Q3 Economic and Financial Market Outlook

Q2 Recap: More of the Same

The U.S. economy is continuing to outpace expectations, supporting stock market gains. However, the stronger economy has meant higher-for-longer interest rates and a headwind for fixed income returns. The consensus forecast for full year 2024 U.S. GDP growth is a solid 2.4%, up from 1.2% at the beginning of the year.ⁱ The U.S. job market remains robust, adding 1.3 million jobs to the economy in the first half of 2024, driving personal consumption expenditures growth of 5.0% on a year-over-year basis in May 2024.

Equity markets continue to move higher. The S&P 500 produced a 4.3% total return in Q2 and 15.3% YTD. The strong economic performance through the first half of the year provides support for the 2024 corporate earnings outlook. Large capitalization growth stocks, especially the Fantastic Five (Nvidia, Microsoft, Alphabet, Amazon, and Meta), continue to be key drivers of both earnings growth and price performance for the S&P 500. We estimate the Fantastic Five are responsible for approximately 55% of the S&P 500’s total return year-to-date and 46% of the S&P 500’s 2024 estimated net income growth.

Fixed Income markets returns were slightly positive. The Bloomberg U.S. Aggregate Bond Index returned 0.1% in Q2 but is down -0.7% YTD.

Interest rates and inflation rose further. The stronger than expected economy in the first half of 2024 and higher than expected inflation readings have tempered Fed rate cut expectations, sending interest rates higher year-to-date. U.S. Treasury yields have fallen from their 2024 highs reached in April; however, two- and ten-year yields were modestly higher for Q2 and are up 47 bps and 49 bps, respectively, year-to-date. High yield bonds continue to be an outlier, producing a year-to-date total return of 2.6%. High yield spreads remain at historical low levels, reflecting the improving economic outlook and perceived low risk of default.

Solid economic growth continued to support stock prices; however, higher than expected inflation and interest rates remained a head wind for fixed income returns.

The Economy Remains on Solid Footing

In the first quarter, U.S. GDP grew 1.4% on a seasonally adjusted annual rate (SAAR) – a bit of a slowdown from the 4.9% and 3.4% SAARs for the third and fourth quarters of 2023, respectively. Slower spending on durable goods (specifically autos), lower levels of inventory building, and an increase in imports slowed growth.

Importantly, the Atlanta Fed GDPNow estimate for Q2 growth is 2.0%, and the FactSet consensus estimate for full year 2024 growth is 2.4%. Together, these estimates suggest that the economy, while slowing, remains on solid footing.

The Labor Market: Stable But Worth Monitoring

Labor demand continues to appear stable, but a divergence between the government’s establishment and household labor market surveys is something to monitor. According to the government’s establishment (i.e., businesses) survey of employment, the U.S. economy has generated positive job growth for 49 out of the past 50 months. Since May 2020, following the massive layoffs resulting from the COVID induced global shutdown, 28.2 million jobs have been added—well above the approximately 21.9 million lost during the height of the pandemic.

Average monthly job growth of 222,000 during the first six months of the year remains respectable. For context, for the ten years prior to the COVID shutdown, the monthly average job gain was 188,000. Conversely, the government’s household survey of employment (which is used to calculate the unemployment rate) suggest flattish job growth year to date, a 13.6% increase in the number of unemployed since last year, and a rise in the unemployment rate to 4.1%, up from a low of 3.4% in early 2023. (To be sure, 4.1% is still a relatively low level on a historical basis.) 

Separately, the Conference Board Consumer Confidence Index also indicates that consumers are increasingly finding jobs less plentiful and harder to get.ⁱⁱ Nevertheless, on balance, the outlook for stability and additional gains in employment appears positive with job openings of 8.1 million. While down from a high of 12.2 million two years ago, this is well above the estimated 6.8 million unemployed workers looking for jobs in the U.S. 

Personal Income Gains and Consumer Spending

As we know, a stable labor market supports personal income gains and consumer spending. Personal income is growing at respectable 4.6% annual rate (year-over-year as of May 2024) and despite stubbornly high inflation levels, real (adjusted for inflation) hourly earnings as of June and real (adjusted for inflation) disposable personal income as of May are both still positive at 0.8% and 1.1%, respectively. To be sure, real income growth rates have decelerated from last year, but current stable labor market conditions are expected to keep income gains positive.

