Equities
The market, as measured by the S&P 500, continued its positive performance in the second quarter, even though the pace was slower compared to the previous two quarters. Using the SPDR S&P 500 ETF as a proxy, the fourth quarter of 2023 and first quarter of 2024 returned over 10%, while Q2 2024 rounded out at 4.4%. Emerging Markets (represented by ticker EEM) were also up 4.4% for the same time period, while International Developed (EFA) markets were flat.
We have implemented and still maintain an overweight positioning to domestic markets and underweight to international developed, which has rewarded growth-aligned portfolios.
While Emerging Markets ended up similarly to domestic markets, we still do not believe that the Emerging Market space offers a compelling risk/return trade off as compared to our current allocation.
Year to date, the way the S&P 500 has arrived at such an impressive performance is eye opening. The “Magnificent 7” (Google, Apple, Nvidia, Microsoft, Tesla, Amazon, Meta) are virtually driving the entire domestic stock market. In reality, it is really the “Magnificent 1”, with Nvidia rising over 160% year to date. What this means is the largest stocks are accounting for the bulk of the performance of the S&P 500. Likewise, it was also the largest stocks that drove the inferior performance in 2022. This phenomenon is called “narrow leadership” and is an issue when a market is reliant on just a few large companies as opposed to having more broad-based participation.
Given that the S&P 500 is market capitalization weighted (the biggest stocks earn the biggest weights), the index is becoming more concentrated as the biggest stocks get bigger. As you can see in the below chart sourced from Goldman Sachs (ending 3/31/24), the S&P 500 is now more concentrated than it ever has been and exceeds the 27% weighting achieved prior to the tech crash in 2000. While this is a cause for concern, the fact is that these large companies have multiple growth avenues not available to smaller companies. Amazon, for example, can do things such as becoming an online pharmacy (and leverage their delivery network) that other companies simply cannot do.
Of course, if one of these large companies falters (and one inevitably will), then the index will trend down. That said, we rely on the market to weight each company according to its merit, rather than attempting to outguess the market. We still believe an underweight to equities in most portfolios is a favorable positioning, while using alternatives such as private equity and private credit to round out the allocations.
Fixed Income
Rates moved up again in the second quarter with no changes in the Fed Funds rate. Inflation is still the key driver of the expected timing of future rate cuts and has remained persistently above the Fed’s target of 2%. Current sentiment is that the market now expects one or two cuts later in the year. At LGT, we have been doubtful that the Fed would cut rates meaningfully since mid-2023, and that belief was reflected in our weighting to floating rate bonds over the aggregate bond index. However, when rate cut expectations fell we believed that it was timely to add some duration in the form of Aggregate and High Yield bonds, although we still remain overweight Floating Rate bonds given the attractive current yields. Given that fewer rate cuts are priced in, assets with interest rate sensitivity (also known as duration) will benefit if/when the Federal Reserve cuts rates.
As you can see below, all the fixed income asset classes represented were positive for the quarter, and the timing of our allocation to Aggregate and High Yield bonds proved to be beneficial for our portfolios.
Macro Environment
As we noted in earlier updates, the markets have continued to rally, even as the expectation of cheaper money (rate cuts) keeps getting pushed back. At this point, it is likely that we will see a cut in rates toward year-end assuming inflation stays on a moderating path. That said, all it will take is one unexpected jump in inflation for the Fed to delay – with one caveat. When Jerome Powell was asked about future rate cuts on June 12th, he said:
"…fortunately, we have a strong economy, and we…have the ability to, you know, approach this question carefully.“
That’s in part because the jobs market, despite some increase in unemployment from historically low levels, has remained relatively robust. What this means is if the job market were to soften (as measured by a spike in unemployment), then we could see rate cuts far more rapidly than if the job market/economy stays strong. Therefore, the reasons why the Fed cuts rates are important. If rates are cut because inflation has moderated and the job market remains strong (referred to as a Goldilocks scenario), then it is likely that equity markets rally further. However, if rates are cut because of high unemployment and slower growth, our expectation would be for equity markets to sell off.
Positioning
Other than taking some duration risk in our public credit allocation, our positioning did not change materially over the quarter.
In private credit, we are starting to diversify from the upper middle market in favor of middle market managers. The upper middle market was more attractive earlier in the year and last year because the banks had pulled back from lending and spreads were wider (interest rates higher) on loans in the space. However, those spreads have moderated somewhat, and we find traditional middle market private credit attractive. Note the return expectations between the upper middle market and middle market are still the same at about 10%.
We continue to favor private equity secondaries and include them in all growth-oriented portfolios. We have begun adding some exposure to secondary venture capital/growth equity where appropriate to add diversification and improve the risk/return profile of private equity portfolios.
As mentioned earlier, we remain overweight domestic markets over international markets, and have no direct allocation to emerging markets.
We are on the low end of equity weighting for most portfolios and still consider the risk/reward trade off of private credit to be the most compelling allocation available today.
We continue to be underweight real estate given the current headwinds in the sector but have added infrastructure allocations as a complement to real estate to diversify the real assets exposure.
Sources: Is the S&P 500 too concentrated? (goldmansachs.com); Amazon Pharmacy: Save time, save money, stay healthy; US Treasury Yield Curve; Civilian unemployment rate (bls.gov)
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