June 2024 Stonemark Market Commentary

As we enter the third quarter and the second half of 2024, it’s clear that this year has been exceptional for investors. U.S. equities have experienced a remarkable rally, reaching more than 30 all-time closing highs and surpassing even the most optimistic expectations. Alongside this equity surge, bonds and even cash are providing substantial yields, creating a robust investment environment.

However, the lion’s share of this market performance has been driven by “big tech,” with five stocks—NVIDIA, Amazon, Microsoft, Alphabet (Google), and Meta (the parent company of Facebook)—accounting for 60% of the rally year-to-date. This concentration raises important questions: Are stocks becoming overheated, or is there potential for further gains?

In this month’s commentary, we will delve into the drivers of the first-half performance, provide a review of June's market dynamics, and outline our expectations for July and beyond.

We are halfway through the year, and the biggest question on investors' minds is: what is driving this remarkable rally? The answer lies in several key factors.

First, hedge funds, both systematic and fundamental long-short focused, have taken significant positions in Artificial Intelligence companies and GLP (obesity and diabetes) drugs. These strategic bets have provided substantial upward momentum.

Second, mutual funds, which are regulated by the Investment Company Act of 1940 and face size limitations for their holdings, have played a crucial role. When there's even a minor pullback in "big tech" stocks, a substantial influx of money flows in as these funds adjust their positions.

Third, the retail investors, who took a step back in 2023, are now fully re-engaged, focusing heavily on the world's ten largest stocks. Their renewed activity has added to considerable buying pressure.

Finally, and perhaps most importantly, corporate buybacks have reached record levels. In 2024 alone, companies have repurchased roughly $1 trillion worth of their own shares, providing a strong underpinning to the market rally.

These combined forces have propelled the market to new heights, creating a dynamic and bullish environment for the first half of the year.

Data released in June provided some conflicting signals about the state of the U.S. economy. The labor market showed surprising strength, with the economy adding far more jobs than expected in May. Nonfarm payrolls increased by 272,000 jobs, surpassing economists' forecasts of 185,000, and annual wage growth reaccelerated, underscoring the resilience of the labor market. This robust job creation reduces the likelihood that the Federal Reserve can start cutting rates in September.

However, the report also highlighted some discrepancies. While job creation was strong, the unemployment rate ticked up to 4.0% from 3.9% in April, a symbolic threshold below which it had held for 27 consecutive months. This divergence between strong job gains and the rise in unemployment is puzzling and suggests underlying complexities in the labor market. Additionally, revisions showed 15,000 fewer jobs were created in March and April combined than previously reported.

Another conflicting signal came from the Job Openings and Labor Turnover Survey (JOLTS) report, which showed that U.S. job openings fell more than expected in April, pushing the number of available jobs per job seeker to its lowest in nearly three years. Job openings dropped by 296,000 to 8.059 million, the lowest level since February 2021. This decline brought the ratio of job openings to unemployed persons down to 1.24 in April from 1.3 in March, well below its post-pandemic peak and matching pre-pandemic levels.

These mixed signals indicate a disconnect in the employment data: job creation remains strong, yet job openings have decreased significantly, and the unemployment rate has risen slightly. The strong wage gains also raise concerns that inflation may remain more persistent than hoped, although the increase in the unemployment rate could temper inflationary pressures. These complexities will likely influence the Federal Reserve's decisions on when to begin lowering borrowing costs, as they balance the need to support economic growth with the goal of controlling inflation.

On the inflation front, U.S. consumer prices were unexpectedly unchanged in May, as cheaper gasoline and other goods offset higher costs for rental housing. The unchanged reading in the consumer price index (CPI) last month followed a 0.3% increase in April, marking the softest reading since July 2022. The CPI has been trending lower since posting solid increases in February and March

Excluding the volatile food and energy components, the core CPI climbed 0.2% in May, the smallest advance since last October, following a 0.3% rise in April. The core CPI nudged up just 0.16% before rounding, the smallest increase since August 2021. Rents accounted for most of the increase in core inflation, with the owners' equivalent rent (OER)—a measure of the amount homeowners would pay to rent or earn from renting their property—gaining 0.4% for the third straight month. However, with market rents trending lower, a significant slowdown in CPI rent measures is expected this year

Higher inflation has soured Americans' perceptions of the economy, even as it continues to expand thanks to the labor market's resilience despite the Fed's aggressive monetary policy tightening in 2022 and 2023. This persistent inflation has also impacted U.S. President Joe Biden's popularity and could be a significant factor in the upcoming November 5 presidential election.

