Quarterly Review & Market Outlook – 3rd Quarter 2024
Pretty good, not bad, I can’t complain
But actually everything is just about the same
– John Prine, “Pretty Good”
The economy seems to have finally left the pandemic era. Inflation[1] is back at target, rising 2.2% over the past twelve months and just 1.5% annualized over the past three. Real (inflation-adjusted) GDP is growing at 3% per year, faster than pre-pandemic. There are signs of softness in the labor market, but a string of recent data calmed those nerves.
There is little precedent for rate cuts in a healthy economy, but there was little precedent for a lot of what happened in recent years. The pandemic was weird. The labor market and supply chains were reorganized on the fly. Inflation spiked and disappeared. Reasonable people disagree on the causes, but, whatever the reasons, it occurred in an environment of constricted supply that no longer exists. The economy is normal now. It makes sense that policy should be too.
The new normal is not the same as the old. After a decade of underinvestment, the US is now building everything from roads to semiconductors to utility-scale battery storage. The numbers are large and reinforcing. The six largest technology companies will invest about $360 billion this year and next. Public and private power generation investment will total about $500 billion over the same period. Success is interconnected through data centers and the semiconductor supply chain.
Some investment waves turn into bubbles, but for now this seems unlikely. One silver lining from the US having underinvested for so long is there is a lot of low hanging fruit on the productivity tree. This wave is also more sustainable since it is not financed by private debt. Household and large corporate balance sheets are remarkably healthy. Spending is a blend of corporate profits, private capital, and government guarantees. Sustainability depends less on the amount and more on how well it is spent. Productive assets grow the economic pie faster than the costs. Wasteful spending does the opposite.
Productivity is rising at the fastest clip in twenty years, so the early signs are positive. Recent advances in Artificial Intelligence (AI) are impressive and being applied across industries. Power generation is growing for the first time in decades. We are getting more efficient every day. Nothing is guaranteed, of course. Investors need a plan that benefits from productive growth and is also resilient to problems that arise along the way. Hope for the best, plan for the worst.
Quarterly Review
Global stocks rose 6.7% in Q3 as the MSCI World Index set new highs. All major equity markets are positive for the year and the number of stocks participating in those gains broadened substantially during the quarter. Within the US, the Technology sector was flat during the quarter while areas with more sensitivity to interest rates and the real economy made up substantial ground. The dismount from the pandemic era has been broadly positive for most sectors and regions.
The 10-year US Treasury yield fell 0.6% to end the quarter at 3.8% as cooling jobs and inflation data eased fears that growth and inflation may be reaccelerating. Proactive risk management from the Fed reduced recession fears and provided a tailwind to riskier credit. Markets have thrived in a variety of interest rate environments. What matters is the level and sustainability of growth.
Market Outlook
Global stock indexes are heavily concentrated among a handful of companies that are woven into our daily lives. Collectively, the six largest—Apple, Nvidia, Microsoft, Alphabet (Google), Amazon, and Meta (Facebook)—earned $350 billion in net income last year, and they are still growing quickly. They have strong balance sheets, disciplined management teams, and tailwinds from public investment.
There are many headlines these days about an expensive market, but of course the market is more expensive now that these companies make up such a large percentage. Using simple measures like Price/Earnings, high quality technology companies have been optically expensive for as long as we can remember. In retrospect, they grew the denominator (earnings) so quickly that the numerator (price) proved to be a bargain.
They were never risk-free. Microsoft was left for dead by investors under the previous CEO. Apple was just a hardware company. Amazon would never turn a profit. They are not risk-free now, either. Reinvesting $100 billion wisely is harder than $10 billion. They face regulatory pressure. AI advances could come too slowly to justify the optimism, or so quickly they disrupt business models. Geopolitical risk is ever present—the most advanced semiconductors are manufactured in Taiwan, one hundred miles off the coast of its larger, militarized, and increasingly hostile neighbor.
Investors need to balance the positive attributes of technology with an appreciation that the sector is still subject to the relentless forces of creative destruction. Winners feel invincible until they aren’t. Nvidia has an enviable position, but there are a trillion reasons to figure out how to displace them.
A balanced, resilient portfolio is built for both speed and safety. We still want to be exposed to the innovation economy. We also want to complement that exposure with companies that can perform well even if technology becomes a less forgiving place. We favor quality businesses with healthy balance sheets, free cash flow, and defensible market positions. We look for strategies that target overlooked and underfollowed companies, especially within the small- and mid-sized universe.
Within fixed income, high-quality short-term bonds provide a strong foundation to withstand market volatility, even as yields start to move lower. We have been skeptical of the role served by long-term bonds, at least until yields moved high enough to compensate for the risk that inflation bounces around a higher base. The market has recently been moving in this direction, creating opportunities to capture high quality yield over a longer period of time.
We also like assets that can work when nothing else is working, especially in a stagflationary world with a more volatile mix of growth and inflation. This risk was overstated during the prior decade and is underappreciated today. Asset-based lending is one of several strategies that can serve this role in a diversified portfolio.
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The last decade had a narrow set of winners. Low investment led to slow growth and rock-bottom interest rates. This favored assets that benefited from financial leverage and falling rates. Some argue that nothing fundamental has really changed, but we think they are missing the big picture. Resilient portfolios are not created through the rearview mirror. The world is constantly changing. Investors need a plan that changes along with it.
Please reach out with any questions or comments.
Written by Waverly Chief Investment Officers
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| Clay McDaniel, CFA
Chief Investment Officer Private Markets |
John B. Cox, CFA, CAIA
Chief Investment Officer Public Markets |
[1] The Personal Consumption Expenditure (PCE) price index is Federal Reserve officials’ preferred measure of inflation.
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