Coming off a year of uncertainty and somewhat unexpected market movements, 2024 has continued the positive momentum through the first quarter. Our Chief Investment Officer, John Bullman, provides an overview of current happenings, as well as portfolio positioning / opportunities.
Equities
The market, as measured by the S&P 500, picked up where it left off in 2023 and continued its strong performance in the first quarter of 2024 posting a 10.6% return. According to the Market Intelligence team at NASDAQ, “The first quarter marked the index’s second-consecutive quarter of double-digit gains for only the ninth time since 1940. Historically, this has been a bullish signal, as the prior eight occurrences were all followed by positive 12-month gains.” While most equity markets were positive in the first quarter, the US (ticker SPX) led the charge while the rest of the world saw appreciation to a lesser degree. Developed markets (ticker EFA) were up almost 6%, while emerging markets (ticker EEM) were up just over 2%. The trend of US outperformance has been in place for some time, which reinforces our strategic alignment of overweighting domestic markets compared to international developed markets and avoiding direct allocations to emerging markets.
The performance of the S&P 500 is even more impressive given the expectations of rate cuts (i.e. cheaper money) fell from six in 2024, to now just two. Inflation remained sticky, forcing the Fed to keep rates “higher for long enough”. Similarly, employment remained strong, which allowed the Fed to maintain its current positioning.
As stated in our 2023 review, we believe equity markets are efficient, and we do not attempt to time the market. That said, we weigh the relative risk/reward ratio of broad markets and allocate accordingly.
Fixed Income
Volatility in the yield curve continued through the beginning of the year. Rates moved up noticeably during the first quarter as the market shifted from expecting six rate cuts to two. The short end of the curve remained stable (the Fed held rates steady), but the longer end of the curve shifted up substantially, meaning that fixed rate bonds lost value. Inflation remains the key variable when assessing the future of interest rates. As long as inflation remains elevated (3.8% as of the latest print compared to the Fed’s target of 2%), the Fed will be forced to keep rates higher.
While we do not specifically forecast rate cuts, we believe overweighting floating rate bonds will continue to prove to be beneficial for income production and yield capture for portfolios.
Given the shift in interest rate expectations, we believe incorporating some duration – depending on client goals – is appropriate.
The graph below provides a visual around the various bond class returns for the first quarter. Floating rate (ticker FLOT) and high yield bonds (ticker HYG) gained value, while core bonds (ticker AGG) ultimately lost value.
Macro Environment
As mentioned earlier, the equity markets continued to rally in the face of adverse rate cut expectations and the continued shrinking of the Federal Reserve’s balance sheet (see below). After peaking at ~$9T in 2022, the Fed’s balance sheet stands today at $7.4T, meaning $1.4T of liquidity has been taken out of the system. The Fed’s ability to shrink its balance sheet is important, as it gives the Fed more ammunition to fight the next recession.
On rates, while we would not be surprised to see the two rate cuts currently priced into the market, there is also the scenario that we will not see any rate cuts at all. How long companies can continue coping with much higher rates than anticipated is a key risk factor that we are monitoring. Stress is already appearing, as interest coverage ratios have come down significantly despite strong economic performance (and growing EBITDA). The below chart provided by BlackRock illustrates the change with strong economic expectations. Without the strong economic performance, these numbers would be worse, and a recession would exacerbate what is already a tense situation between companies and their creditors.
The same wars and conflicts we wrote about as part of our 2023 update remain with the war in the Ukraine & Palestine grinding on with no real end in sight. Other risks persist such as the issues in commercial real estate and the potential impact on banks, rising commodity prices (tied into our concerns on inflation), and issues in emerging markets (particularly China).
Positioning
Our positioning has not materially changed given the current events. We continue to believe that private credit offers the best risk/reward trade off and remain overweight the asset class, although interest coverage ratios are a concern as noted above. When investing in private credit we favor large managers that have in-house private equity expertise. The reasoning comes down to the manager being able to take control of companies, as needed, to preserve value.
On the public credit side, we will continue to incorporate some interest rate risk (duration), but maintain a healthy allocation to floating rate bonds.
In general, our weightings to the public equity markets have not changed. We continue to avoid emerging markets based on our assessment of the relative risk/reward as compared to the developed world. And, within developed economies, we favor the US over international developed markets.
Private equity remains a key allocation, where we are currently overweight as compared to private real estate allocations. That said, we are selectively introducing infrastructure where appropriate.
Sources: Historic S&P 500 Rally In Q1 Flashes Bullish Signals For 2024: 'Only The Ninth Time Since 1940' | Markets Insider (businessinsider.com); Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level (WALCL) | FRED | St. Louis Fed (stlouisfed.org); US Treasury Yield Curve; Civilian unemployment rate (bls.gov)
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