   

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.  There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.  

Centura Wealth Advisory is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Centura Wealth Advisory and its representatives are properly licensed or exempt from licensure. 12255 El Camino Real, St. 125, San Diego, CA 92130.  

After experiencing zero in 2023, the S&P 500 took more than two years before making a new all-time high. Fast forward to the end of the first quarter, witnessing the S&P 500 march its way to 22 new all-time high levels, on pace for the most ever. While much uncertainty surrounding monetary policy still exists, the equity markets brushed off the noise, experiencing minimal volatility. The quarter’s maximum S&P 500 drawdown of -1.7% would mark the smallest drawdown in history if the year ended as of March 31. Even gold and Japan’s stock market joined the all-time highs party, with the latter doing so for the first time since 1989.

Unlike recent quarters, chinks in the armor of the Magnificent 7 appeared to form, as three of the seven constituents (Apple, Alphabet, and Tesla) failed to outpace the broad index return of 10.8%. Ten of the eleven S&P sectors turned in a positive return. On the other hand, Nvidia continued its AI-fueled meteoric ride on way to a Q1 return of more than 82%, and we witnessed a reawakening of the meme stock mania as traders poured into the Reddit Inc., Trump Media, and Technology IPOs.

A year removed from the collapse of Silicon Valley Bank, we were reminded of the stress that higher rates have applied to the balance sheets of small and regional banks. New York Community Bank reported surprise losses on their multifamily commercial real estate loan portfolio, reminding investors that there could still be another shoe to drop. Regional banks tend to have a very large percentage of commercial real estate loans on their books, with many experiencing a high number of defaults, though the market quickly shrugged off the news and risks. 

Highlighted last quarter, we felt the bond market got ahead of itself and overpriced the timing and magnitude of Fed rate cuts. Entering 2024, the market anticipated the U.S. central bank would cut six times, resulting in a projected 1.50% (150 basis points) in rate reductions, starting as early as March. As the market reassessed the Fed’s rhetoric and repriced their expectations, market yields for longer dated bonds rose sharply by 0.46% before the 10-Year U.S. Treasury rate settled and ultimately ended the quarter at 4.20%.  

Market Recap

Equities – 2023 witnessed a positive correlation between yields on longer dated bonds and equity prices, which resulted in higher equity levels as yields fell and downward pressure as yields rose. This was particularly highlighted over the final two months of 2023, when the yield on the 10-Year U.S. Treasury fell from nearly 5% to 3.88% and ignited the ‘everything rally.’ The largest benefactors were asset classes like small caps and technology, which tend to be the most sensitive to higher interest rates. In contrast to last year, 2024 has seen a significant decoupling of the relationship between equities and bond yields. Fueled by AI-driven enthusiasm, expectations of Fed cuts, and unexpectedly robust earnings, the S&P 500 surged 10.8% for the quarter. This performance marks the best first quarter for the U.S. large-cap index since 2019, delivering consecutive quarters of double-digit returns.

Conversely, higher yields continue to plague smaller companies with today’s higher cost of debt marring their outlook. As the market reassessed monetary policy and rates rose in the first quarter, the small-cap Russell 2000 index experienced turbulence to start the year, but ultimately eked out a 5.18% YTD return. 

With a ‘soft landing’ to ‘no landing’ all but expected, the market appears to have accepted the Fed’s latest projections and are closely observing economic data for signals the Fed has the green light to lower rates. As important indicators surrounding inflation, jobs, and overall economic health flood the market, we expect the market to continue reacting counterintuitively to good news, treating it as bad news, while reacting to bad news as though it is good news. Should core inflation remain sticky and economic data remain strong, we would not be surprised to see volatility return as investors start to extend expectations surrounding a June Fed pivot. 

Bonds – As yields reversed course, bonds kicked off 2024 adding to their multi-year downward trend. With stronger-than-expected economic data and Fed uncertainty, the market repriced Fed expectations and the yield on the 10-Year U.S. Treasury shot from 3.88% to as high as 4.34% in mid-March. While the market has appeared to reprice monetary policy changes, robust U.S. debt issuance and the demand for U.S. Treasury securities continues to wane, failing to absorb supply and applying upward pressure on yields, exemplified by the Bloomberg U.S. Aggregate Bond Index falling 0.78% over the quarter.

Source: YCharts. The Bloomberg US Aggregate Index was used as a proxy for Bonds; the Bloomberg US High Yield 2% Issuer Capped Index was used as a proxy for High Yield Bonds; the Russell 2000 Index was used as a proxy for Small Cap Equities; and the MSCI ACWI Ex USA Index was used as a proxy for Foreign Equities. 

