Under the Surface
“There is more going on beneath the surface than we think, and more going on in little, finite moments of time than we would guess.”
– Malcom Gladwell
The first half of this year has appeared to be a smooth trip higher for equity markets, especially in the United States. With broad stock indices up over 15% for the year, markets have been able to shrug off higher sustained interest rates, simmering geopolitical tensions, and indications that the US consumer is becoming stressed to march to all-time highs. Headline volatility has been low, index level earnings per share have been strong, and inflation appears to be moving back towards long-term targets. On the surface, capital markets seem almost boring.
However, a look under the surface reveals some conflicting data points. While the S&P 500 as a whole has produced an outstanding start to the year, six of the eleven sectors produced a negative return in the second quarter. Even within the robust technology and communications services sectors, which were up 13.8% and 9.4% in the quarter, returns are being driven by the mega-cap firms seen as gaining significant traction in artificial intelligence (AI) such as Nvidia, Microsoft, Alphabet, and Meta, while smaller and less profitable firms have seen their share prices struggle.
On the economic front, US GDP has continued to climb in the face of higher rates and none of the interest rate cuts that were expected from the Federal Reserve (the Fed) at the start of the year. Inflation readings have continued their trend lower after being surprisingly stubborn for several months, and this has forced the Fed to delay rate cuts until September. However, we are starting to see some weakness in the labor market and indications that some US consumers may need to slow spending as years of higher prices, higher rates, and now slowing wage growth catch up with them.
In addition to these market and economic dynamics, pivotal elections in the EU, France, and, above all, the United States are just starting to draw investor attention and focus. Given this backdrop it would be a surprise if the second half of the year was as calm on the surface as the first.
Recent Market Activity
The broad US equity market as defined by the S&P 500 index enjoyed another robust quarter with a return of 4.3% bringing year to date returns above 15%. This strong headline number has been largely driven by the performance of a select few stocks that have mostly benefited from excitement around AI or GLP1 weight loss drugs. Those firms have seen their stock prices increase dramatically because they have produced outstanding earnings growth and are very, very profitable. They have been handsomely rewarded for excellent performance, and that is not a sign of irrational exuberance.
However, these firms; including Microsoft, Nvidia, Meta, Alphabet, Apple, and Eli Lilly; may struggle to continue to surprise to the upside. If the equity index is going to continue to perform well the rest of the market must begin to produce stronger earnings growth. Fortunately analysts are predicting that the 493 stocks outside of the “magnificent seven” will grow earnings by 7% in Q3 2024 and by 17% in Q4 as they start to match the earnings per share growth (EPS growth) exhibited by the largest technology related equities.
International developed market equities posted a negative return for the quarter and continue to trail US market returns. Developed markets in Europe and Japan lack the mega-cap technology stocks that have driven results in the US and are more heavily weighted towards value-oriented sectors such as financials, industrials and energy that have faced challenges. The dollar has also remained strong as higher interest rates and more attractive investment opportunities have pulled capital towards the United States. Emerging markets have enjoyed stronger returns than developed international stocks driven by gains in Taiwan and India that have helped offset weakness in Brazil and mediocre returns in China. The trend of US outperformance seems set to continue as the European Central Bank has started cutting rates while the Fed holds firm. This should support additional dollar strength and will pose a hurdle to international returns that must be translated back into dollars for domestic investors.
The US aggregate bond index was flat on the quarter and remains negative on the year. The ten-year US Treasury yield has risen from 3.88% at the start of the year to 4.39% today, providing a headwind to total returns. Riskier portions of the bond market, including high yield and leveraged loans, have done better than the investment grade market but even those returns of 2.58% and 4.62% respectively do not appear particularly compelling versus money market returns that remain above an annualized 5%. Municipal bonds have also been uninspiring this year, producing slightly negative total returns for the quarter and the year to date.
Commodity markets, as measured by the Goldman Sachs Commodity Index (GSCI) which includes energy, metals and agriculture products, was flat for the quarter after a robust return in the first three months of the year. Oil prices were volatile but ended the quarter near where they began in the low $80’s, while gold was up 4.4% and natural gas gained 10%.
Beneath the Waves
The broad market has performed well with limited volatility displayed in the Vix index; an indicator derived from options activity linked to the S&P 500 that is also known as the “fear index”. In times of stress, the Vix will spike to measures above 30 but has averaged 13.8 over the past 6 months and was recently registering at 12.2, a level generally associated with limited stress and a strong outlook. This contrasts with sector level returns that were negative for more than half of the S&P 500 index sectors.
This placid reading at the market level masks more churn beneath the surface. Dispersion, or a measure of the spread in performance of individual stocks versus the index, has risen 33% this year indicating that individual stocks are subject to additional volatility at a time when the market appears calm. There is anecdotal evidence to support this when one examines how specific equities have performed when investor expectations are not met, with Nike being a recent example. The blue-chip athletic shoe and sportswear brand announced on June 28th that it expected revenue to drop slightly in the next year when investors had expected 2% growth. The stock immediately plunged over 18% and has struggled to regain its footing in the past few weeks. There are numerous other examples over the past quarter of relatively dramatic moves in individual share prices when a firm reports news that fails to beat heightened expectations, and the cost for missing projections seems to be increasing as we move through the year.
In many ways this is healthy, firms producing strong earnings per share are rewarded and those that disappoint are punished, but it also speaks to a market on edge. When one of the mega-cap technology companies announce less than stellar profits, which they must at some point, their stock price will react quickly to the news. This is not a reason to blindly sell equities, but it is a sign that within the index underlying risks may be growing. It is also a reminder of the importance of reviewing an equity portfolio to ensure that there is an appropriate amount of exposure to less expensive parts of the market that should provide diversification from the broad market. Balancing pricey growth stocks with cheaper value firms is one strategy we have advocated.
