Market Commentary - February 2024

Monthly Update

The stock market’s winning ways continued in February as Artificial Intelligence excitement offset the impact of the reduction in the number of Fed rate cuts that were priced into the bond market. It was expectations of about six interest rate reductions that fueled the sharp November and December 2023 rally that brought the markets off the mat in Q4. Those expectations are now down to three according to the fed funds futures market but AI euphoria more than offset that in terms of the market mood so far this year. Nothing says AI exuberance like the incredible earnings and stock market rally seen with Nvidia and other tech companies that are involved in the build out of the infrastructure needs for specifically large language generative AI models. Keep in mind that AI in its initial concept and form began 70 years ago so we’re just talking about the current iteration.

In terms of market breadth, it did improve in February after the very narrow leadership seen in January. For example, after falling by 4% in January, the Russell 2000 did rebound by 5.5% in February[1]. This joined similar percentage increases for both the S&P 500 and the NASDAQ. Globally, the star of the show has been the Japanese Nikkei 225 which after 34 years finally exceeded its December 1989 bubble peak in nominal terms. This index rose 8.4% in January and by another 8% in February to reach that mark[2]. The Hang Seng has had a wild as it fell 9.2% to start the year only to bounce back by 6.6% in February[3]. The rally in Europe has been more measured as the Euro STOXX 600 was up by 1.4% in January and followed by a 1.8% increase in February[4].

The interest rate story was also very notable in February. As stated above, the last two months of 2023 saw a sharp drop in rates as comments from some Federal Reserve members seemed to lean into the beginning of rate cuts in 2024 and markets took that commentary and ran with it. The running of this ball took the bond market to price in about 6 rate cuts even though the Fed in their estimation were only predicting three. That started to reverse in February as Fed members continued with their speeches to walk back the market’s rate cut expectations. So, after falling by 83 basis points in the last two months of 2023, the US 2 yr. yield, highly correlated to Fed rate expectations, has risen by about 40 basis points since[5]. The US 10 yr. yield was down about 100 basis points at the end of last year and has since rebounded by almost 40 basis points[6].

There are a lot of very interesting crosscurrents influencing markets and the economy. As for the economy, I don’t believe I’ve ever seen so many mixed signals. With respect to the US consumer, the higher income decile is spending robustly on travel, leisure, hospitality and entertainment. Concert halls are packed as are stadiums and restaurants. On the other hand, their spending on goods has been more muted after gorging during covid. With respect to the lower income consumer, they have been more focused on prioritizing their spending and have been more ‘choiceful’ to use the word from the CFO of Walmart when talking about what they’ve seen in their stores about consumer behavior.

With the US housing market, the pace of existing home transactions is near the lowest since 1995 but new home construction has done better as the need for more supply is acute. As the existing home market dominates total sales, its slowdown means less need for carpet, paint, flooring, etc... On the manufacturing side, we’ve been in contraction globally for more than a year now as consumers shifted their spending to services and away from goods and many retailers in particular have tried to right size their inventory levels after last years burst higher. On the other hand, via the CHIPS Act, the wrongly worded Inflation Reduction Act and the infrastructure legislation passed a few years ago, has resulted in a sharp rise in the pace of manufacturing facility building, along with infrastructure renovations. This government induced spending and tax incentives has helped to lift GDP growth. On the other hand, capital investment otherwise from the corporate sector has been flattish with AI growth being offset by reductions elsewhere.

With regards to inflation, the main economic macro story over the past few years, it does continue to moderate but at a measured pace. We’ve seen the pace of goods price inflation fall back to its pre-Covid pace of zero on a year over year basis, but I don’t think it stays down and at current levels. Service price inflation has remained persistent but should slow as rental growth has moderated. Overall, the combination could still lead to some rate cuts by the Fed this year, but we still expect a more sustainable 3-4% rate of inflation in the coming years rather than the pre Covid trend of 1-2%.