June also featured a Federal Open Market Committee (FOMC) meeting where the Federal Reserve decided to hold interest rates steady and indicated that rate cuts might not start until as late as December. Policymakers outlined their view of an economy that remains stable across its major dimensions for the foreseeable future. With growth and unemployment levels exceeding what the Fed considers sustainable in the long run, Fed Chair Jerome Powell stated that policymakers are content to maintain current rates until the economy sends a clear signal for change—either through a more convincing decline in inflation or a significant rise in the unemployment rate.

Based on current projections, barring any surprises in upcoming inflation or jobs data, rate cuts are unlikely to begin until December, thus avoiding interference with the November 5th U.S. presidential election cycle. The Fed's new projections suggest the economy will continue to grow at a slightly above-trend rate of 2.1% this year, despite a sluggish first quarter, and the unemployment rate is expected to remain at its current level of 4% throughout the year.

Wrapping up the economic forecast for June, the U.S. Leading Indicator Index dipped 0.5% in May to 101.2, steeper than the 0.3% decline expected and following April's 0.6% decrease, according to The Conference Board. Although the Leading Indicator Index's six-month growth rate stayed negative, the index doesn't currently signal a recession, she added. The Conference Board projects that real GDP growth will slow to less than 1% during Q2 and Q3 2024, as elevated inflation and high interest rates affect consumer spending.

Wrapping up the economic forecast for June, the U.S. Leading Indicator Index dipped by 0.5% in May to 101.2, a sharper decline than the 0.3% drop expected, following April's 0.6% decrease, according to The Conference Board. Although the Leading Indicator Index's six-month growth rate remained negative, it does not currently signal a recession. The Conference Board projects that real GDP growth will slow to less than 1% during the second and third quarters of 2024, as elevated inflation and high interest rates weigh on consumer spending.

As we enter the second half of 2024, several key factors will shape the investment landscape, including interest rates, inflation, and the U.S. presidential election. Despite these challenges, we see compelling opportunities across fixed income, equities, and alternatives.

One prominent theme is the potential dominance of fiscal policy over monetary policy. Unlike monetary policy, which the markets can price with various tools, fiscal policy lacks such mechanisms, creating uncertainty. This fiscal dominance is expected to impact markets significantly into the presidential election and beyond, influencing taxes and spending policies well into 2025.

Additionally, concerns about the U.S. dollar's valuation and stability as a global reserve currency persist amid high government spending, debt levels, and twin deficits. However, historical data shows that high deficits do not consistently lead to a depreciation of the dollar, thanks to the U.S.'s monetary sovereignty and strong institutions.

Emerging market debt (EMD) presents a valuable opportunity for increased income, diversification, and enhanced returns. Despite being under-owned, the current macro environment, valuations, and investor flows make EMD attractive, especially compared to developed market fixed income.

The equity outlook is positive, with the S&P 500's forward P/E ratio suggesting a year-end target closer to 6,000. Election years typically benefit stocks as fiscal spending primes the economy, particularly benefiting sectors like Industrials, Materials, Semiconductors, and Equipment.

Bank loans and collateralized loan obligations (CLOs) offer yields twice that of core bond market proxies, providing high coupons and liquidity. These can serve as a defensive asset class, complementing portfolios across various scenarios.

Lastly, alternative investments are undergoing a transformation, driven by shifts in the interest rate regime. Private credit, hedge funds, private equity, and real estate are all seeing improved opportunities, making them attractive options for return generation in the current market environment.