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 rising more than 10% in the first quarter of 2024, the S&P 500 stumbled out of the gate in the second quarter. The index contracted more than 4% in April and produced the first negative month of the year as the market reassessed the timing of the Fed’s first rate cut. While the Fed’s higher for longer mantra has not changed, they are stressing their dependence on data, which has proven mixed. The market, on the other hand, has become Fed-dependent, placing great emphasis on each major economic reading, primarily inflation, labor, and economic production. With hopes that the Fed will initiate rate cuts sooner, the market applauds lower inflation and negative growth signals, like a slowing economy or consumer spending. Conversely, traditionally well-received data points, such as a robust and resilient labor market, can trigger market selloffs. This counterintuitive reaction occurs because positive economic news suggests that the Federal Reserve might delay its first rate reduction, extending the timeline for monetary easing.

Following two positive reports that inflation is trending lower, the S&P 500 witnessed solid rebounds of 4.80% and 3.47% in May and June, respectively, driven primarily by gains in Big Tech stocks. With hopes of an early rate cut, the equity markets continued to fuel the Nvidia-led AI frenzy. The sustained AI rally is heavily influenced by expectations surrounding the timing of monetary policy adjustments.

In line with the April selloff in equities, bonds saw the yield on the 10-year US Treasury whipsaw 0.37% higher, from 4.33% to 4.70%, before peaking on April 25. Like their equity counterparts, longer-dated bonds have become too reliant on the path of monetary policy, with return expectations tied to the timing of the Fed’s first cut. As the Fed provides clarity on their path forward, yield volatility should ultimately subside, leading to more stable outcomes. Until then, we expect continued bond volatility.

Market Recap

Equities – Unlike the ‘everything rally’ that closed out 2023, where small caps and technology stocks – both sensitive to elevated interest rates – were the largest benefactors, 2024 has witnessed further decoupling amongst asset classes. Any projected rate cut speculation has tended to support higher returns by the Magnificent Seven and technology stocks, though small caps have lagged behind. Small caps, measured by the Russell 2000, produced only about half the return of their large cap counterparts in the first quarter. The second quarter witnessed smaller companies contract -3.62%, bringing the year-to-date gains to a paltry 1.02%. Meanwhile, the S&P 500’s price advances for the second quarter was 3.92%, bringing the index’s return for the year to 14.48%.

Bonds – As yields reversed course, bonds kicked off the quarter in the red, 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 rose sharply.  As inflation readings and consumer spending data continued trending lower, the market again reassessed their rate cut projections, sending the 10-year U.S. Treasury yield back to 4.2% and bringing the bond index back into positive territory for 2024. The Fed’s messaging that it needs to witness several months of sustained data before feeling comfortable lowering rates prompted another yield reversal upward with the 10-Year U.S. Treasury closing the quarter at 4.36%. While the market has appeared to reprice monetary policy changes, robust U.S. debt issuance and the demand for U.S. Treasury securities remains relatively weak, failing to absorb supply and applying additional upward pressure on yields. The Bloomberg U.S. Aggregate Bond Index rose by a modest 0.7% in the quarter, while it declined -0.71% for 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.  All returns are based on price returns as of 06/30/2024.

Though economic data remains mixed, base case expectations still call for the Fed to successfully achieve a ‘soft landing’ and avoid recession. However, many growth metrics continue to moderate, leading many to question the Fed’s decision to keep rates elevated for longer.

Economy: The Consumer continues to slow

After growing approximately 2.5% in 2023, the U.S. economy continues growing at a moderate pace. Driven primarily by softening consumer spending, the first quarter of 2024 GDP grew 1.4%. Reflecting an uptick over the first quarter, as of July 2, 2024, the Atlanta ‘Fed’s GDPNow model for Q2 has been revised from 2.2% to 1.7%. This revision is primarily due to lower projections for consumer spending and net exports, which have contracted from the initial growth forecast.

