Growth has moderated, can the expansion continue?

by Badgley Phelps | Jul 22, 2024

Outlook: 3rd quarter 2024

Economy remains on an upward trajectory 

The economy remains on an upward trajectory with growth of approximately 2.0 percent expected this year. The outlook has been tempered modestly since our last update as the economy expanded at a rate of just 1.4 percent in the first quarter. However, a resilient employment market, a record level for consumer net worth, a high level of government spending, significant investment by businesses in the development of artificial intelligence, and strong demand for services continue to underpin this expansion.

Recent data shows that growth remains uneven with consistent demand for services coupled with upward pressure on prices. In contrast, demand for goods varies from industry to industry and inflation rates are generally falling in these areas. Accordingly, some manufacturing-based industries are at risk of returning to the rolling recessions that were prevalent during the pandemic.

Given the uneven nature of the expansion and moderating inflation, investors expect a change in the Federal Reserve’s policy later this year. However, the central bank remains vigilant, and they are now guiding to just one interest rate cut by the end of the year. For the sake of comparison, the central bank’s guidance in March suggested they would cut rates three times this year.

Inflation continues to moderate

Inflation continues to moderate but remains above the Federal Reserve’s 2.0 percent target with the Consumer Price Index coming in at 3.0 percent in June. Notably, the recent data softened with a modest decline in prices for the headline reading month over month. A closer look at the data shows that prices for services continue to rise, led by rent, auto insurance, and health care. However, price increases for goods are moderating.

Inflation is expected to continue its gradual decline given the Federal Reserve’s emphasis on containing price increases. The central bank’s policy rate is now more than two percentage points above the rate of inflation, and they are reducing liquidity in the financial system by shrinking their balance sheet. These policies, collectively, are intended to slow the pace of growth and reduce the inflationary pressure in the economy.

 

U.S. dollar has exceeded consensus expectations this year

The U.S. dollar has exceeded consensus expectations this year and remains elevated. Expectations for an eventual reduction in interest rates have led to a decline from the 2022 peak, but the ongoing economic expansion in the U.S. and interest rate cuts in foreign countries have provided a fresh boost to our currency. Looking forward, we expect the economic expansion and the Federal Reserve’s emphasis on fighting inflation to keep the dollar at a relatively high level.

Asset class outlook for Q3 2024

Cash/Money Market Instruments

At its most recent meeting in June, the Federal Reserve maintained the target range for the federal funds rate at 5.25 to 5.50 percent. Looking ahead to the second half of the year, our central bank is now guiding to just one interest rate cut by December and a review of their long-term projections points to a terminal rate of 3.1 percent. In our view, this implies that while the Federal Reserve may be uncertain on the pace of rate cuts, the end goal remains the same: It expects to gradually lower interest rates to a neutral level over the next 12 - 36 months.

Intermediate Government/Credit Bonds

With potential interest rate cuts on the horizon, we believe opportunities are most attractive in intermediate-term U.S. investment-grade bonds relative to short-term debt and cash-like instruments. While the yields on short-term bonds and cash are attractive today, these investments carry greater reinvestment risk and longer-term bonds allow investors to lock in today’s higher rates for longer periods of time.

Within the investment-grade bond universe, we continue to emphasize high-quality corporate bonds balanced with a mix of government debt securities. The economy has been resilient, and the outlook for corporate bonds remains positive despite credit spreads that are at historically low levels. Government bonds are additive as they offer excellent liquidity and diversification.

Tax-Exempt Municipal Bonds

The municipal market has experienced a significant uptick in issuance this year, with tax-exempt supply reaching levels not seen since 2007. This marks a departure from the below-average supply over the last few years, a period when state and local governments benefited from federal stimulus funds and a better-than-expected recovery from the pandemic. On the demand side, the market has responded with a continuation of strong inflows as interest rates remain at multi-year highs. Municipal market fundamentals continue to show strength as we approach the second half of 2024. Tax revenues and reserves have moderated but remain well above pre-pandemic figures and are not far from historic highs.

U.S. Equity

The S&P 500 Index generated a strong gain in the first half of the year with a total return of approximately 15 percent. Stocks in the growth segment continued to be the best performers driven by the companies that provide the infrastructure for artificial intelligence (AI), such as those in the semiconductor industry or cloud services.  

In the second quarter, growth stocks led the major indexes to record highs. However, the returns across the market were mixed. While the Russell 1000 Growth Index generated a return of more than 8.0 percent, stocks in the value and small/mid cap styles declined. These performance disparities have been a persistent theme during this bull market, and they are indicative of the variation in growth trajectories for industries across our economy. 

On a positive note, earnings growth is accelerating after two years of modest increases. To date, a large percentage of that improvement has been generated by the stocks in the artificial intelligence ecosystem. However, profit growth is expected to increase in the second half of the year fueled, in part, by more broadly-based participation, with companies outside of the technology sector generating higher profits.

In the coming quarters, we will be watching for a continuation of the recent inflection in earnings growth. Solid earnings, coupled with the ongoing economic expansion, provide a positive backdrop for equities. However, the market may struggle to generate unusually strong performance from current levels given today’s high equity valuations.  Currently, the market is trading at a multiple of approximately 21x forward earnings, which represents a premium to the long-term average of 16x. 

International Equity

Foreign stocks participated in the rally with solid performance in the first half of the year. In fact, returns were exceptional in local currency terms, but the appreciation of the U.S. dollar created a headwind for domestic investors in foreign stocks. Equities in the emerging markets outperformed those in the developed countries, given strength in most regions outside of Latin America. Within the developed markets, European and Japanese stocks were the best performers.