With stronger economic data, base case expectations call for the Fed successfully achieving a ‘soft landing’ and avoiding recession. However, as data has continued to surprise to the upside, many growth metrics continue moderating. 

Economy: The Consumer starts slowing 

After avoiding the widely anticipated recession of 2023, and growing approximately 2.5%, the U.S. economy continues to grind higher at a moderate pace. As of March 29, 2024, the Atlanta ‘Fed’s GDPNow model for the first quarter is projecting growth of 2.3%, with the largest contribution expected to come from consumer spending, once again, and net exports expected to detract from growth. 

Despite higher borrowing costs, the U.S. continues to outperform its global peers, largely due to a stable labor market that has consistently produced wage increases outpacing inflation for 10 consecutive months, through February. March’s labor report is due Friday, April 5 and wages are expected to continue to outpace pricing pressures for an 11th straight month, further supporting consumers’ ability to spend. 

Unemployment 

February’s Labor Market Report registered the 38th consecutive month of job gains. Estimates called for 198,000 jobs in February, and the market surprised to the upside with the addition of 275,000 jobs, though unemployment jumped 0.2% to 3.9%. 

February’s unemployment rate also marked the 27th consecutive month unemployment has held below 4%, which is the longest streak since the 1960s. The labor market continues to post robust results. While trending lower since peaking in 2022, job openings (JOLTs) have been a mixed bag from month-to-month, and still remain elevated at 8.86 million. This brings the ratio of job openings to those unemployed to 1.371. While the ratio of 1.37:1 is still considered elevated above levels historically witnessed, the ratio has fallen significantly from nearly two job openings for every job posting in 2022. This indicates slack is working itself out of the system and the labor market is showing signs of tightening. The number of open jobs has fallen, while the number of unemployed job seekers has trended higher, as evidenced by the additional 334,000 unemployed persons from January to February.  

For now, the strength and resiliency of the labor market has given the Fed the confidence to keep rates higher for longer. However, sticky wage growth continues to give the Fed anxiety, as this metric has been effectively stuck around 4.3% since October 2023. While persistent and elevated wage growth brings fears of an inflation resurgence, any break below the 4% threshold would temper those fears and be well received by the Fed.

Inflation 

The Fed appears to be winning their battle against inflation, as pricing pressures look to be tamed and headed towards the Fed’s 2% target – though it is still too early for the Fed to declare their victory lap. On the surface, all major inflation readings reside below 4%, with both PCE readings printing below 3% over the last year, through February. 

Shelter and gasoline represented approximately 60% of the monthly gain in Headline CPI in February, with additional pricing pressure from used cars, apparel, motor vehicle insurance, and airfares at the highest levels since May 2022. Boeing woes are forcing airlines to cut their flight capacity and we expect further pricing pressure on air travel over the next several months. Additionally, we anticipate continued upward pressure on energy prices, leading to volatility on the headline CPI numbers as we progress through the summer months.

Just as elevated wage growth remains troublesome to the Fed, the stickiness of core services, particularly shelter costs, supports their decision to exercise patience before cutting rates. The rolling three-month core CPI is running at an annualized rate of 4.2%, which is the highest since June 2023. 

Too Soon to Pivot

Defying market expectations of a March rate cut, the Fed met twice in the first quarter and left rates unchanged, illustrating their unflagging commitment to bring inflation back to its long-term target of 2%. Since initiating rate increases in March 2022, the Fed raised rates eleven times, bringing the target range for the Fed Funds rate to the current range of 5.25% to 5.50%. During this period, Fed Chair Jerome Powell has also been reducing the Fed’s balance sheet by $95 billion per month, resulting in a decrease in assets of nearly 16.5%, or approximately $1.48 trillion, since its peak in April 2022.  

The Federal Open Market Committee (FOMC) elected to keep rates unchanged in March for the fifth consecutive meeting. While the Fed’s decision was largely expected, the big news was the Fed’s changes, or lack thereof, to their Summary of Economic Projections. Of particular interest was their median projection for rate cuts, which policymakers held unchanged at three cuts in 2024. Only two Fed officials projected no cuts in 2024, while two anticipated only two cuts. Only one member voted in favor of more than three rate cuts in 2024, signifying a stark contrast to the Fed’s December 2023 projections where five members anticipated more than three cuts in 2024. We also saw the Fed lift economic projections, like GDP, for 2024, while also increasing their 2024 inflation expectations and revising their 2025 path of rate normalization.

Powell recognized that inflation has been stickier than anticipated the last couple of months, though the latest data “haven’t really changed the overall story, which is that of inflation moving down gradually on a sometimes-bumpy road towards 2%.” He further reiterated “we’re not going to overact…to these two months of data, nor are we going to ignore them.”