Personal consumption expenditures are growing at a 5.1% annual rate (year over year as of May 2024) and on a real basis (adjusted for inflation) are growing at a 2.4% rate. While overall spending remains solid, there is some recent evidence of a slowdown in spending on durable goods and in discretionary services spending, such as food and recreation. Nevertheless, consumers’ sentiment related to their present situation remains near post-pandemic high levels, helping to support continued gains in spending.ⁱⁱⁱ (Note: Personal consumption expenditures are typically the largest component of GDP growth.)

Government Spending

Government spending has also been supportive to the economy and is likely to continue. The U.S. federal government continues to run a significant budget deficit. In 2023, that amounted to $1.7 trillion dollars, or 6.3% of GDP; and for 2024 the Congressional Budget Office (CBO) projects a $1.9 trillion deficit, or 6.7% of GDP.  This would bring the cumulative deficit since the pandemic (2020) to over $11 trillion.

State and local governments have also been relatively significant contributors to economic growth. A portion of this is attributable to spending related to the American Rescue Plan Act (ARPA), which provided $350 billion of federal funding to state and local governments to be expended through 2026.

Tempered Fed Rate Expectations

Future Fed policy may also be helpful to 2024 and 2025 GDP growth prospects; however, earlier expectations for aggressive Fed rate cuts in 2024 have faded. Coming into 2024, the Fed funds futures market anticipated 150 bps of rate cuts in 2024.^iv The Fed also projected rates cuts in 2024, but a more modest 75 bps of cuts.^v However, inflation readings in early 2024 came in higher than expected, tempering expectations for aggressive Fed Funds rate cuts in 2024. 

The more recent inflations readings, however, suggest inflation is moderating once again and moving towards the Fed’s 2.0% target, which could be a catalyst for rate cuts. The June 2024 Consumer Price Index (CPI) came in at 3.0% on a year-over-year basis, the lowest level since March of 2021. Similarly, Core CPI (i.e., changes in the price of goods and services, excluding food and energy) came in at 3.3%, the lowest level since April 2021. The Fed’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) Price Index, is also exhibiting signs of deceleration in the past few months. The latest reading for the PCE Price Index and its core component were both 2.6%, the lowest levels since early 2021.

In his most recent testimony to Congress in early July, Fed Chair Jerome Powell acknowledged that inflation is no longer the only risk faced by the economy and Fed; there is also the cooling labor market, which is just as undesirable as elevated inflation.  Essentially, his most recent comments suggest the Fed may be close to lowering rates. 

The Fed funds futures market, which provides insight into investors’ future expectations for the fed funds rate, is now expecting 50-75bps of cuts in 2024, and importantly, an additional 100-125 bp of cuts in 2025.^vi  That is, we could be on the brink of a Fed loosening cycle and lower interest rates, which in turn should theoretically be stimulative to the economy.

We could be on the brink of a Fed loosening cycle and lower interest rates, which in turn should theoretically be stimulative to the economy.

Economic Outlook: No Recession but Still Risks

We remain optimistic that the economy will avoid recession in 2024 and 2025; however, it is not without some concerns. We, like most, continue to be pleasantly surprised by the resiliency of the U.S. economy and are incorporating a much more sanguine viewpoint into our outlook, but there are still some tangible risks to monitor. 

Fed’s Restrictive Policy

First and foremost, the Fed’s restrictive monetary policy stance since March 2022 continues to muddy the outlook. The economy has easily absorbed 525 bp of Fed funds rate increases from March 2022 through July 2023, which was the largest and fastest rate increase since 1980. However, the impact of monetary policy involves “long and variable lags” that can take 9 to 24 months to impact the economy.^vii  This impact may still be felt even if the Fed has finished raising rates and starts cutting sometime in 2024. Past Fed fund rate increase cycles have led to a slowdown in economic growth and often recession. 

Inverted U.S. Treasury Yield Curve

The U.S. Treasury yield curve remains inverted, which has historically been a strong indicator of recession. Both the 2y – 10y U.S. Treasury spread and 3m – 10y U.S. Treasury spread continue to be inverted as of June 30, 2024, at -35 bp and -99 bp, respectively – and have been for an extended period. The recession probability indicator of the Federal Reserve Bank of New York, based on U.S. Treasury yield spreads, puts the probability of recession within the next twelve months at 56%.^viii

Challenging Operating Conditions in the Banking Industry^ix

Although fallout from bank failures early in 2023 was contained, and results of the Fed’s annual stress test on the country’s largest banks suggests these banks are sufficiently capitalized,^x operating conditions continue to be challenging for the banking industry.

