The market overcame a rocky start in Q2 to finish higher as inflation trended lower and optimistic investors began anticipating the Fed’s seemingly inevitable management of interest rates [1]. April’s strong corporate earnings reports and solid economic indicators including retail sales and GDP growth stoked investor confidence. The Federal Reserve maintained its neutral stance on interest rates during its April meeting, further reassuring investors and fueling market gains [2].

The momentum continued in May as investor interest in AI-related technologies remained high. Companies that reported updates or advancements in Artificial Intelligence saw notable stock price increases. Decelerating inflation, steady unemployment figures, and continued strong GDP data despite a slight moderation further supported positive market sentiment [3].

Investor confidence was again boosted in June when the Fed indicated the possibility of rate cuts later in the year. To mark the strong second quarter finish, the S&P 500 and other major indices reached new highs with the technology sector seeing substantial gains driven by AI and semiconductor advancements [4].

 

ECONOMIC CONDITIONS:

U.S. – Sustained Growth

GDP: Despite a moderation in the U.S. economy’s growth rate, economists have been impressed with its overall performance. They cite the fact that it is now operating at full employment and that real gross domestic product (GDP) is nearly at a growth rate of 2% annually. Within this context, the Bureau of Economic Analysis released the third estimate of the Q1 2024 real GDP, a seasonally adjusted annualized rise of 1.4%. This is a slight increase from the 1.3% prior estimate, but a significant slowing from the previous quarter.

LABOR: Employers added 272,000 jobs in May, higher than the 190,000 economists expected. The unemployment rate edged up to 4.0% in May and average hourly earnings increased by 4.1% year-over-year [6].

HOUSING: The existing home market continues to be impacted by high mortgage rates. Sales remain significantly below their ten-year average and leading indicators present a mixed outlook for the upcoming month. The National Association of Realtors’ pending

home sales index and mortgage purchase applications indicate weakness, although mortgage rates have started to stabilize after a rise in late May, hovering around 7%. Additionally, affordability remains close to a 30-year low, restricting many households from entering the housing market.

International: Positive Shifts

The European Central Bank cut interest rates by 25 basis points in early June. However, the scope for further cuts may be limited by sticky inflation. Annual inflation in the euro area was 2.6% in May, up from 2.4% in April. Forward-looking data pointed to a slowdown in the eurozone’s economic recovery. The flash HCOB composite purchasing managers’ index (PMI) dipped to 50.8 in June from 52.2 in May. PMI data is based on surveys of companies in the manufacturing and service sectors. A reading above 50 indicates growth while below 50 indicates contraction. Politics was a key focus in the quarter. European parliamentary elections saw gains for right-wing nationalist parties. This was notably the case in France and President Macron responded by calling parliamentary elections in a move that surprised markets and saw French equities underperform the broader eurozone index.

U.K.: Having suffered a mild recession over the second half of 2023, it was confirmed the U.K. economy rebounded strongly in the first quarter of 2024, recording GDP growth of 0.7%. However, more recent data revealed growth had stagnated in April with the three-month unemployment rate (to April) rising to 4.4% as the economy shed 140,000 jobs. Meanwhile, annual consumer prices index inflation fell back to 2.0% in May, hitting the Bank of England’s (BoE) target for the first time since July 2021. Despite slowing U.K. growth and encouraging inflation trends, the BoE maintained base interest rates at 5.25%. This was amid market concerns that the fall in U.K. inflation may only be temporary, and that high wage inflation is driving the elevated annual rate of inflation in services which was 5.7% in May. Prime Minister Rishi Sunak fired the starting pistol for the race to form the next government by calling a general election held on July 4.

Japan: Japan’s stock market continued its exceptional rally with the TOPIX Total Return index gaining 19.5% in yen terms. Foreign investment drove the market supported by optimism about Japan’s economic cycle. The Bank of Japan’s policy adjustments and a strong corporate earnings season further boosted investor confidence [10].