Source: US Federal Reserve Summary of Economic Projections, March 20, 2024

Barring any resurgence of inflation, we believe the Fed has finished its rate-hiking campaign and are nearing their first rate cut. Given the Fed’s steadfast commitment to bringing inflation down, our base case assumptions from the last several quarters have not changed. We continue to believe the earliest the Fed will cut rates is June, which now aligns with current market expectations. However, any prolonged stickiness or resurgence of inflation would likely push our expectations for rate cuts into the third quarter of this year.

Centura’s Outlook

The Fed’s goal to lower inflation back to its 2% mandate and avoid recession is now the base outcome expected by the Fed and most market participants. The successful delivery of lower inflation and Fed policy normalization should bode well for both equities and bonds. However, we continue to believe the market appears priced to perfection, and investors should proceed with caution as any resurgence or sustained stickiness of inflation could result in monetary policy uncertainty and lead to bouts of market angst or volatility. 

In the face of higher borrowing costs, corporate profits have remained surprisingly resilient as the S&P 500 posted positive earnings growth for the second consecutive quarter in the fourth quarter of 2023, rising 4.2%. Interestingly, those companies with more than 50% of their revenue generated outside of the U.S., generated better profits than companies generating most of their profits domestically. As margins continue to face pressure, FactSet has witnessed revisions for first quarter earnings, dropping from 5.8% on December 31 to 3.6% as of March 28. 

Source: FactSet Earnings Insight

Forward 12-month P/E ratios are approximately 20.9x, above both their five-year and ten-year averages of 19.1x and 17.7x, respectively. This indicates that equities are slightly overvalued and thus priced to perfection. For further confirmation, the earnings yield relative to the yield on the 10-Year U.S. Treasury also indicates that equities are relatively valued today, as the S&P 500 earnings yield (Earnings/Price) is 4.30%, compared to the yield of on the 10-Year U.S. Treasury of 4.33% as of April 1. 

The market remains too dependent on the Fed, which has become dependent on poor economic data; with worsening conditions, the more likely the Fed is to pivot and cut rates sooner. However, we believe economic activity will continue to surprise to the upside, realistically extending the timing of the widely anticipated rate cut. Should expectations shift from June to later in the year, we would expect markets to react negatively, and volatility would ensue.

We entered the year with our allocations aligned with our long-term targets. While higher rates will continue to cause issues for some companies, earnings are expected to grow from 2023 levels in 2024. While equities generally produce a positive return during election years, we expect volatility will likely increase as we approach the election in the third and fourth quarters. However, the improving market breadth, as evidenced by the roughly 70% of S&P 500 companies trading above their 200-day moving averages, gives us optimism that markets should continue to grind higher. Outside of Fed policy-related market volatility, we are more fearful of potential exogenous events that are harder to predict.

As expected, yields rose to start the year as the market repriced its expectations surrounding Fed rate cuts. When yields reversed higher, we took the opportunity to further extend the duration of our fixed income allocations. While the path may be bumpy, ultimately, we believe yields should continue to grind lower over the course of the year, presenting attractive opportunities to produce asymmetric returns in bonds. Extending duration should allow investors to clip an attractive yield, while also providing them with the opportunity to experience capital appreciation for a total return exceeding what they will clip sitting in money market funds or short-term Treasury bills.

Elevated interest rates continue to punish private real estate returns, with further slight downward valuation adjustments expected from their previous marks. Real estate is an interest rate-sensitive asset class, meaning as rates move lower, we anticipate a pick-up in activity, and a subsequent reversal of valuations over the next several years. While we believe we are nearing the light at the end of the tunnel for several real estate sectors like multifamily and industrial, unfortunately, we believe more pain will be experienced, particularly with the underlying debt that real estate operators hold. There is a reason S&P Global just downgraded five regional banks based on their commercial real estate loan exposure. Like S&P Global, we anticipate a pickup in defaults across several real estate sectors, which will likely result in further pain across both public and private markets. 

Private credit presents an opportunity to earn attractive returns, given private credit is predominantly floating and tied to a base rate such as the Secured Overnight Financing Rate (SOFR), closely linked to the Fed Funds overnight rate. Yields on private credit should remain at their current levels until the Fed begins to cut rates. Even as the Fed cuts rates, the floating rate on private loans does not adjust immediately. Rather, there is a delay before the loan terms reset lower, typically every three months. Barring a catastrophic event, the Fed is likely to lower rates more methodically than they hiked them, supporting higher yields in private credit. Fortunately, private companies have weathered the elevated rate storm better than anticipated. As Cliffwater recently shared with us, borrowers demonstrated strong performance, as evidenced by the 15% year-over-year revenue growth and 13% EBITDA growth. Lower rates should support improved health of borrowers and support attractive returns, relative to traditional fixed income going forward. Combining traditional bonds with private credit should produce a balanced and diversified approach toward income production and total return in 2024. 