Deposit outflows appear to have stabilized, but higher yielding competing products may continue to draw deposits out of the banking system, raise the cost of funds, and lower income and profitability from lending. Banks continue to hold significant unrealized investment losses in their investment securities portfolios, and the continued increase in interest rates has likely provided little relief. The combination of higher borrowing costs and reduced liquidity could keep bank lending standards tight, which are already at levels historically associated with economic slowdown and recession.^xi

Other Economic Indicators: Caution is Warranted

The Leading Economic Index (LEI)—which includes ten components across financial, labor, manufacturing, consumer, and housing markets—continues to weaken; however, the year-over-year contraction is moderating, signaling slowdown, but not recession.^xii

The Institute for Supply Management (ISM) indexes for both manufacturing and services activity indicate a slight contraction in activity overall. Importantly, the new orders component of both indexes also suggests a slowdown. The manufacturing index has signaled a slower growth environment since October 2022. The services index just recently indicated a slowdown in activity.

The U.S. housing market continues to struggle. Existing home sales, which fell to GFC (Global Financial Crisis of 2007–2008) levels in 2023 following a sharp rise in mortgage rates, continue to languish near trough levels (with year-over-year growth still in negative territory – down 2.8%). Housing starts, which had experienced periodic signs of strength through and post pandemic, have recently turned negative – down 16.5% year over year in May 2024. On a positive note, home price gains which continue to be a bright spot and helpful to consumer net worth and financial outlook, are up 7.2% on a year-over-year basis in April.

Consumer confidence levels, specifically the future expectations component, is at a level typically associated with recession. The present situation component of consumer confidence levels is relatively strong; however, consumers’ outlook on the future is much dimmer.

U.S. Government’s Fiscal Health

We continue to be a bit concerned about the U.S. Government’s fiscal condition and its potential to negatively impact government spending and tax policy, and in turn economic growth, in the years to come.

The gross debt of the United States Government has grown $11.6 trillion, or 50%, since the end of 2019 (just before the pandemic) – and now stands at $34.8 trillion (as of 6/30/24).^xiii Due to the significantly higher debt levels and the sharp rise in interest rates over the past year, the Congressional Budget Office (CBO) estimates that net interest payments on the nation’s debt (or the cost to service the debt) will rise to over 20% of total government revenue by 2025, up from 14.8% in 2023 and an average of 8.7% from 2013-2022. This has significant implications for government spending and tax policy in the years to come, especially given that the U.S. budget already operates in a deficit, which the CBO estimates to be approximately 21% of revenue in 2024, excluding net interest expense.^xiv

We continue to be a bit concerned about the U.S. Government’s fiscal condition and its potential to negatively impact government spending and tax policy, and in turn economic growth, in the years to come.

Financial Markets

Positive economic momentum is supportive of overall corporate earnings and stock prices, but market breadth is narrow, and valuation is at a premium. Stubbornly high inflation and higher-for-longer interest rates have hindered fixed income returns, but we may be close to a Fed pivot to more accommodative monetary policy, which could be a positive for fixed income returns going forward.

Fixed Income

With yields still in the higher-end of their 15-year ranges and renewed prospects for Fed easing in 2024 and 2025, it may make sense to add duration to portfolios, with a preference for high quality. Credit spreads are extremely tight and do not appear to adequately compensate investors for the added credit risk; as such, it may be too early to add exposure to lower quality corporate bonds and other higher-risk, credit-sensitive segments of the fixed income market.

Yields. The 2-year Treasury ended Q2 yielding 4.72%, down from the 2024 high of 5.03% in April, but up from 4.25% at the beginning of the year and still at the high-end of the 15-year range of 0.09%-5.21%. The 10-year Treasury ended Q2 yielding 4.37%, down from the 2024 high of 4.70% in April, but up from 3.88% at the beginning of the year and still at the high-end of the 15-year range of 0.50% -4.99%. 

Inflationary pressures reemerged in early 2024, eliminating prospects for aggressive Fed rate cuts in 2024 and resulting in upward pressure on interest rates. Higher interest rates in the first half of the year resulted in modest to negative returns across the fixed income market. However, recent inflation readings suggest prices across the economy are moderating once again – and the labor market, while still relatively strong, is showing some early signs of cooling. 