 

EQUITIES: Continued Strength

U.S. EQUITIES: Stock prices were on balance higher for the third consecutive quarter. Unlike previous quarters, however, gains were relatively concentrated in a few economic sectors. Stock investors have bid prices higher based on continued strength in the labor market, an expectation that inflation is stabilizing, and the overall economy’s impressive resilience. After a brief dip early in the quarter, stocks reversed course and marched steadily higher, closing out the quarter near its highest point. When the quarter ended, the S&P 500 Index had advanced 4.3%

DEVELOPED INTERNATIONAL EQUITIES: International stocks underperformed U.S. equities. The MSCI ACWI Ex-USA Index rose 1.0%, while the MSCI EAFE Index fell 0.4%. Eurozone shares declined due to uncertainty from French parliamentary elections and reduced expectations for interest rate cuts. The information technology sector gained, led by semiconductor stocks, while the consumer discretionary sector declined. The European Central Bank cut rates by 25 basis points in June, with inflation rising to 2.6% in May. The economic recovery slowed, with the HCOB composite PMI dipping to 50.8 in June. Political gains for right-wing nationalist parties and French election surprises added to market uncertainty.

EMERGING MARKETS: Emerging market equities outperformed developed peers in Q2. Softer U.S. macroeconomic data eased concerns about U.S. interest rate cuts, and a rebound in China supported EM returns. Turkey was the best performer, driven by optimism about economic policy. Taiwan posted double-digit returns due to enthusiasm for technology stocks, particularly AI. South Africa also performed well, with investors welcoming the coalition “Government of National Unity” formed after general elections. India saw political developments boost equity market returns, with Prime Minister Modi’s BJP-led National Democratic Alliance retaining its parliamentary majority, despite BJP losing its single-party majority.

FIXED INCOME: Stable Yields

U.S. FIXED INCOME: The Federal Reserve kept interest rates on hold at 5.25- 5.5%. Inflation remained moderate, with a slight uptick to 2.6% year-on-year in June. The yield on the 10-year Treasury exhibited range-bound movements throughout the quarter, peaking in the latter part of April. Within this context, the yield on the 3-month Treasury Bill settled at 5.36% at the end of the quarter, slightly lower by one basis point from the previous quarter. The yield on the 5-year Treasury Note ended the quarter at 4.38%, compared to 4.21% on March 31, and as mentioned above, the yield on the 10-year Treasury Note settled at 4.40%, compared to 4.20% over the same period. The yield on the 30-year Treasury Bond was higher, ending the period at 4.56%, compared to its beginning level of 4.34%. The 10-year Treasury yield ended the quarter at 4.34%, reflecting market stability [14].

DEVELOPED INTERNATIONAL FIXED INCOME: Inflation concerns eased with U.K. 10-year gilt yields at 4.0% and German 10-year Bund yields steady at 2.1%. The quarter began poorly for global bonds due to U.S. inflation worries but improved with softer labor market conditions and favorable inflation news. Political risks affected emerging markets, with French elections causing local weaknesses. Investment-grade corporate bonds in the U.S. and Europe performed well, benefiting from higher income as credit spreads widened. Financials outperformed despite French bank weaknesses. High-yield markets excelled, outperforming government and investment-grade corporate bonds. Securitized, covered bonds and mortgage-backed securities delivered modest returns.

 

QUARTERLY FOCUS: New Highs

The recent upswing in equity prices marks a significant shift in investor sentiment that began with positive news on US inflation and growth. This shift has led to a sharp recovery in equity prices as the market began to price in a combination of a soft landing and potential rate cuts. Initially, the market had priced in seven US rate cuts at the start of the year, but these expectations have since faded. Despite this, equities have remained buoyant due to a series of positive macroeconomic surprises and growing optimism around artificial intelligence (AI). This optimism has notably helped the Nasdaq achieve a Sharpe ratio of 2.3 over the past twelve months, underscoring the market’s resilience and the impact of technological advancements. One remarkable aspect of this rally is the absence of a 5% pullback since the correction in the latter half of last year. This steady climb in equity prices has left many investors feeling that they may have missed out, leading them to remain on the sidelines in anticipation of a pullback before committing their capital. However, history indicates that markets at all-time highs can still present attractive opportunities. Strong performance often leads to continued strength, suggesting that even at peak levels, there can be potential for further gains. As we transition into the second half of the year, the risks for equity holders are rising. The environment is unusual, characterized by elevated valuations and an increased focus on political risks.