Thank you for your continued confidence and support. If you have questions or concerns, please contact your Centura Wealth advisor.   

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. 

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.  

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such. 

Centura Wealth Advisory is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Centura Wealth Advisory and its representatives are properly licensed or exempt from licensure. 12255 El Camino Real, St. 125, San Diego, CA 92130.  

Move over, FAANG! The Magnificent Seven have taken over the markets. Representing the seven largest companies in the S&P 500, Alphabet, Apple, Meta, Microsoft, Amazon, Tesla, and Nvidia have been anointed by investors as leading the market and tech rally. 

The first half of 2023 was powered by mega-tech stocks, with the rest of the companies in the S&P 500 contributing an incremental amount to the indices’ return. The NASDAQ Composite registered its strongest first-half performance in 40 years, with Apple stock paving the way for an all-time high closing price on June 30, 2023 of $193.97, becoming the world’s first $3 trillion company. 

Like the dot-com euphoria, artificial intelligence (AI) has offered tailwinds for the tech industry. AI has sparked big investments by companies and investors wanting to capitalize on the Generative AI race. Meanwhile, the June 1st debt ceiling ‘deadline’ was practically a non-event. The final agreement passed by the House and Senate suspended the debt limit until after the next presidential election and restricted government spending through 2025. However, that hasn’t stopped them from increasing the deficit. As the markets look past signs of economic cooling, indices push higher in the year’s second quarter.

Market Recap  

Equities – The Fed has remained steadfast in its fight against inflation, and the prospects of higher interest rates for longer have been unable to derail the tech-heavy NASDAQ 100 momentum, on its way to a second quarter return of 15.16%, bringing the index’s 2023 return to 38.75%.  

Driven primarily by the returns of the index’s largest constituents, the S&P 500 has rebounded more than 20% since bottoming in late 2022, joining the bull market rally with the NASDAQ 100. Higher rates coupled with tighter financial conditions and more stringent lending standards have dampened the outlook for smaller companies. The small-cap Russell 2000 index has only gained 7.24% for the year, more than half of that occurring in the last week of the quarter. 

While market participants expect the Fed to continue lifting rates and no longer anticipate a pivot this year, recent economic data and stronger earnings have given bulls optimism that a recession might be avoided. For now, with an eye on the future, it appears the market is discounting the lagged impact of monetary policy; gravitating to AI-centric companies; pushing interest-rate-sensitive equities higher; and creating a larger gap between market technicals and economic fundamentals.

Bonds – Bonds, on the other hand, have been sending conflicting signals. Driven by fears of a US government default and potential Fed-induced recession, bond volatility continued in the year’s second quarter, posting a -0.84% return; bringing the overall return on bonds to 2.09% in 2023.  The current climate reminds us that while investing in ‘safe-haven’ Treasury securities removes credit risk, investors are still very much exposed to interest rate risk and ensuing volatility from changes in yields. Experiencing swings ranging from as high as 4.10% to as low as 3.37%, the yield on the 10-Year U.S. Treasury Note sits at 3.81%, or a mere 0.07% below where it started the year.  

 Source: YCharts. The Bloomberg US Aggregate Index was used as a proxy for Bonds; the Bloomberg US High Yield 2% Issuer Capped Index was used as a proxy for High Yield Bonds; the Russell 2000 Index was used as a proxy for Small Cap Equities; and the MSCI ACWI Ex USA Index was used as a proxy for Foreign Equities.

Despite declines in economic growth and activity, the economy has remained resilient as economists contend whether we are currently in or headed towards a recession.

Economy: What recession?

The economy continues to defy expectations and march higher in an environment with one of the most anticipated recessions in history. The last week of June delivered the final revisions to first-quarter GDP growth from 1.3% to 2%. Major gains came from robust consumer spending and surging exports, likely supported by the nearly 9% cost-of-living adjustment for Social Security participants. The 4.2% rise in consumer spending, as measured by personal consumption expenditures, was the fastest pace since the second quarter of 2021, and exports rebounded sharply, up 7.8%.  

While Real GDP may be growing at a decent pace, several indicators point towards further contraction or possible recession.   

