Stocks saw modest gains in January amid upbeat Q4 corporate reports and positive economic data in areas including retail sales and gross domestic product (GDP), which together helped offset a mixed inflation update. As expected, the Fed kept rates unchanged at its January meeting and their neutral language led some to believe the Fed will be slow to adjust rates due to lingering concerns over inflation. The lack of a rate drop took the wind out of the stocks’ sails, curtailing the month’s gains.²

In February, stocks regained some momentum as investor enthusiasm surrounding artificial intelligence (AI) overshadowed the anticipation of the Fed’s next move with interest rates. By mid-month, investors’ attention shifted to any company offering an AI update in its quarterly report.

Decelerating inflation, steady unemployment, and strong but moderating GDP growth all helped propel stocks forward in March; all three averages set record highs during the month.³ At its March meeting, the Fed left rates unchanged again yet signaled its inclination to cut interest rates three times this year by a quarter of a percentage point each time. Markets rallied to new highs following the news, and the S&P 500 displayed its best first-quarter performance in five years.⁴

 

US ECONOMIC CONDITIONS: Increasing Growth

GDP: Led by consumer and government spending, the U.S. economy grew at a 3.4 percent annualized rate in Q423, revised up from the initial estimate. The GDP was higher than expectations but slower than the 4.9 percent expansion in the third quarter.¹¹

Labor: Employers created 275,000 jobs in February, beating expectations. The unemployment rate increased to 3.9 percent while average hourly earnings increased slightly less than expected.¹²

Housing: Single-family housing starts rebounded in February thanks to milder weather, climbing 11.6 percent. That compared with a drop in January. Sales of existing homes increased 9.5 percent in February to a seasonally adjusted annualized rate of 4.38 million units, the largest monthly gain in a year. Higher demand boosted the median sales price by 5.7 percent to $384,500, the eighth straight month of year-over-year increases.¹⁶ New home sales in February slipped 0.3 percent over the prior month but increased by 5.9 percent over February last year.¹⁷

 

INTERNATIONAL ECONOMIC CONDITIONS: Shifting Expectations

In Q1, Eurozone equities experienced a notable rise, largely propelled by the information technology sector due to the surging demand for  AI-related technologies. Financials, consumer discretionary, and industrials also post significant gains, driven by an optimistic economic outlook and announcements of shareholder return improvements by banks. Conversely, utilities, consumer staples, and real estate lagged. The quarter witnessed an improvement in Eurozone business activity. The flash Eurozone Purchasing Managers’ Index (PMI) edged closer to stability, marking 49.9 in March, up from February’s 49.2. This near-50 score suggests that business activities were close to leveling out, indicating a halt in contraction and a potential shift towards growth.

In the UK, equities also enjoyed an upward trajectory, with financials, industrials, and the energy sector leading the gains. The market began to anticipate an earlier- than-expected interest rate cut as inflation fell below the Bank of England’s projections. Despite entering a technical recession in the latter half of 2023 due to diminishing post-pandemic spending and the pressures of higher inflation and interest rates, the UK’s policy rate remained unchanged at 5.25% in March. Interest in smaller and mid-sized UK companies from overseas buyers remained robust.

Japan’s stock market saw an exceptional rally, with the TOPIX Total Return index soaring by 18.1% in yen terms. The rally was majorly supported by foreign investment, spurred by optimism around Japan’s economic cycle marked by gentle inflation and wage growth.

 

EQUITIES: Continued Strength

U.S. EQUITIES: Stocks notched solid gains in the first quarter as enthusiasm about artificial intelligence, signs of a soft landing, and dovish talk from the Fed buoyed investor confidence. For the quarter, the Dow Jones Industrial Average rose 5.62 percent, the Standard & Poor’s 500 Index gained 10.16 percent, and the Nasdaq Composite picked up 9.11 percent.¹