Source: Atlanta Fed GDPNow

The combination of unwavering spending in the face of rising prices and a robust labor market has underpinned the strong economic growth of recent years. However, with the $2 trillion of pandemic savings now exhausted as of March, household debt has reached record levels, and delinquencies are beginning to mount, threatening the sustainability of the nation’s growth. Despite elevated borrowing costs, the consumer continues to spend, albeit at a slower pace, thanks in large part to a strong labor market, producing wage increases that have outpaced inflation for more than a year. While the market is hoping for the labor market to soften and result in an earlier Fed rate cut, too much labor market deterioration could result in further spending reductions, ultimately leaving little room for the Fed to thread the needle and both produce a ‘soft landing’ and avoid a recession.

Unemployment    

June’s Labor Market Report registered the 42nd consecutive month of job gains. Estimates called for 200,000 jobs in May, and the market once again surprised to the upside with the addition of 206,000 jobs. On the other hand, the unemployment rate edged up slightly to 4.1%, the highest level since October 2021.

The labor market continues to post robust results. While trending lower since peaking in 2022, job openings (JOLTs) surprisingly broke its three-month trend of fewer job openings in May. They reversed back above eight million (8.14 million), bringing the ratio of job openings to those unemployed to down to 1.22:1. While the ratio of 1.22:1 is still elevated above levels historically witnessed, the ratio has fallen significantly from nearly two job openings for every job posting in 2022, indicating 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 687,000 unemployed persons from January to May.

For now, the strength and resiliency of the labor market have given the Fed the confidence to keep rates higher for longer. However, the data point that is giving the Fed continued anxiety is wage growth. Despite falling below the key level of 4% in April for the first time since 2021, wage growth has exhibited stickiness and has been hovering around the 4% threshold, rising 4.1% and 3.9% year-over-year in May and June, respectively. While wage growth outpacing inflation bodes well for continued consumer spending, prolonged, elevated wage growth raises concerns about a potential resurgence in inflation. Several readings below the 4% threshold would certainly be welcomed by the Fed.

Inflation

On the surface, all major inflation readings have fallen below 4%, with both PCE readings coming in at 2.6% in May. Core services increased by 0.2% in May, lifted by higher housing, utilities, and healthcare, and financial services, while insurance costs declined by 0.3% after five consecutive months of growth. Housing, financial services, and insurance costs were among the major drivers supporting elevated services costs, so witnessing a reversal in two of the three variables presents a positive affirmation that inflation is indeed heading lower.

Just as elevated wage growth is troublesome to the Fed, the stickiness of core services, particularly housing, fortifies the decision to exercise patience before cutting rates. Federal Reserve Chair Jerome Powell stated “we want to be more confident that inflation is moving down towards 2%” before lowering rates.

More Evidence Needed

The Federal Open Market Committee (FOMC) elected to keep rates unchanged in June for the seventh consecutive meeting. While the Fed’s decision was largely expected, the big news was centered around the Fed’s changes to their Summary of Economic Projections, particularly their median projection for rate cuts, where policymakers adjusted their expectations from three rate cuts in 2024 to only one 0.25% rate cut. The Committee also raised its projection for 2025 as well, indicating a slower pace of change as the Fed adopts a more patient data-dependent position. The number of Fed officials who projected no cuts in 2024 doubled from two to four, and not one official anticipated cutting rates more than twice. We also saw the Fed lift economic projections for 2024 increasing their 2024 inflation expectations and revising their 2025 rate normalization path.

Powell acknowledged that inflation has begun trending lower, yet expressed concerns that cutting rates too early may jeopardize the progress made towards reducing inflation. Interestingly, the Core PCE print in May was 2.6%, which is higher than the Fed’s year-end projection for Core Inflation. This indicates that the Fed anticipates a slight increase in prices from this point, which would likely be accompanied by ensuing market volatility.

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

Barring any resurgence of inflation, we believe the Fed has finished its rate-hiking regime and is nearing its first rate cut. Our base case assumptions have not changed given the Fed’s steadfast commitment to bringing inflation down. We continue to believe the earliest the Fed will cut rates is September, 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 fourth quarter this year.