May marks the 14th consecutive month that the Conference Board’s Leading Economic Index (LEI) contracted, an early indication that a recession is all but certain. Senior Manager of Business Cycle Indicators at The Conference Board Justyna Zabinska-La Monica said: 

“The US Leading Index has declined in each of the last fourteen months and continues to point to weaker economic activity ahead. Rising interest rates paired with persistent inflation will continue to further dampen economic activity. While we revised our Q2 GDP forecast from negative to slight growth, we project that the US economy will contract over the Q3 2023 to Q1 2024 period. The recession likely will be due to continued tightness in monetary policy and lower government spending.”    

While Treasury Secretary Janet Yellen, President Joe Biden, and the Fed all believe a recession will be avoided, the question is not whether we will enter a recession but, rather, when and how deep the recession will be.

Inflation & Interest Rates  

April and May’s headline Consumer Price Index (CPI) came in at 4.93% and 4.05%, respectively, while core CPI (excluding energy and food) registered 5.54% and 5.33% year-over-year readings over those same periods. The persistence of pricing pressure on core services, particularly shelter, has proven problematic. Shelter represents about 1/3 of CPI and has remained elevated, increasing 8% over the last year. Although the Fed’s restrictive monetary policy appears effective in bringing year-over-year inflation off its June 2022 peak of 9.06%, price pressures have proven painstakingly resilient and remain elevated more than the Fed prefers.  

On a positive note, rents are coming down and home prices are off their June 2022 peak, indicating lower inflation readings ahead. While the downward trend in CPI is reason for optimism, we are more concerned with the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE), which has remained relatively flat at 4.62%, the same level reported in December 2022.  

As highlighted in the previous quarterly market overview, uncertainty regarding the Fed’s inability to dampen inflation while avoiding an economic contraction has led to an almost certain harbinger of a recession: an inverted yield curve. Inverted yield curves occur when yields on longer-dated bonds are lower than yields on short-term notes and have proven to be solid predictors of recessions. 

Debt ceiling negotiations, or lack thereof, consumed headlines through June. While the negotiations were essentially a non-event, one of the most meaningful outcomes has been the US government’s subsequent issuance of new debt since June 5th, which received little recognition in the media.   

It was anticipated that a whopping $1 trillion of new Treasury securities would be issued by the end of the third quarter. Surprisingly, those estimates were off. The U.S. Treasury has already issued approximately $800 billion of new debt in less than a month, pushing the nation’s deficit beyond $32 trillion. Issuance of new securities serves as additional quantitative tightening to support higher yields and may lead to an equity pullback and widening of credit spreads according to both Citigroup and JPMorgan.

Don’t Expect a Pivot

True to their word, the Fed is committed to doing whatever is necessary to bring inflation back to its long-term target of 2%. In March 2022, the Fed embarked on its current Quantitative Tightening (QT) cycle, resulting in ten consecutive rate hikes over fifteen months and a federal funds rate of effectively 0% to 5%. During this period, Federal Reserve Chairman Jerome Powell additionally led the $95 billion per month balance sheet reduction, shedding approximately $625 billion since assets peaked in April 2022.

June’s Federal Open Market Committee (FOMC) meeting marked the first time since March last year that the FOMC voted not to hike rates further. The decision was telegraphed and highly anticipated. The Fed also conveyed that they are likely not finished raising rates, further tightening is likely required to lower inflation, and their June decision should be considered nothing more than a pause.  

June’s FOMC release and updated economic projections showed a target peak Fed Funds rate of 5.6%, indicating another 0.50% of increases in 2023. Following the Fed’s June decision and updated Dot Plot, the market finally accepted our base case and what the Fed has been saying all along: rates will remain elevated to ensure inflation is under control. Barring a catastrophic event, no Fed pivot is expected in 2023. The first rate cut is now expected in early 2024.  

Source: Federal Reserve

Unemployment  

One of the Fed’s primary concerns is wage growth. Although wage inflation has been trending lower, it remains elevated at 4.3%, which worries the Fed. Strong wage inflation increases the risk of a wage-price spiral that could prolong elevated inflation. While May’s CPI print showed headline CPI back below wage growth, core inflation measures remain higher, indicating that earnings are not keeping pace with cost-of-living increases.  

The labor market remains robust, despite some conflicting signals. May’s Labor Market Report registered the 29th consecutive month of job gains, though it showed signs of tightening. Estimates called for 195,000 jobs added in May and the market surprised to the upside with 339,000 jobs. Unemployment jumped 0.3% to 3.7%, marking the largest monthly bounce since April 2020. More than 440,000 people entered the unemployment market in May, also matching the largest monthly loss since the onset of the pandemic.  