The fear of missing out, which has driven much of the recent rally, may begin to wane. Additionally, equities have significantly outperformed bonds since the low in October 2023, as expectations for interest rates have been revised upward. Despite these concerns, it is important to note that historically, it is uncommon for second-half returns to be weak following such a strong first half. The S&P 500, for example, has recorded more than 30 all-time highs so far this year. This robust performance has created a perception among some investors that they have missed their opportunity, leading to a cautious approach. However, market history shows that periods of strong performance often beget further gains (see chart right). Investors should consider that markets at all-time highs can still offer attractive entry points, and waiting for a pullback might not always be the optimal strategy. Given the current market dynamics, investors should carefully evaluate their strategies as we move into the second half of the year. While the potential for continued equity gains remains, it is also essential to be aware of the heightened risks associated with elevated valuations and political uncertainties. Diversification remains a key strategy, balancing equity exposure with fixed-income assets to mitigate potential volatility.

The optimism around AI and technological advancements is likely to continue influencing market sentiment. Investors should stay informed about developments in these areas, as they can present significant growth opportunities. However, it is also crucial to remain vigilant about broader economic indicators and geopolitical developments that could impact market stability. Looking at historical trends, it is clear that strong first-half performances often set the stage for continued strength. The market’s behavior this year aligns with past patterns where positive momentum leads to sustained gains. Investors should consider this historical context when making decisions, recognizing that the fear of having missed out can lead to missed opportunities. should consider that markets at all-time highs can still offer attractive entry points, and waiting for a pullback might not always be the optimal strategy. Given the current market dynamics, investors should carefully evaluate their strategies as we move into the second half of the year. Diversification remains a key strategy, balancing equity exposure with fixed-income assets to mitigate potential volatility.

 

DPWM OUTLOOK: Diversification May Shine

The outlook for the economy this year appears promising. Consumers are actively contributing by spending sufficiently to bolster broader economic expansion. Real incomes – and consequently consumers’ purchasing ability – are improving thanks to a robust job market. Moreover, substantial excess savings accumulated during the pandemic by middle- and higher-income households persist in supporting spending, providing consumers with disposable income as their wealth increases. The U.S. economy remains robust, even though growth has slowed somewhat, with real GDP expected to increase by approximately 1.5% annualized in the first half of this year, down from 2.5% last year. This deceleration is seen positively as the Federal Reserve aims to stabilize the job market and curb inflation. Unemployment remains low at 4% but has risen by 0.5 percentage points in the past year, accompanied by a softening in hiring and decreases in hours worked and temporary employment, two key indicators of future job growth.

Pressures on wages and inflation are easing, and the Fed’s target of 2% inflation appears achievable. However, many economists and analysts are of the opinion that as growth decelerates and unemployment edges upwards, the economy appears more delicate and exposed to risks. Numerous factors could disrupt the current trajectory, including geopolitical tensions that may escalate and the potential for significant downturns in the stock and bond markets which are currently at elevated valuations. One of the prominent concerns among analysts is that there will be a misstep in Federal Reserve policy. In addition, market participants are now paying closer attention to election polls in an attempt to handicap the outcome in November’s elections. Globally, despite aggressive monetary policy tightening over the past two years, economic growth has proven more resilient than anticipated. The previous year was overshadowed by persistent fears of a global recession, but with inflation cooling and the prospect of interest rate cuts on the horizon, households and businesses in most developed economies seem reassured that conditions are on the mend. Overall, while economists and analysts are generally positive on the economic outlook, investors should be diligent in monitoring diversification in their portfolio as the election cycle begins to heat up.

Broadening profit growth should support a more inclusive equity market rally. Results from the 1Q24 earnings season looked solid, as margin expansion helped pro-forma earnings grow by over 6% year over year. As has been the case for some time now, earnings growth has remained dominated by the “Magnificent 7,” the seven tech stocks dominating the S&P 500 gains. However, we don’t expect this trend to last. As 2024 progresses, broadening profit leadership across sectors should support a more inclusive equity market rally. As we can see in the chart to the right, recent earnings growth outside of the Mag 7 appear to be catching up while performance has drastically lagged over the past two years.