Centura’s Outlook

The Fed’s goal to lower inflation to its 2% mandate and avoid recession is now the base outcome expected by the Fed and most market participants. However, given the slowdown in consumer spending, 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, there are several potential risks looming and investors should proceed carefully.

In the chart below, Pitchbook outlines four likely paths forward: scenarios of stagflation, higher for longer, recession, or a soft landing. While any of the four scenarios could occur and the risk of recession has fallen, this risk remains above average due to the restrictive level of interest rates. Ultimately, our expectations fall into the lower right-hand corner: the soft-landing camp. We believe inflationary pressures will continue to ease while labor demand and wage growth will soften, resulting in the Fed slowly beginning to bring short-term rates down.

In the face of higher borrowing costs, corporate profits have remained surprisingly resilient, illustrated by the S&P 500 posting positive earnings growth for the third consecutive quarter in the first quarter of 2024, rising 5.9%. As of June 21, FactSet estimates second-quarter earnings to accelerate and grow at 8.8% year-over-year. Last year, the Magnificent Seven were 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. While this trend is expected to hold in 2024, with gains of 30% and 7%, respectively, we are encouraged that JPMorgan is expecting the remaining companies outside the Magnificent Seven to catch up and accelerate earnings over the remainder of the year. Both groups are expected to experience year-over-year earnings growth of 17% in the fourth quarter. A broadening of earnings growth should bode well for increased market breadth and carve a path for higher broad-based returns on equities.

Source: JPMorgan Guide to the Markets

The market remains too dependent on the Fed, which has become dependent on poor economic data. Following worsening conditions, the Fed is more likely to pivot and cut rates sooner. We believe economic activity will continue to surprise moderately, putting the Fed on pace to start lowering rates in either September or November, yet any resurgence of inflation will likely spur bouts of volatility in both stocks and bonds.

Persistent, elevated rates will continue to cause issues for some companies, like small caps, though earnings are expected to grow broadly in 2024 and 2025. While equities generally produce positive returns during election years, we expect volatility is likely to increase as we approach the election in the third and fourth quarters. The recent political turmoil in France and India, the first U.S. Presidential Debate, and the ensuing market volatility remind us how sensitive the markets are to political uncertainty. While we anticipate increased volatility as November nears, we do not believe this volatility source is sustainable. Outside of a resurgence of inflation or Fed policy misstep, we believe geopolitical risks pose a major threat and are more fearful of those potential exogenous events that are harder to predict.

While the path may be bumpy, 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 within portfolios 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 might clip sitting in money market funds or short-term Treasury bills, particularly in municipal bonds on an after-tax basis.

Elevated interest rates continue to punish private real estate returns, with further slight downward valuation adjustments expected from their previous marks. Real estate serves as an interest rate-sensitive asset class; 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. We anticipate a pickup in defaults across several real estate sectors, likely resulting in further pain across both public and private markets. For the foreseeable future, we remain extremely cautious and selective, focusing on select submarkets 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 present challenges for private equity valuations, though according to Pitchbook, elevated and expanding public equity market valuations position new buyout investments favorably when compared to their public market counterparts. Generally, when public market valuations are well above historical norms, buyout strategies launched during these periods tend to outperform, particularly smaller and emerging managers, which aligns with our natural preference.  With limited private equity exit opportunities today, we also align with Pitchbook’s stance that secondary investments should also create attractive opportunities for investors in this environment.

Given that 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, we believe the asset class remains attractive. Yields on private credit should remain similar to 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.  Barring a catastrophic event, the Fed is likely to lower rates slowly, supporting higher yields for longer in private credit. According to commentary shared with us from Cliffwater, companies appear to be navigating the higher financing costs well, as interest coverage in their pipeline has increased from 1.75x to 1.93x.

Like markets and the Fed, we are digesting data points as they print, but 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.