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The Economy

The U.S. economy continued to expand in the second quarter of 2024. While there are some cracks forming in certain areas such as unemployment claims and credit card delinquencies, the broad message is the economy is mainly healthy. After real GDP growth slowed in Q1 to 1.4%, the economy is projected to have grown 1.5% in Q2 according to the Atlanta Fed’s GDPNow model. While still positive, this is slightly below the long-term trend of roughly 2.0%. Looking out at the rest of the year, the Federal Reserve expects real GDP to expand 2.1% and unemployment to remain low at 4.0%.

The main driver of the economic growth seen over the past year has been strong consumer spending. Many economists projected a slowdown in consumption this year as pandemic era savings ran dry, and inflation impacted spenders. However, recent data has shown that older, higher-income households have benefited over the past several years due to higher investment income, rising stock markets, and wage growth that has outpaced inflation. These households tend to make up a larger portion of spending, as can be seen in the chart below, and have been prioritizing their spending on experiences such as travel, live entertainment, and dining out.

While we do not foresee a recession in 2024, there are several things we are watching closely. First is the rising number of unemployment claims. These have ticked up in recent months and could signal that the labor market is beginning to soften. Second is geopolitical risks stemming from wars in the Middle East and Ukraine as well as elections in countries such as the United Kingdom, France and the U.S. Finally, we continue to monitor the Fed’s actions to access whether there is a risk of a policy error impacting the economy and markets.

Inflation

After a brief period of reacceleration in Q1, inflation resumed its downtrend in Q2. The May Consumer Price Index (CPI) came in soft with the headline rate flat for the month and the core rate, which excludes food and energy prices, up 0.2%. Over the past year, headline CPI was up 3.3% while core CPI rose 3.4%. Looking back a year ago to May 2023, headline and core CPI were 4.1% and 5.3% respectively, indicating the Fed has made progress on lowering inflation. However, recent figures remain well above their long-term target of 2.0% and explain why restrictive monetary policy has been held in place.

Services inflation has been the thorn in the side of the Fed over the past year. Services prices grew at a 5.3% year-over-year pace in May, well above the pre-COVID average of roughly 3.0%. Rising home prices, escalating rent, and surging insurance premiums account for much of the gain in services prices over the past year.

On the flip side, goods prices have returned to their pre-pandemic average of no growth over the past year and some areas are even experiencing deflation. One area that is experiencing declining prices is durable goods. Prices for items like household appliances, furniture, and used cars swelled during the pandemic as locked-down consumers spent their stimulus checks and the supply chain slowed due to COVID. These tailwinds have reversed over the past few years, with consumers prioritizing experiences over goods and the supply chain largely returning to normal.

We expect inflation to grind lower over the rest of the year but a quick return to 2.0% seems out of the question. The consequence of sticky inflation is higher interest rates for a longer period. Higher short-term rates favor asset classes such as cash, short-term bonds, and private credit.

The Federal Reserve

The Federal Reserve met twice in Q2, electing to leave their short-term rate unchanged at both meetings. The Federal Funds Rate has been in the 5.25-5.50% range for nearly a year, with the last hike occurring at the Fed’s July 2023 meeting. The Fed did make a tweak to their quantitative tightening program, shifting down their redemption of U.S. treasuries from $60 billion per month to $25 billion per month.

The Fed released an updated Summary of Economic Projections at their June meeting. The big change was the dot plot, which is an aggregation of all the members interest rate forecasts over the coming years. The dot plot showed the Fed now expects to cut just once in 2024, down from a projection of three cuts in March. This adjustment was in reaction to the stickiness of inflation over the first half of this year. This stickiness also prompted the Fed to raise their end-of-year forecast for core inflation from 2.6% to 2.8%.

At the beginning of the year, the market was pricing in six rate cuts in 2024. These were quickly reversed as the hot inflation reports in Q1 came rolling in. Now, the market is pricing in one to two cuts in the back half of this year, in line with the Fed. We think one or two cuts this year seems reasonable given still elevated inflation and healthy economic growth. Next year, the Fed is likely to adjust its policy rate lower throughout the year as inflation grinds towards 2.0% and economic growth eases back to its long-term trend.

Equities

The stock market, represented by the S&P 500 Index, ended the second quarter 4.1% higher. The index stumbled in April, falling 5.4% in the first three weeks of the quarter. However, the market found its footing in May and June, advancing 10.0% from the late-April bottom. The rally was led by mega-cap technology names as index heavyweights Nvidia, Apple, and Alphabet advanced 36.7%, 22.8%, and 20.7% respectively. Given the strong performance of technology, growth outperformed value yet again as the Russell 1000 Growth rose 8.1% and the Russell 1000 Value fell 2.6%. International stocks failed to keep up with U.S. markets as the MSCI ACWI Ex USA fell 0.5%.

