Quarterly Review & Market Outlook – 2nd Quarter 2024

“The dimming of the light makes the picture clearer.”

– Brian Eno & David Byrne, “Home”

Inflation slowed sharply in the second quarter, sparking optimism that rate cuts are finally in sight. Skepticism is natural. After all, we are still riding in the wake of a pandemic hurricane and the waves have not yet settled. Inflation has swung back and forth each of the last four quarters, with analysts overreacting every time. The best course of action has been patience.

This time could be different. In addition to softer inflation, the unemployment rate, while still low at 4.1%, ticked higher each of the last four months and already sits above the Fed’s year-end forecast.

It is getting hard to find a new job. Monthly wage surveys are back to normal. In addition, there are signs that consumers are tightening their belts. Real consumer spending grew just 1.5% during the first half of the year, down from 3.2% in the second half of last year.

Fed policy is not a light switch turned on and off. It is more like a thermostat that continuously adjusts to changing weather patterns in the economy. Sometimes an ounce of prevention is worth a pound of cure. In fact, it is possible a proactive Fed may not need to cut rates much at all.

Among the three pillars of the economy—companies, government, households—the first two are still playing offense. It is households (e.g. consumers) that have been the main conduit for tight monetary policy. Since before the pandemic, both consumer debt and mortgage debt have grown more slowly than the economy. Monthly payments have increased due to higher rates. Disposable income has grown as well, and the ratio of the two—the Debt Service Ratio—is holding steady near its 40-year low. Balance sheets are in good shape, and unless companies stop investing (discussed below) or the government rediscovers austerity (unlikely from either party), the consumer is in a reasonably strong position to react quickly to any meaningful reduction in interest rates.

The new normal is taking shape. Prior economic and market cycles are a poor guide for today because the starting conditions are so different. This cycle was started by a virus, not the typical excesses of a market economy. There are no imbalances that need to be fixed, few losses that need to be absorbed. Despite the lousy feeling most of us have when we read the news, the US is not on the knife’s edge of recession. Rate cuts may be warranted, but it also may not take much to keep growth on track.

Quarterly Review

Global stocks rose 2.6% in Q2 as the MSCI World Index set new highs. Most major equity markets are positive for the year, though the number of stocks participating in those gains faded through the quarter. Countries with exposure to Artificial Intelligence—the US, plus South Korea and Taiwan—posted strong gains at the expense of everywhere else.

Interest rate volatility remains high. The 10-year US Treasury traded in a wide range, ending the quarter somewhat higher at 4.4% yet well off the highs of late April. No one, including the Fed, knows for sure what level of interest rates will balance the supply and demand for investment in the new normal, though we are learning more about it every day. So far, the lack of visibility has not been a headwind for equity or credit markets.

Market Outlook

Artificial intelligence (AI) is driving a major corporate investment cycle that shows no signs of slowing. Unlike most new technologies, diversified investors have benefitted from this cycle because the cash needs to compete on the AI frontier are so large that venture capital-backed private companies are forced to partner with the publicly traded technology giants. OpenAI works with Microsoft. Anthropic partnered with Google and Amazon. They all buy semiconductors from Nvidia.

Valuations reflect a lot of optimism, and there are a growing number of anecdotal stories of hype and excess causing us to raise an eyebrow. Taxi drivers want to talk about semiconductors. Tech company CEOs are receiving rock star-like receptions at AI conferences. We are paying attention, but we also remind ourselves that the world was introduced to ChatGPT less than two years ago. These are still the early innings. Nobody knows where AI is going, but the early results justify some of the optimism.

There is also a strong case for owning these companies even if making money from AI is harder than expected. The buildout of high-speed internet allowed platforms like Microsoft and Google to secure a quasi-monopolistic position in their respective markets. Alongside that, the ever-plummeting cost of computing power allows them to grow quickly despite their enormous size. The technology giants are so profitable that, despite the huge-sounding number, their total AI investment to date—about $200 billion—amounts to only a few months of revenue. They are not (yet) betting the farm.

No investment works well all the time. The technology-heavy Nasdaq Index has a great 10-year track record, but it was down over 30% in 2022. It fell by two-thirds when the internet bubble burst in 2000. Fortunately, investing is not a light switch either. We can own a little more or less of something depending on our view. We can also reduce portfolio risk by adding investments that behave differently. We use a range of tools to complement the concentrated cap-weighted indexes, with a focus on healthy balance sheets, free cash flow generation, and income generation.

In fixed income, sometimes the easy path is also the right one. High quality short-term bonds yield more than inflation and provide a strong foundation to withstand market volatility. If the economy performs and rates come down slowly, equities should be fine even if bonds earn less. If the Fed falls behind the curve and causes a recession, bonds should protect capital and provide the option to buy into a cheaper market. If inflation reaccelerates, bonds are quickly reinvested at higher rates.

The case for long-term bonds is less obvious. They helped portfolios for many years, nicely offsetting stock market volatility while still earning an attractive return as rates fell. For most of the last three years, though, long-term bonds have moved in step with equities, adding to portfolio risk instead of reducing it. This positive correlation limits their usefulness compared to other assets.

Our conviction in High Yield credit is lower today than it was last year. This sector has performed well, and now the prices of riskier bonds reflect a rosier outlook. We have reduced our tactical overweight.

∞

Diversification and rebalancing are valuable because they are hard. The human instinct is to buy what is going up, no matter the price. To sell what is going down, no matter the value. Investors today are excited, perhaps even overexcited, about an unproven technology and uncertain rate cuts. We agree the outlook for both seems positive. We also see a lot of opportunities that do not require the future to work out exactly as planned, which it never seems to do.