Given the increasing probability over the next 12-24 months of a more accommodative Fed, lower interest rates, and lower inflation, we would expect to see yields to eventually move lower across the fixed income markets.  We continue to see opportunity to extend portfolio duration (that is, extend maturities) and lock in some higher yields for the longer term.  A move towards lower yields also provides a tailwind to fixed income total returns (bond prices move inversely with interest rates – as rates move lower, prices move higher; and vice versa). Furthermore, current high money market yields are likely to fall, and potentially rapidly, should the Fed begin to lower the Fed funds rate.

Of course, there is risk that yields could continue to rise, resulting in a headwind for fixed income returns. Inflation could reemerge and force the Fed to hold steady with interest rates. Additionally, “bond vigilantism”^xv may grow if investors become uneasy with the U.S. government’s large budget deficits and growing debt, prompting demands for higher-risk premiums (yields) to offset the perceived risk of unsustainable spending and debt accumulation. 

Nevertheless, yields are at the high end of their decade plus range, and based on consensus forecasts, it could be we have already witnessed peak yields this cycle. Timing the exact inflection point of peak yields is probably not the best investment strategy. 

Credit spreads. Credit spreads remain at the low end of historical ranges and do not appear to price in any hiccups in the economy – and especially not any significant slowdown and/or recession; therefore, it may be too early to add exposure to lower quality corporate bonds. Investment grade spreads at 94 bp remain slightly below the twenty-year average of about 149 bp and significantly below spreads during economic slowdowns and recessions. High Yield spreads at 309 bp remain significantly below the twenty-year average of about 492 bp and spreads during economic slowdowns and recessions.

Equity

Stock prices continue to defy gravity, with the S&P 500 up 15.3% year-to-date and up 34.0% from the most recent low on October 27, 2023.  The outlook for corporate earnings growth in 2024 and 2025 is supportive of stock prices; however, both the S&P 500’s price performance and earnings growth is not broad-based and heavily reliant on a relatively small group of companies.   The current valuation level leaves little room for any disappointment. 

Corporate earnings. The solid performance of the U.S. economy is clearly helping corporate earnings growth, which is supportive of stock prices. Current consensus S&P 500 earnings estimates call for 2024 and 2025 earnings per share growth of 10.7% and 14.4%, respectively, up from 0.4% growth in 2023. We view these consensus numbers as somewhat reasonable given economic growth forecasts; however, we would not be surprised to see some moderation in these growth estimates in the back half of 2024 due to:

• Historical patterns in the trend of annual earnings estimates (i.e., calendar year earnings estimates tend to fall as the year progresses).
• Concerns about earnings growth estimates for certain sectors (e.g. the financial sector is expected to grow adjusted net income by 6% in 2024 and contribute over 13% of the S&P 500’s adjusted net income growth in 2024, which seems optimistic in our opinion).
• The concentration of 2024 earnings growth among a relatively small number of companies (e.g. the “Fantastic Five” companies are estimated to contribute almost half of the S&P 500’s adjusted net income growth in 2024 – see additional details below)

“Fantastic Five” Impact on S&P 500. The underlying dynamics of the S&P 500 are not as strong as the aggregate numbers suggest. Large capitalization stocks, and specifically large capitalization growth stocks, account for a significant portion of both the S&P 500’s total return and earnings growth in 2024. The “Fantastic Five” stocks (Nvidia Microsoft, Alphabet, Amazon and Meta) comprise about 24% of the S&P 500’s market capitalization, but account for approximately 57% of the S&P 500’s total return year-to-date; with Nvidia alone accounting for roughly 28% of the year-to-date return.

The median stock in the S&P 500 (excluding the “Fantastic Five”) produced a total return of only 5.4% versus 30.5% for the “Fantastic Five” and the 15.3% total return for the S&P 500. Further, the “Fantastic Five” stocks account for approximately 46% of the S&P 500’s estimated adjusted net income growth in 2024, and only twenty companies in the index account for approximately 90% of the S&P 500’s estimated net income growth in 2024.

We continue to have a cautious outlook for stock prices. With the ongoing stock price rally, stocks do not appear “cheap.” 

While the reliance on a small group of companies presents risk for the S&P 500, there are some positive benefits. The “Fantastic Five” are innovative companies benefiting from their exposure to several sustainable, long-term secular trends, such as artificial intelligence. As such, their growth prospects look attractive and somewhat more reliable than the average company. This provides support for, and some degree of confidence in, the index’s overall performance. 