Q1 earnings came in better than expected as U.S. companies grew their bottom lines by 6.0% year-over-year. Earnings growth is expected to accelerate the rest of the year with analysts forecasting 8.8% growth in Q2 and 11.3% for all of 2024. Earnings growth was concentrated in the AI-beneficiaries in Q1. However, growth is expected to broaden the rest of the year, providing a tailwind to other segments of the markets besides technology.

The market is expensive at current levels, with the S&P 500 trading at a forward P/E ratio of 21x and AI-beneficiaries trading at roughly 35x. With this backdrop, we favor a barbell approach to U.S. equities, pairing allocations to the mega-cap technology names with stable, defensive companies trading at lower valuations. We believe this mix allows us to play both offense and defense in this uncertain market environment.

Fixed Income

Interest rates were volatile in Q2 with the 10-year treasury yield rising over 50 basis points in the first few weeks of the quarter. Ultimately, the 10-year yield ended the quarter at 4.4%, a rise of 20 basis points. Index returns were muted over the quarter as the Bloomberg U.S. Aggregate Bond Index gained 0.8% and the Bloomberg Municipal Bond Index rose just 0.1%. Yields on both indexes remain attractive for income-seekers with taxable debt yielding 5.0% and tax-exempt debt yielding 3.5%.

The Fed appears to be done hiking rates this cycle, which provides a ceiling for how high rates should go. This should help interest rates find a trading range over the remainder of the year. Looking out into next year, the Fed is likely to guide interest rates lower as inflation eases, providing a tailwind to intermediate and long-term bonds.

For now, we continue to favor short-term treasuries and short-duration credit given the inverted yield curve and lack of significant rate cuts in the immediate future. We maintain an anchor position in intermediate, investment-grade bonds to provide steady income as well as protection should a recession or market dislocation impact equities. Finally, we continue to allocate to private credit, which provides portfolios with an attractive income stream and a differentiated return pattern compared to public markets.

Conclusion

In the second quarter of 2024, the U.S. economy exhibited continued expansion despite pockets of concern such as rising unemployment claims and consumer credit delinquencies. Following slightly below-trend economic growth in the first half of the year, the economy is expected to expand in the second half of 2024. Robust consumer spending, fueled by wealth gains among higher-income households, drove much of the growth in the first and second quarters. Looking ahead, while risks like geopolitical tensions and potential policy missteps from the Federal Reserve persist, the economy is projected to grow modestly at 2.1% for the remainder of the year.  Inflation remains above the Fed’s target but continues to moderate.

Aurdan Capital remains focused on managing potential volatility in the second half of 2024, with strategic investments designed to participate in upside and protect in any drawdowns. Please contact us with questions or to discuss the economy and markets in greater detail.

– The Aurdan Capital Management Team

IMPORTANT DISCLOSURES

The views, opinions and content presented are for informational purposes only. The carts and/or graphs contained herein are for educational purposes only and should not be used to predict security prices or market levels. Advisory services offered through Aurdan Capital Management, LLC., an Investment Adviser registered with the U.S. Securities & Exchange Commission. The information presented in this piece is the opinion of Aurdan Capital Management and does not reflect the view of any other person or entity.  The information provided is believed to be from reliable sources, but we cannot guarantee the accuracy or completeness of the information, no liability is accepted for any inaccuracies, and no assurances can be made with respect to the results obtained for their use.  The information contained herein may be subject to change at any time without notice. Past performance is not indicative of future results.

Use of the Russell indices

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Use of the MSCI Inc. and S&P Global Market Intelligence Global Industry Classification Standard (“GICS”) sectors

The Global Industry Classification Standard (“GICS”) was developed by and is the exclusive property and service market of MSCI Inc. (“MSCI”) and S&P Global Market Intelligence (“S&P”) and is licensed for use by Aurdan Capital Management, LLC. Neither MSCI, S&P, nor any party involved in making or compiling the GICS or any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability, and fitness for a particular purpose with respect to any of such standard or classification.  Without limiting any of the foregoing, in no event shall MSCI, S&P, any of their affiliates or any third party involved in making or compiling the GICS or any GICS classifications have any liability for any direct, indirect, special, punitive, consequential, or any other damages (including loss of profits) even it notified of the possibility of such damages.