DEVELOPED  INTERNATIONAL  EQUITIES:  The  MSCI  EAFE  Index rose  5.06 percent during the first quarter on signs that the European Central Bank and others were considering cutting short-term rates. In fact, Switzerland’s Swiss National Bank cut its main policy rate in late March.⁸ In Europe, Spain (+9.63 percent, Italy (+14.49 percent, Germany (+10.39 percent, the United Kingdom (+2.83 percent, and France (+8.78 percent all posted gains for the quarter.⁹ Pacific Rim markets also trended higher, with Japan (+20.63 percent and Korea (+3.44 percent leading.¹⁰

EMERGING MARKETS:  In Q1 2024, emerging market (EM equities saw gains but lagged behind their developed market counterparts. China’s performance was weak despite policy stimulus efforts, and anticipation of delayed Federal Reserve interest rate cuts impacted markets,  especially  Brazil.  Taiwan stood out, buoyed by enthusiasm for AI and tech, while India benefited from currency strength and political stability ahead of its general election. Korea’s speculative sectors led to underperformance, and China struggled, particularly in healthcare, amid US-China tensions. South Africa and Brazil faced challenges due to political uncertainty and prior gains, respectively. Egypt was the quarter’s weakest performer, largely due to a significant currency devaluation.

 

FIXED INCOME: Falling Yields

U.S. FIXED INCOME: The Federal Reserve (Fed) kept interest rates on hold at 5.25-5.5%. US inflation ticked up slightly to 2.5% year-on-year in February, from 2.4% in January (as measured by the personal consumption expenditure metric). Fed chair Jerome Powell said that the central bank will be “careful” about the decision on when to cut rates. The latest “dot plot” that details policymakers’ expectations of rate cuts suggests three cuts this year. The US 10-year Treasury jumped from 3.87% at the end of Q4 2023 to 4.21% at the end of Q1 2024.

DEVELOPED INTERNATIONAL FIXED INCOME: Inflation remained a central concern for markets. Despite indications of diminishing inflationary pressures, unexpected high inflation readings tempered enthusiasm for imminent rate cuts. Both the US and eurozone reported inflation rates exceeding forecasts, raising alarms about the enduring nature of service sector inflation. As the quarter progressed, governmental bond yields adjusted in response to shifting market sentiments and economic indicators. 10-year government bond yields increased across the board (meaning prices fell). The UK 10-year gilt yield rose from 3.54% to 3.94%, while the German 10-year Bund yield steadied at 2.03% – a 26 basis point increase from the end of Q4.

 

QUARTERLY FOCUS: Irrational Exuberance?

In recent months, a cluster of tech stocks has been at the epicenter of financial market dynamics, owing to their pronounced impact on major indices and their heightened sensitivity to macroeconomic trends. This group, often referred to as the “Magnificent Seven,” includes some of the most influential tech companies: Apple, Microsoft, Alphabet (Google), Amazon, Meta Platforms (formerly Facebook), NVIDIA, and Tesla. These entities alone account for more than 28% of the S&P 500 Index, underscoring their significant weight and influence on the overall market performance.

The outperformance of these stocks versus the general market became particularly noteworthy following the Federal Reserve’s indication that it would pause interest rate hikes in December. This decision was further cemented by a continuation of the policy stance through March 2024. Such announcements generally lead to market optimism, as lower interest rates can make borrowing cheaper, potentially spurring business investments and consumer spending. This period of heightened optimism was characterized by expectations of forthcoming rate cuts and the prospect of a “soft landing” for the economy, a scenario where economic slowdown is mild and does not lead to a recession.

Extreme optimism, however, may not bode well for future returns. Tools like those from Ned Davis Research (chart right) have shown a surge in investor optimism during this period, which can often serve as a “contrarian” indicator. Historically, when optimism reaches extreme levels, it suggests that the market might be overvalued, prompting cautious or bearish outlooks among some investors. Such extreme positive sentiment is traditionally viewed as a harbinger of potential market corrections. This implies that while the general market momentum appears favorable, there is a need for enhanced risk management strategies. Moreover, the anticipation of a market pullback is not unfounded, especially considering the latest economic data. Recent inflation figures have come in higher than expected, which could temper the enthusiasm for imminent rate cuts. Initially, the market anticipated as many as six rate cuts in the coming year, but has since adjusted its expectations to just two. This recalibration reflects a more cautious approach by the market, aligning with a broader reassessment of economic conditions.