Looking globally, it is also very much a mixed picture. Germany and Japan are in a technical recession, China’s economy has slowed but the Indian economy just printed a robust 8.4% GDP growth rate for Q4[7]. Other emerging market economies have outperformed too and an is investing area of the world that might finally have its day again as we think it will.

With respect to the stock market, as stated, the AI focused stocks have stolen the show but we are seeing other good macro stories like weight loss drugs. On the other end, the EV story is losing its luster as demand has faltered as consumers have preferred hybrids to the pure EV’s. Overall, valuations have lifted to high levels again and something to acknowledge. According to Apollo Management, the median P/E ratio of the top 10 S&P 500 stocks is now higher than what was seen in 2000. Also of note, the market rallied in 16 out of the past 18 weeks, the first time that has happened since 1971, according to Rosenberg Research. So, it’s possible that markets might be about to catch its breadth after quite an amazing sprint higher over the past four months.

Bitcoin also was a major highlight in February as it broke higher by 45% and is nearing its late 2021 record high[8]. That catalyst was the SEC approval of spot ETF’s and the slew that were created in response. That buying to fill the ETF’s drove the rally. We're uncertain about the future direction, but another asset sharing Bitcoin's traits - limited in supply, beyond the reach of central bank printing, with a 5,000-year history, and a key asset for central banks, namely gold—achieved a record high close on March 1st[9]. Central banks have been large buyers of gold and have bought record amounts over the past few years according to the World Gold Council.

Conclusion

After ending 2023 at about the same level as the end of 2021, stocks have broken out to the upside so far this year and are finally showing some gains over a multi-year time frame. As stated, much has to do with the AI excitement which also means this excitement needs to be realized sooner rather than later in terms of profitability via its vendors and users as a lot of great news has been priced into the stocks that have risen in response.

We still believe that interest rates will remain higher for a while which provides great opportunities for fixed income investors but also is a tougher funding environment for businesses, particularly commercial real estate that is highly interest rate sensitive and will have a few difficult years for those who have loans coming due this year and next. After a lengthy period of about 15 years of extraordinarily low and artificially suppressed interest rates, the new higher rate backdrop continues to evolve, and the transition is certainly bumpy and still could be for a period. This, especially for the US government that is increasing the size of its debts and deficits by large amounts and now being financed at higher rates.

With the Fed rate hiking cycle likely over, the shift in focus is when and how much to cut. Also, there is a big question as to what the Fed will do with its still oversized balance sheet which has only shrunk a touch from its peak. If the Fed cuts just a few times that could imply the economy remains resilient. If they cut more aggressively it might mean the economy enters a recession and the unemployment rate goes higher. It’s certainly a confusing picture for sure.

We acknowledge that we live in a different macro world than that enjoyed in the 15 years pre-Covid and need to have eyes wide open on how things proceed from here. Whatever comes our way in this very tricky investing landscape, it remains vital that investors have adequate short-term liquidity over the next 2-3 years. Knowing that period is covered can help separate the balance of one’s portfolio from the ups and downs of the markets. Time horizon is always crucial and is always the best friend of any investor. We are in the risk management business and always believe that by watching our back and focusing on the risks, the upside should take care of itself.

Disclaimer

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The market and economic data is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The information in this report has been prepared from data believed to be reliable, but no representation is being made as to its accuracy and completeness.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The Stoxx Europe 600 index also called the STOXX 600 is an indicator of the performance of the European stock market. It measures the performance of large mid and small-cap companies across 17 countries in Europe. The number of constituents is fixed at 600.

The Hang Seng Index is a freefloat-adjusted market-capitalization-weighted stock-market index in Hong Kong. It is used to record and monitor daily changes of the largest companies of the Hong Kong stock market and is the main indicator of the overall market performance in Hong Kong. These 82 constituent companies represent about 58% of the capitalization of the Hong Kong Stock Exchange.

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The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index.

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[1] Bloomberg

[2] Bloomberg

[3] Bloomberg

[4] Bloomberg

[5] Bloomberg

[6] Bloomberg

[7] Bloomberg

[8] Bloomberg

[9] Bloomberg