July 1, 2024 – Investment Commentary

Market Performance

Last week, equity performance was mixed, and bonds were down. The MSCI EAFE non-US developed index outperformed the MSCI Emerging Markets and S&P 500 indices. The best performing sectors in the S&P 500 were energy, communication services, and REITs. Across U.S. style & market cap indices, small-cap value did the best, and the value factor led more broadly.

As for fixed income, the 10 yr. treasury yield rose 12 bps on the week to 4.37%, and the 2/10 treasury yield spread steepened to -35 bps. The Investment Office is mindful of potential reflationary tactics from tariffs to tax cuts which may aggravate the budget deficit and push yields higher. The best performing parts of the bond market were bank loans, high yield, and municipals. High yield bond spreads fell on the week to 309 bps, still well below their 20-year average of roughly 500 bps.

A Few Observations

• Data Reports: Housing data mixed, U.S. PCE decelerates to its lowest since Q1 2021, and the jobs market is still broadly stable.
• Market Concentration: U.S. equity market concentration in Q2 was one of the highest
• Pending Data this week: JOLTs and ISM

The U.S. housing market continues to be key to the economic cycle as it is a large component in the inflation dynamics and should slow based on Fed policy (elevated mortgage rates). While initial jobless claims ticked down, continuing claims made a two-year high of 1.83 million. The jobs market has been the pillar of the U.S. economy for this entire cycle, and it is now showing some modest cracks. Companies are struggling with slowing revenue growth and, therefore, focusing on cost controls to manage margins. The jobs data suggests that there are not a lot of layoffs, but once laid off it is getting harder to find a job. This upcoming week, we get the JOLTs report and the monthly NFP jobs report for June. The consensus estimate for job openings is a decline to 7.9 million. We monitor jobless claims as we perceive it a somewhat timely indicator of a more significant slowdown potentially developing.

The Fed’s preferred inflation measure, core PCE, came down month on month and landed at 2.6% year on year in May. This is slowly bouncing its way toward the Fed target of 2%. The bond market continues to price in two rate cuts to end the year in September and December. While housing/rent prices continue to be sticky contributors to inflation, however, we monitor various “real time” market rent trends which are below the “owners equivalent rent” metric. Additionally, many other inflation metrics are in a downward trend. We do not believe the bond market is pricing in the disinflationary trends that have developed after Q1 as the 10 yr. ended Q2 at 4.37% after starting the year at 3.88%. This could mean bond returns end up being back end loaded if the bond market perceives a better disinflation environment.

Concentration

The Investment Office has highlighted before that the top 10 stocks in the S&P 500 make up over 30% of the index, which is the highest in history. Of the 15.3% total return of the S&P 500 year-to-date end June 2024, the top 10 stocks in the index have contributed 11.1% or nearly 73%. In reviewing Q2, the concentration became more extreme at the expense of market breadth. In Q2, the S&P 500 was up 4.3%,with the top 10 stocks contributing 5.6%, meaning the stocks outside of the top 10 in aggregate were negative.

From a style box perspective, there has also been incredible concentration with the large growth style bond being the driver of overall returns especially in Q2. The momentum factor was the best performer in Q1 and was tied with quality factor in Q2. The momentum factor can be a painful one for investors as it tends to do its best (become overbought) before changing directions. The catalyst for a change in market leaders likely comes from an earnings/economic trajectory change.

Mid-Year Outlook

In our current mid-year outlook, we maintain our overweight to U.S equities and credit.

• Economy. Resilient but Slowing Growth
• Inflation. Sticky but declining overtime to Pre-GFC Normal
• Fed. Dilemma of Fighting Inflation At the Expense of Growth
• Fundamentals. Valuations, Earnings Growth, Balance Sheet Strength
  • As the old saying goes valuations are not a catalyst, likely need a market or macro regime change or earnings slowdown to break the current leadership trend.
  • The good news is that the big tech companies are high quality with superior margins and strong balance sheets. As a result, we are still calling for exposure to the technology sector complemented by certain exposure to U.S. dividend growers, mid- cap non U.S. equities.
  • The largest 10 names in the S&P 500 make up 37% of the capitalization and 31% of the net income. This is an important difference from the tech bubble in 2000 when capitalization far exceeded earnings.
• Public Quality Bonds.
  • Opportunity to lock in municipal and investment grade credit at elevated rates as the Fed engages in a balancing act between price stability andfull employment. Taxes may increase, making exemptions provided by munis more valuable.
• Alternatives
  • Private markets may offer a variety of opportunities to earn income and grow wealth over time, including in private equity, private credit, and real assets.