Surprisingly, as measured by the JOLTS, job openings unexpectedly reversed course and surged back over 10 million. Due to the higher number of unemployed, the ratio of job openings to those unemployed remained relatively flat at 1.65:1.  

Centura’s Outlook

The Fed remains resolute in combatting 40-year high inflation, despite ‘pausing’ for a break, not letting concerns of a potential recession derail its tightening efforts. Interest rates remain at levels not seen since the Great Financial Crisis and will likely move higher over the next couple of months. The Fed’s goal to tighten financial conditions and slow the economy just enough to lower inflation back to their 2% mandate is a move that will likely force a recession.  

Earnings for the first quarter were stronger than expected, leading many to believe higher rates and inflation aren’t wreaking as much havoc as initially feared. However, higher rates for longer periods spells lingering bank liquidity concerns and potential economic recession have prompted analysts to revise earnings forecasts lower.  

According to FactSet, the estimated earnings growth for the S&P 500 in the second quarter has been revised lower from the expected -4.7% in March to -6.8%. If accurate, this would represent the largest decline the index delivered since the second quarter of 2020 of -31.60%.   These negative revisions highlight companies’ challenges in 2023 to produce profits. Given that higher rates are likely to persist, additional pressure may be applied over the coming quarters.    

A company’s ability to service debt is negatively impacted by elevated rates. The road ahead will likely remain a challenge given the increased cost of labor and companies’ struggle to pass increased cost of goods onto consumers.  

Forward 12-month P/E ratios have risen to approximately 18.9, slightly above their five-year average of 18.5. This indicates that equities are slightly overvalued and additional drawdowns may be in store before equities become attractive from a valuation standpoint. When banks kick off earnings season in mid-July, executive managements’ comments on the health of their companies’ and consumers’ balance sheets should prove insightful, particularly as it pertains to banks’ revisions to loan loss reserves. This should provide an indication of the direction and magnitude of companies’ future expected defaults, which we expect to increase.    

Until inflation breaks lower, we remain cautious and anticipate that equities could experience turbulence in the second half of the year, particularly if inflation remains elevated or resurges.  We also believe the market is discounting the impact of the Fed’s aggressive monetary tightening actions. Bankruptcies are quietly rising, and defaults are starting to tick up. As rates go higher, we expect further stress on companies and consumers. 

Conversely, we also recognize that the market is forward-looking, often pricing in future economic recoveries before they occur and that investors are irrationally exuberant. While we do not subscribe to, or make investment decisions based on FOMO (Fear of Missing Out), it exists and can often be the catalyst a market needs to continue to push higher. Through our experience, we have found when a large disconnect between economic fundamentals and market technicals exists, we should consider shifting allocations towards our neutral strategic allocations. 

Like many institutional investors, our cautious outlook has guided our allocations and we remain underweight to respective equity targets in client portfolios. [MT3] [CO4] Our quality bias, which served investors well in the angst of 2022, has served as a headwind in the first half of the year. Given the strength of the equity market recovery since late last year, we began bringing some of our equity positioning back toward our long-term target allocations. We intend to exercise caution while also monitoring opportunities to capitalize on any future market dislocations.    

Our fixed-income allocation has seen a reduction in non-traditional fixed-income investments that served portfolios well, as interest rates rose sharply. With end-of-rate increases in sight, over the last several months, we have been extending duration and increasing the quality of underlying bonds, emphasizing U.S. Treasury and investment grade fixed income securities. At this stage in the cycle, we believe this positioning should provide long-term benefits to portfolios and be benefactors of a ‘flight to quality’ that may ensue with any equity market volatility.   

We continue to succeed in improving returns and reducing risk by incorporating many private and liquid alternative investments into our allocations. Spiking interest rates have impacted private real estate, and we expect additional downward valuation adjustments across many sectors and markets. Our focus on real estate industries possessing a largely favorable supply/demand imbalance, like multifamily real estate, should help mitigate losses relative to other real estate sectors not possessing similar disparities. Despite the expected challenges in the real estate market, we maintain our dedication to exercising patience and selectivity in our decision-making process. For example, we are finding great opportunities in private credit. Most private credit is floating rate, possessing short durations and experiencing lower price sensitivity to spiking interest rates than similar public credit while also delivering a high-level of income production. We are beginning to observe defaults increase in the market, though they remain well below historical averages. With higher rates expected, additional pressure on borrowers’ ability to service debt will be applied. As such, our focus is on partnering with high-quality managers who have a proven track record of reducing loss. While we face significant uncertainties, we remain anchored by our core principles. Thank you for your continued confidence and support. If you have questions or concerns, please contact your Centura Wealth advisor.   

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. 

