Third Quarter Economic/Market Commentary: Interest Rate Cuts on Deck and Standing on the Shoulders of Tech Giants

Global economies trod along during the second quarter and delivered a mixed bag of investment gains and losses.  Bolstered by strong performance from the Silicon Valley tech giants, the NASDAQ 100 and S&P 500 gained 8.5% and 4.3% during the quarter (yCharts).  Middle- and smaller-sized companies lagged, with the S&P 400 Mid Cap and S&P 600 Small Cap Indexes dropping over 3.5 %.  Developed international markets lagged behind, with the MSCI Europe, Asia, and Far East (EAFE) Index falling 1.6%, while emerging markets rose on the heels of strong performance from the Taiwan Semiconductor Manufacturing Company (TSM).  TSM is the largest semiconductor chip manufacturer in the world and has gained 66.0% during the first half of the year and 27.8% in the second quarter alone.

Economics – Seeing Opportunity in Longer-Term Bonds

On the economic front, the Fed is expecting to cut rates once or twice this year, and several more times in 2025 and 2026.  They point to recent price inflation, or the lack thereof, as evidence that it’s appropriate to begin cutting rates.  Some categories of goods (e.g., vehicles) are actually experiencing deflation on a year-over-year basis.

What does this mean for portfolios and investments?  We see opportunity.  Lower interest rates and a more accommodative Federal Reserve should provide a tailwind to bonds and bond performance.  Notably, this tailwind has not been present since the depths of the COVID-19 pandemic.  In fact, since January 2021, the Barclay’s U.S. Aggregate Index is down 10.3% on a total return basis (yCharts ).  We recognized that risk in 2022 and 2023 and allocated more to shorter-term bonds, which are less sensitive to interest rate changes.  In 2024, we expect rate cuts, not hikes, and we know that longer-term bonds usually perform better when interest rates are falling.  As such, we swapped out most of our floating rate bonds for longer-term U.S. Treasuries in June.

Chart of short, intermediate, and long-term Treasury investment performance since 2003

Source: yCharts

In addition to potentially being better positioned to profit from future rate cuts, this move should enhance portfolio diversification, as holding long-term Treasuries can help smooth out returns of a broadly diversified portfolio.

This Year’s Stock “Rally” Is Actually Only a Few Stocks

Moving onto equities, the “global” stock market rally this year has become quite selective, and it’s apparent that a relatively few big stocks are driving market gains.  For example, the median year-to-date return for the top 10 companies (using only the A-share class of Alphabet’s stock) in the S&P 500 is 31.5% as of July 3st.  The median year-to-date return of the other 490 companies in the S&P 500 Index is a paltry 3.6% (Money.net).  In other words, many stocks are only eking out meager gains in 2024.

Investment returns of popular technology stocks in the first half of 2024.

Source: Money.net

Let’s dig deeper.  On July 3th, with the S&P 500 at a new all-time high, 9.2% of stocks were within 2% of their 52-week highs, and 45.0% of the stocks within the index were within 10% of their highs.  22.7% of S&P 500 stocks were down 20% (a standard threshold to declare if a stock is in a bear market) or more, while 9.0% of stocks were down over 30% (Money.net).  Individual, usually smaller stocks falling into their own bear markets is a typical characteristic of a rally with potentially fragile underpinnings.

Rallies can get even narrower before weak “breadth” becomes a bigger problem.  For instance, on the date of the bull market top in the Dow Jones Industrial Average in January of 2000, 55.3% of stocks were already down 20% or more (Lowry Research, Financial Sense).

We will be monitoring the rally going forward for further evidence of selective strength.  For now, with a still-positive economic backdrop and accommodative Federal Reserve, we think it stills pay to be cautiously bullish, with a focus on prudent diversification across all sectors, and not just invested in the popular but likely overvalued artificial intelligence (AI)/big tech space.

Why We’re Now Watching the Yield Curve and Why It Can Pay to Wait for the “Re-Steepening”

Frequent watchers of CNBC and Bloomberg may be familiar with the phrase “inverted yield curve,” which refers to the uncommon phenomenon where long-term borrowing rates fall below short-term borrowing rates.  It’s called an “inverted” yield curve because, if you create a line chart of bond yields at different maturities, you’ll see that it is downward sloping, or inverted.  The Treasury yield curve in the United States has been inverted since mid-2022.

Example illustrations of upward sloping and inverted yield curves.

Pundits will frequently cite the presence of an inverted yield curve as a warning sign of a recession.  And, while it is true an inverted yield curve has preceded every economic recession since WWII, the long and widely varying lead time between the first inversion and the stock market/economic cycle peak makes its utility for precise timing and portfolio management poor.  A likely much better use of yield curves to predict economic slowdowns or stock market tops entails looking for an inversion which is then followed by a “re-steepening.”  A re-steepening, which refers to short-term interest rates falling more quickly than longer-term interest rates, can coincide with weakening economic growth, rising unemployment, and elevated recession risk.  In fact, inversions followed by re-steepenings have historically occurred just months prior to almost every recessionary bear market in modern history, making it an often-useful tool for portfolio management.  See the image below for previous yield curve inversions and inversions plus re-steepenings using the 2-year Treasury yield as a proxy for short-term interest rates and the 10-year Treasury yield for long-term rates.

The yield curve has been inverted since the spring of 2022 and started to re-steepen late last year before halting its trend.  Further re-steepening, but only if accompanied by weakening economic data, could indicate higher economic risk going into 2025.

Final Thoughts – Watch the Labor Market and the Consumer in Q3

In 2022, what economists called the “most predicted recession ever” never occurred.  In hindsight, we now know why—there was a dire labor shortage, and consumers had excess savings from COVID lockdowns/stimulus to offset the impact of rising prices.  In other words, slowing spending and rising unemployment—the hallmarks indicators of a recession—were never apparent.  In 2024, inflation is normalizing, but consumers are feeling pinched, with credit card and auto loan delinquencies creeping higher.  Even so, joblessness remains a non-issue, so we remain cautiously bullish on the economy and stock market until the evidence suggests otherwise.

Chart of the percentage of mortgage, home equity loan, auto loan, and credit card accounts which are delinquent by 90 days or more and historical delinquency rates.

Source: yCharts

As always, we are gracious you allow us to be your trusted partner through your financial journey.  Happy summer, and we’ll be looking forward to hearing from you soon.

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