Hints of a Headwind
The US economy seems poised to grow near the consensus forecast of 2.4% for 2024 with analysts expecting growth to decelerate to 1.8% in 2025 as the full impact of 18 months of higher rates starts to bite. Equity earnings are on track to grow 10.5% in 2024 and 14.4% in 2025 according to FactSet, as firms are expected to maintain solid profit margins as interest expenses, employment costs, and raw material prices are expected to moderate in the next twelve months. These are solid numbers and support most of the equity returns we have seen to this point.
As we scan the horizon, there do appear to be some headwinds forming to this consensus. Consumer spending drives 67.7% of US GDP and is a key input for corporate earnings. Since the pandemic, a strong consumer supported by government relief programs, a tight labor market, and rising wages has supported US growth, but there are indications that the consumer may soon need to take a pause.
The labor market has remained more resistant to higher interest rates than many expected, but cracks may be forming. The unemployment rate has moved up to 4.1%, continuing unemployment claims have grown, and job openings have dropped. These factors coupled with slowing wage growth, indicate that many consumers will see their incomes plateau. At the same time, credit card balances have grown to record levels and the interest rates charged on that revolving debt load remain elevated. Slowing income, growing debt levels, and less government support should have a negative impact on consumer spending in the near future.
A Deep Dive
Opportunities to deploy capital outside of public equity and fixed income markets can help add additional return streams to a well-diversified portfolio that act independently of daily moves in the S&P 500. Opportunities in private markets often present themselves when investors begin to prioritize liquidity over returns; when a sector or strategy falls out of favor and quality assets are sold in a rush due to their association with a negative macro trend; or complexity causes some investors to ignore attractive opportunities.
Examples of these issues can be seen in various structured credit markets. Structured credit is less liquid than traditional bonds that are now paying reasonable yields, they are thought to be overexposed to negative macro tends, and they are complex and require unique management skill to navigate the marketplace. Commercial mortgage-backed securities (CMBS) and corporate collateralized loan obligations (CLO’s) are two example of markets that present interesting opportunities that have little to do with moves in the traditional stock market.
The CMBS market has been impacted by the sharp increase in interest rates, a perception that the asset class is overexposed to office buildings, and fewer buyers since generalist fixed income managers have rotated to other sectors. These bonds are backed by pools of loans linked to specific commercial real estate properties such as apartment complexes, retail centers, office buildings, hotels, and industrial parks, and each pool of loans will have several bonds issued against them that have different priority on the cash flows and assets. The most senior bonds rank ahead of the others and there can be several classes, called tranches, of bonds in the offering. As noted, these can be complex assets.
However, this complexity provides opportunity when a manager is able to fully underwrite and assess each loan in the pool backing the bonds and get a clear sense of the quality of the underlying real estate. Thus, when negative headlines on office properties cause generalist investors to sell indiscriminately, an experienced real estate focused firm can find attractive segments to purchase. A manager we are conducting due diligence on has presented several examples of bonds they have been able to purchase at substantial discounts that are set to yield mid-teen cash on cash returns due to their ability and willingness to look through the complex nature of the securities and asses the actual real estate that drives the ultimate value.
In the corporate CLO space, there are similar opportunities available. The corporate loans that make up CLO portfolios were thought to be under pressure due to higher interest rates and a potential hard landing for the economy that would hurt the credit quality of the companies issuing the loans. Some analysts were projecting a spike in defaults across all industries. However, managers that are equipped to underwrite the individual companies in a pool of 100+ loans can draw firm specific views and not rely on macro forecasts. This ability to make idiosyncratic credit quality assessments on individual loans provides a real edge in markets sometimes driven by daily headlines. Once a CLO manager has a clear picture of the quality of the loans backing the portfolio, they can target the part of the capital structure they wish to own, focused on achieving low to mid-teen cash yields.
Both of these strategies are under review for inclusion in our private credit partnership and are good examples of the types of exposures that are available in alternative asset classes today.
Changing Conditions
The markets have been surprisingly calm in the face of evolving interest rate expectations, a volatile geopolitical scene, and indications of a tiring US consumer. We continue to believe that our current positioning is the best way to balance risk and return in the current environment but recognize that we may be approaching rougher seas ahead
We remain overweight in US equities versus international stocks but want a balance between growth and value; seek to maintain a healthy cash reserve to allow for distributions and rebalancing if a dramatic market move occurs; and are allocating to attractive opportunities in private credit, cash flowing energy assets, select private equity, and attractive real estate properties that perform independently of broad equity index products and are subject to specific risk and return characteristics that make for a more attractive and efficient portfolio.
The third and fourth quarters are historically quite eventful for financial markets and with an important earnings season, consequential Federal Reserve meetings, and a hotly contested election in the US in the next few months, the second half of the year may not be as smooth as the first. A well-diversified portfolio that can take advantage of opportunities as they arise is the best way to navigate rougher waters.
We hope you are having a wonderful summer and have not been impacted by recent storms in the Houston area. We look forward to visiting soon and hope you are able to enjoy some time away this season.
Sincerely,
Steve Sprengnether
President & Chief Investment Officer
scs@legacytrust.com
Brad Bangen
VP, Head of Private Markets
Laurence Unger
VP, Head of Public Markets
lunger@legacytrust.com