Looking ahead to 2025, consensus estimates suggest 2025 net income growth will broaden out. In 2025, the “Fantastic Five” are expected to account for only about 26% of the S&P 500’s adjusted net income growth, down from 46% in 2024. Broader earnings growth will hopefully broaden stock price performance.

The S&P 500’s price/earnings ratio (valuation) is at a relatively expensive level. Current valuation levels leave little room for any disappointment, whether it be from the economy, corporate earnings, or some other unforeseen risk. The ongoing rally in stock prices puts the current S&P 500 p/e ratio based on 2024 estimates at 22.4x. This is not a cheap valuation, especially in a still relatively high inflationary and interest rate environment. If inflation and interest rates fail to fall in the coming year, then we see a downside risk to valuation.

There is an inverse correlation between inflation and p/e ratios. Higher inflationary environments typically result in lower p/e ratios; and vice versa. Since 1960, 2%-3% inflationary environments (as measured by the CPI) have resulted in average low and high P/E ratio range of 17x-21x. To be sure, there are certainly times when the P/E ratio is above or below this range, and for an extended period.  As such, today’s 22.4x P/E ratio, while higher than average, does not mean that stock prices are poised to fall. However, in our opinion it does indicate a higher level of valuation risk. 

While high P/E ratios do not necessarily provide good insight into subsequent one-year stock returns, they do exhibit a higher degree of correlation with longer-term returns. That is, high P/E ratio environments typically see lower subsequent longer-term (5-year) returns, and vice versa.^xvi

Small- and mid-capitalization stocks. We have a neutral position on small- and mid-cap stocks relative to large cap stocks, but that could change should the Fed pivot to a more accommodative monetary policy stance.

 Small- and mid-cap stocks look cheap, especially compared to large-cap stocks; however, the small and mid- cap indices lack exposure to the “growthier” segments of the economy. Small- and mid-cap stocks are trading P/E ratios that are at 32% and 27% discounts, respectively, to their 20-year historical P/E valuation relative to large-cap stocks (S&P 500).

The S&P 600 Small-Cap Index and the S&P400 Mid-Cap Index have significantly less exposure to growth sectors of the economy such as information technology (IT), communication services, and healthcare. For instance, IT stocks comprise only 12.8% and 9.5% of the S&P small- and mid-cap indices, respectively, versus 32.5% for the S&P 500. Communication services stocks comprise only 2.8% and 1.6% of the S&P small- and mid- cap indices, respectively, versus 9.3% for the S&P 500. As such, until economic growth prospects broaden beyond the IT segments of our economy (such as artificial intelligence), we suspect the small- and mid- cap stock indices will continue to trade at discounts to large-cap stocks.

A Fed pivot to more accommodative policy and aggressive rate cuts could also present an opportunity for an improvement in the small- and mid-cap valuation discount relative to large-cap. Small- and mid-cap stocks have significantly more exposure to cyclical and interest rate sensitive areas of the economy such as industrials, material and financials.

We have a neutral position on small- and mid-cap stocks relative to large cap stocks, but that could change should the Fed pivot to a more accommodative monetary policy stance.

International Equity. We continue to underweight our exposure to international equities but see performance benefits from a weak U.S. dollar. Although valuations appear significantly lower than in the U.S., earnings growth rates across the developed international countries are much less attractive, partly due to their more modest exposure to global scale information and medical technology companies. 

In addition, the Russian/Ukraine and Israel/Hamas conflicts have a much greater and direct impact on economies outside of the United States. Across Europe, 2024 economic growth projections are relatively poor and below 1%.^xvii

In the emerging markets, heightened risks keep us cautious – specifically, geopolitical risks related to China. We do recognize a weaker U.S. dollar will boost unhedged international investment returns.  The U.S. dollar increased 3.0% versus the Euro in the first half of 2024; however, the consensus forecasts call for dollar weakness in anticipation of lower U.S. inflation, a more accommodative U.S. Federal Reserve policy, and improving global economic growth relative to the U.S.   As such, we do see value in having some exposure to international equities.

A Word on the Upcoming Election

In general, history suggests financial markets react more to economic conditions than election results – and over long periods, stock prices move higher regardless of the political party in the White House or in control of Congress. While contentious and hotly contested elections can certainly create investor anxiety, any change in investment positioning based on a forecast of election results is purely speculative. As such, investors should stay focused on their long-term financial goals.

We will have more commentary on the election and its potential implications in upcoming publications.

Enjoy your summer and please reach out to your Washington Trust wealth advisor team with questions about how the economy and market may impact your portfolio and long-term financial plan.