It has been a strong year for stock investors thus far, with the S&P 500® Index up by more than 15% year-to-date and many of the other major indexes notching record highs.
Optimism is driven by the current backdrop of strong corporate earnings, declining inflation, and the potential for the first rate cut in over four and a half years, reversing the uptrend from a Fed funds rate hike cycle from near zero to the current 5.5%. However, caution is always necessary, and it is important to remain vigilant for unforeseen risks and sudden changes in prevailing expectations, especially regarding Federal Reserve actions.
Equity markets continued to be led by the largest of the large companies through June 30th, with the top ten names in the S&P 500® representing 37% of the index. During the quarter, the bias and narrow nature of performance were evidenced, with the S&P 500® Index gaining 4.28% while the S&P 500® Equal Weighted Index fell slightly, recording a -2.63% return. Smaller companies, represented by the Russell 2000®, also saw a decline of -3.28%.
Inflation, economic growth, and Artificial Intelligence (AI) are central themes in the current market environment. While inflation is moderating, the Fed remains cautious about rate cuts due to previous unexpected spikes, which have affected borrowing costs and profit margins, especially for small-cap stocks. Despite the yield curve inversion suggesting a recession risk, the economy continues to expand moderately.
Economic growth in the second quarter was moderate. Q1 Real Gross Domestic Product (GDP) was revised to 1.4%, and the Atlanta Fed’s GDP forecast for Q2 is 2.7%, down from an earlier estimate of 3%. This moderation is due to reduced government spending, lower exports, and slower consumer spending. As measured by the latest Core Personal Consumption Expenditures Index (Core PCE), consumption increased by 0.1% in May, the smallest rise in six months, with a year-over-year rate of 2.6%. Core Consumer Price Index (CPI) stands at 3.3%, above the Fed’s 2% current stated target.
Given that both GDP and consumption measures suggest softening and moderating inflation, we believe the Fed could cut sooner rather than later.
Artificial Intelligence advancements continue to attract significant investment and interest. The rapid advancements in this breakthrough technology have captured investor interest, and rightly so, as it has the potential to weave its way into many facets of our daily lives and drive productivity enhancements for corporations. Much like in the late 90s, as the internet began to transform communication and access to information, AI is transforming our ability to evaluate vast amounts of data and put it into actionable insights, which is increasingly automated. Technological innovation that delivers on its promise has significantly driven world economic development by enhancing standards of living, economic productivity, and innovation, and in turn, helped drive stock market performance over time.
Companies are reprioritizing spending to capture this technology's benefits, which drives investor interest in the ‘Magnificent Seven.’ Spending on data centers, semiconductor chips, and software is spurring the fundamental growth of the largest companies. Some have suggested an analogous situation to the tech bubble of the late 1990s; however, we do not concur with this conclusion. Though there may be similarities, today, the companies have actual earnings and cash flow and are not being valued on such spurious measures as clicks on a website.
Beyond this dominant theme are others that offer potential opportunities, such as investment in our domestic infrastructure, on-shoring manufacturing, cybersecurity, and energy efficiency. We believe there are also niche companies, within industries that may be experiencing macro challenges, that may provide compelling returns over the long term as they capture market share and participate to a greater degree once their industries return to growth.
Our team has highlighted in prior commentaries we are working to be more active in decreasing or increasing our position weights to consider near-term challenges and/or extended valuations balanced with longer-term opportunities. The execution of these portfolio actions continues within the long-held fundamental aspects of our strategies, which have been developed over five decades, as we strive to balance conviction with market realities.
The concentration of performance and investor interest in such a few companies does have similarities to prior periods, which then ultimately reversed. The timing and catalyst for this shift to a broadening market are unknown, but in our opinion, there exist situations within the market on which we are seeking to capitalize.
In the United States, the next President will be determined in just over 100 days. With the presumptive party candidates being President Biden and former President Trump, it would be the first time in U.S. history that two previously sitting presidents have faced off against each other in a presidential election.
The truth of the old adage “the market hates uncertainty” often serves as the common denominator triggering significant drawdowns or heightened volatility. Fortunately, policy uncertainty should be lower post-election, as the market has operated under these two administrations over the last seven and a half years.
Election-year returns have been generally positive, with the S&P 500® delivering positive returns in 19 out of 23 election years (83%). Annual market return data by party control (presidential) are virtually identical, in fact determining which party is “better” for the markets can be argued both ways, depending on how the data is analyzed. The best long-term conclusion to-date is that party control is a non-factor in explaining market performance, with economic fundamentals far more important than election outcomes.
As we consider our existing holdings and potential candidates, our team closely monitors economic trends and the effects of interest rates on profitability and growth. Though our domestic growth continues, we are attentive to new data that may suggest further moderation. This leads us to continue to balance our offensive and defensive positioning while monitoring valuations and estimated growth on both an absolute and relative basis.
As always, we continue to work diligently on your behalf, and we thank you for your trust and confidence.
Have a wonderful summer.
Warm regards,
Peter J. Connors, CFA
President
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