If inflation remains persistent, it could lead the Federal Reserve to adjust its policy stance, thereby influencing interest rates and economic growth projections. Such developments would inevitably affect investor sentiment and could lead to a cooling-off period for these stocks. Investors would be wise to monitor several factors closely. These include updates on Federal Reserve policies, inflation rates, and other economic indicators like consumer spending and employment rates. Additionally, global economic events, such as geopolitical tensions or international trade agreements, could also sway market conditions and impact these tech giants.

 

In summary, while the current market outlook is infused with optimism due to favorable monetary policies, the substantial influence and sensitivity of the “Magnificent Seven” tech stocks require a balanced and informed approach to investment. With the potential for economic indicators to sway market conditions, and the looming possibility of a market correction, investors must remain vigilant, employing robust risk management tactics and staying abreast of both macroeconomic and company-specific developments. This comprehensive approach will be crucial in navigating the uncertainties of an ever-evolving market landscape.

 

DPWM OUTLOOK: Cycle High

The extreme concentration of the US market can be used as a backdrop for broader opportunities found elsewhere. DPWM points to the MSCI EAFE Index which tracks developed market equities excluding the US and Canada as a prime example of these opportunities: unlike the S&P 500 where the top 5 companies constitute 23% of its value, the MSCI EAFE Index is less concentrated with its top five companies representing only 9% if its value. This lower concentration level not only highlights the diversification within the index but also contrasts sharply with the current US market’s trend towards a handful of stocks dominating market movements.

The differentiation in sector and style compositions between non-US markets and US markets further underscores the natural diversification benefits available. Non-US equities present a varied landscape, offering investment opportunities distinct from the heavily tech-centric and growth-oriented US market. This divergence is particularly relevant in an era where US equities have experienced soaring stock prices (chart right), leading to a pronounced valuation premium over their non-US counterparts. Although non-US equities might show lower estimated earnings per share (EPS) growth over a three to five-year horizon, DPWM suggests that when adjusted for price per unit of growth, these assets appear significantly more attractive.

This perspective challenges the prevailing market sentiment that often favors US equities for their growth potential, by highlighting the valuation disparities that may overlook the inherent value in international markets. DPWM’s investment philosophy emphasizes the importance of a broad-based approach, investing in companies across both US and non-US developed markets.  This strategy aims to capitalize on market shifts that reduce concentration in a limited number of equities, thereby potentially offering more sustainable growth opportunities across a diverse set of sectors and regions.

By focusing on these less concentrated, more diversified portfolios, DPWM advocates for the potential overlooked in non-US developed markets. This stance is grounded in the belief that as markets evolve and potentially become less dominated by a select few US equities, a broad-based, globally diversified investment approach will be well-positioned to benefit from the growth opportunities in developed markets around the world.

CITATIONS

1. WSJ.com, March 31, 2024
2. WSJ.com, January 31, 2024
3. CNBC.com, March 28, 2024
4. CNBC.com, March 28, 2024
5. SectorSPDR.com, March 28, 2024
6. BureauofLaborStatistics.gov, 2024
7. CNBC.com, February 13, 2024
8. MSCI.com, March 31, 2024
9. MSCI.com, March 31, 2024
10. MSCI.com, March 31, 2024
11. CNBC.com, January 25, 2024
12. BureauofEconomicAnalysis.gov, March 28, 2024
13. CNBC.com, March 8, 2024
14. FederalReserve.gov, March 15, 2024
15. Reuters.com, March 19, 2024
16. CNBC.com, March 21, 2024
17. CNBC.com, March 25, 2024
18. CNBC.com, March 12, 2024
19. Reuters.com, March 26, 2024
20. WSJ.com, January 31, 2024
21. WSJ.com, March 20, 2024
22. NYtimes.com, December 8, 2023
23. Womentalksports.com, December 27, 2023
24. Womentalksports.com, December 27, 2023
25. Olympics.com December 3, 2023
26. Olympics.com December 3, 2023