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.  There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

Centura Wealth Advisory is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Centura Wealth Advisory and its representatives are properly licensed or exempt from licensure. 12255 El Camino Real, St. 125, San Diego, CA 92130.

It is not the strongest or the most intelligent who will survive but those who can best manage change.

-Charles Darwin

Recap

The investment landscape is constantly evolving. 

Over the last 6 weeks, we’ve experienced 3 of the 4 largest US Bank failures in history, with First Republic Bank the being most recent domino to fall. JPMorgan Chase quickly acquired the majority of First Republic’s assets, and assumed the deposits and certain other liabilities of First Republic Bank from the Federal Deposit Insurance Corporation (FDIC) for $10.6 Billion, with FDIC providing 80% loss coverage of First Republic’s single-family residential mortgages for 7 years. The fair value of the single-family residential loans is ~$22 Billion, with an average LTV of 87%.

In previous communications, we stated we did not anticipate further bank contagion following the demise of Silicon Valley Bank and Signature Bank. We have since adjusted our outlook and acknowledge the possibility of more regional banks failing in the near term. While we shift our outlook and advise clients to consider limiting regional bank deposits to FDIC-insured amounts of $250,000 (or your bank’s threshold as several banks possess multiple charters, allowing for more than the standard $250,000 limit), we believe larger national and international banks maintain much more resilient capital structures and controls in place which offer greater safety in deposits. 

Hike rates until it Breaks!

The Fed has an abysmal track record playing their part in several former crises. They generally tighten until something breaks.

The Savings & Loans (S&L) Crisis

In the early 1980s, the Federal Reserve increased interest rates to combat inflation, which made it more expensive for S&Ls to borrow money. Many S&Ls had funded their investments in real estate and other ventures with borrowed funds, so the interest rate hikes increased their borrowing costs and squeezed their profits. At the same time, the S&Ls were offering fixed-rate loans to homebuyers, which meant that they were locked into low interest rates and couldn’t adjust their rates to match the higher borrowing costs. When the real estate market declined in the late 1980s and early 1990s, many S&Ls were left with significant losses and were unable to repay their debts, leading to a wave of bank failures and government bailouts. The historic interest rate hikes contributed to the S&L crisis by increasing borrowing costs for the S&Ls and reducing their profits, which led to risky investments and fraudulent practices^[1] to try to recoup losses. The crisis resulted in the closure of over 700 S&Ls and cost taxpayers over $100 billion in bailout funds.

The Dot Com Crash

From the late 90’s to early 00’s, investors engaged in speculative investing in internet-related companies which led to a market crash. At the time, many of these companies relied on debt financing to fund early expansion. Companies were able to sell ideas to investors through the novelty of the dot-com concept, most of which were unprofitable. 

The Fed’s rate hikes to combat growing inflation pressures made it more difficult for companies to obtain financing and led to a decline in investor confidence, which subsequently followed with a stock market sell-off. Although greed served as the main driver of the crash, the Fed’s hiking cycle served as a catalyst.

The Great Financial Crisis

The hiking cycle of interest rates played a significant role in causing the Global Financial Crisis (GFC) of 2008. In the years leading up to the crisis, the Federal Reserve had lowered interest rates to stimulate economic growth following the dot-com crash and the September 11 terrorist attacks. These low interest rates, combined with lax lending standards, led to a housing boom as many people took advantage of the easy credit to buy homes, invest in real estate, and even take second and third mortgages on their homes. However, in 2004, the Federal Reserve began to raise interest rates to combat inflation stemming from cheap money. This made borrowing more expensive and slowed down the housing market. At the same time, many of the homeowners who had taken out adjustable-rate mortgages (ARMs) found themselves unable to make their payments as the interest rates on their mortgages increased. This led to a wave of foreclosures This, in turn, led to a credit crunch, as banks became reluctant to lend money to each other or to other borrowers, exacerbating the economic downturn. The hiking cycle of interest rates played a key role in causing the GFC by slowing down the housing market, leading to a wave of foreclosures. This, in turn, created a chain reaction of losses and defaults throughout the financial system, ultimately leading to a credit crunch and a global economic downturn.

Current Day

The current hiking cycle of interest rates to combat 40-year high inflation is creating a regional bank crisis. Banking institutions, heeding the Fed’s guidance that inflation was transitory and rate hikes would not occur in the near future, searched for ways to increase yields on excess deposits invested in fixed-income securities. Many banks began increasing duration, reducing convexity^[2], and taking greater interest rate risk to capture a positive return on investments. When the Fed began aggressively increasing interest rates, these investments lost value, and institutions holding these investments began to experience stress on their capital stack. Simultaneously, bank deposits continued to yield nearly zero. Regional banks with the most exposure to these investments have experienced significant outflows, and in some cases, failure. 

Fed tightening cycles tend to have a way of exposing weaknesses formerly masked by easy money environments; similar to the economic environment investors have enjoyed since the GFC.  When the Fed starts raising rates, the impact generally takes months before working through the system and affecting markets.  We’re now witnessing the impact of the Fed’s most aggressive tightening cycle in four decades, and stress is being felt throughout the financial system.

What is happening now, and why did we adjust our outlook?

On Wednesday, May 3rd, the Fed continued its war against inflation and raised the target Federal Funds Rate (FFR^[3]) by 25 bps to a target range of 5.00% – 5.25%. In 14 months, the Federal Reserve has increased rates 10 times, for a total increase of 500 bps.  While the Fed will likely hit the pause button on rate increases in future meetings, they intend to keep rates elevated, adding additional pressure on banks and the debt service on corporate balances sheets.

Unlike their national and international counterparts, regional banks typically have less diversified business lines, less hedging (hedging is quite expensive and requires expertise), and more operational risk. Cracks within the foundation of Regional Banks subsequently began to appear during the current hiking cycle when depositors, unhappy with their meager deposit yield (most savings accounts were yielding <1%, while checking accounts were paying 0.01%) began withdrawing deposits and allocating funds to higher-yielding instruments like US Treasury Bills and money market funds. For example, from Q1 2022 to Q4 2022 (when the hiking cycle began), Money Market Funds total assets grew from 5.032T to 5.223T^[4]. To free up liquid capital to maintain capital adequacy requirements from bank outflows, regional banks were forced to sell financial assets. Most fixed-rate bonds have lost value, forcing these banks to realize losses. Because banks are highly leveraged businesses, it doesn’t take much for a bank to get wiped out if it experiences an exorbitant amount of excess deposits invested in fixed-rate bonds during an extraordinary rising interest rate environment. We saw this with First Republic Bank (FRC).

By providing the concessions to JPMorgan Chase in the FRC deal discussed earlier, the Fed set the blueprint for larger banks to wait for FDIC to seize a failing bank and subsequently purchase the institution for pennies on the dollar. If regional bank failures persist, we anticipate this trend will continue and large banks will be successful in consolidating market share. 

PacWest, a Beverly Hills, California-based bank is working to solicit interest in the sale of its lender finance arm to strengthen its balance sheet. Through May 9th, PacWest subsequently has lost approximately 75% of its value in 2023. Hence why we believe PacWest, among other regional banks are suffering the wrath of the Fed and lack of consumer confidence.  

We continue to monitor the situation closely and assess possible contagion to other sectors of the economy.  We do not believe that regional banks are out of the woods quite yet as they are one of the primary lenders to commercial real estate operators, and we expect that they will remain under pressure as they look to navigate the billions of dollars in maturing commercial real estate loans this year and next.  At the current level of interest rates, we expect to see defaults across commercial real estate increase in the coming quarters, particularly for those operators using primarily floating-rate debt to finance their operations.

Further, we recommend clients review their banks’ FDIC limits and proceed with caution if choosing to hold cash above the insured amounts.  While many banks have started to increase the rate they pay on savings accounts, we would still caution against holding above-insured limits, and encourage clients to explore options such as holding excess funds in investments like Treasury Bills, government-backed money market funds, or even brokerage CDs to name a few.  We are happy to discuss which options would be optimal for you.  We encourage you to reach out to your advisor to make appropriate changes.  

If you have any questions, please do not hesitate to contact us. 

[1] One example of Securities fraud was the chairman of Lincoln Savings and Loan, Charles Keating. Keating used his position and influence to engage in fraudulent practices that ultimately led to the collapse of Lincoln Savings and Loan. He convinced depositors to invest their savings in high-risk junk bonds issued by his own company, American Continental Corporation (ACC), which was the parent company of Lincoln Savings and Loan. Keating misrepresented the quality and risks associated with these bonds, assuring investors that they were safe and would provide high returns. In reality, these bonds were high-risk and lacked sufficient collateral. Keating used the funds from these investments for personal gain, supporting an extravagant lifestyle and making political contributions.

[2] Convexity is a measure of the curvature in the relationship between bond prices and interest rates. It reflects the rate at which the duration of a bond changes as interest rates change. Duration is a measure of a bond’s sensitivity to changes in interest rates. It represents the expected percentage change in the price of a bond for a 1% change in interest rates.

[3] Federal Funds Rate. The target interest rate range set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

[4] Taken from Fred Economic Data

General Disclosures

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

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