In the second half of this year, we expect foreign economies to experience modest improvement while also being positively impacted by sustained growth in the U.S. This should provide a positive tailwind to equities. In addition, valuations remain attractive in foreign stocks, providing a wider safety margin relative to domestic markets. However, many of the world’s major regions or countries are dealing with issues that may limit their upside or lead to bouts of volatility. For example, China is struggling with a multi‑year bubble in its real estate markets and the economies in both Europe and Japan continue to be characterized by low rates of growth.

Commodity

Commodities generated solid performance in the first half of the year with broadly-based gains across the energy and metals segments. However, returns were mixed last quarter. Oil prices declined from their April high given increased production in the U.S. and other countries. Gold continued its ascent and set a record given expectations for an eventual reduction in interest rates, rising government debt, and elevated geopolitical risks. Industrial metals generally increased with copper reaching a record high last quarter, but agricultural commodities bucked that trend and were broadly lower.

We continue to have a favorable view of commodities. The U.S. economy is generating solid growth, in aggregate, and there is potential for foreign economies to follow suit, placing upward pressure on demand. In addition, heightened geopolitical risks provide the potential for energy prices to rise. Gold has rallied, but the drivers of the recent price increase remain in place and continue to provide support for precious metals.

Potential opportunities & risks for Q3 2024

Opportunities

The emergence of artificial intelligence and other new technologies—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes such as the growth of artificial intelligence, Big Data, quantum technologies, and cloud computing. 

A productivity boom—According to some estimates, technology was pulled forward two to three years during the pandemic. That development coupled with a persistent shortage of labor is leading companies to invest in new technologies with the goal of boosting productivity, automating processes, and adapting to today’s constrained labor markets.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.

Expansion of robotics—Recent technological breakthroughs are taking advantage of 5G communications, sensors, and artificial intelligence providing for an expansion of robotics in healthcare, restaurants, construction and other industries. Some estimates project total global robotics spending will jump from $40 billion last year to $260 billion in 2030.

Personalized healthcare—Advancements in technology support tailoring treatments to each patient, streamlining the drug discovery process, providing continuous data analysis in real time, and improved clinical trials through digitization. Investment opportunities across the healthcare spectrum have been enhanced as artificial intelligence and machine learning increasingly result in better healthcare experiences.

Risks

Rising Government Debt—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt outstanding has increased 57 percent since the end of 2019 and that trend shows no sign of reversing course with persistent budget deficits. While the short-term implications of higher debt levels are manageable, the long-term impact may be substantial as rising interest costs burden taxpayers.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring the wars in Ukraine and the Middle East along with the relationship between the West and China. 

Inflation—Given the unparalleled amount of fiscal and monetary stimulus in previous years, persistent federal budget deficits coupled with high government debt, the wars in Ukraine and the Middle East, reduced investment in production capacity for some commodities, the trend towards deglobalization, and a shortage of labor, there is a risk that inflation may remain above the average of the last thirty years.

Deglobalization/Protectionism—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions, upward pressure on inflation, a rising cost structure for some industries, and the potential for moderation in the rate of economic growth.

Political risk and increasing government regulation—Our historical studies show that the average stock market return over presidential terms is similar regardless of which party holds the Presidential office. However, elections can generate risks for specific industries if they become the target of a candidate’s proposed legislation. For example, some of the leading technology companies are facing increased scrutiny as their business success has resulted in dominant market positions.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.

 

Originally posted on July 18, 2024

Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable. However, Badgley Phelps cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Badgley Phelps does not provide tax, legal, or accounting advice, and nothing contained in these materials should be taken as such.

 

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Growth has moderated, can the expansion continue?

by Badgley Phelps | Jul 22, 2024

Outlook: 3rd quarter 2024

Economy remains on an upward trajectory 

The economy remains on an upward trajectory with growth of approximately 2.0 percent expected this year. The outlook has been tempered modestly since our last update as the economy expanded at a rate of just 1.4 percent in the first quarter. However, a resilient employment market, a record level for consumer net worth, a high level of government spending, significant investment by businesses in the development of artificial intelligence, and strong demand for services continue to underpin this expansion.

Recent data shows that growth remains uneven with consistent demand for services coupled with upward pressure on prices. In contrast, demand for goods varies from industry to industry and inflation rates are generally falling in these areas. Accordingly, some manufacturing-based industries are at risk of returning to the rolling recessions that were prevalent during the pandemic.

Given the uneven nature of the expansion and moderating inflation, investors expect a change in the Federal Reserve’s policy later this year. However, the central bank remains vigilant, and they are now guiding to just one interest rate cut by the end of the year. For the sake of comparison, the central bank’s guidance in March suggested they would cut rates three times this year.

Inflation continues to moderate

Inflation continues to moderate but remains above the Federal Reserve’s 2.0 percent target with the Consumer Price Index coming in at 3.0 percent in June. Notably, the recent data softened with a modest decline in prices for the headline reading month over month. A closer look at the data shows that prices for services continue to rise, led by rent, auto insurance, and health care. However, price increases for goods are moderating.

Inflation is expected to continue its gradual decline given the Federal Reserve’s emphasis on containing price increases. The central bank’s policy rate is now more than two percentage points above the rate of inflation, and they are reducing liquidity in the financial system by shrinking their balance sheet. These policies, collectively, are intended to slow the pace of growth and reduce the inflationary pressure in the economy.

 

U.S. dollar has exceeded consensus expectations this year

The U.S. dollar has exceeded consensus expectations this year and remains elevated. Expectations for an eventual reduction in interest rates have led to a decline from the 2022 peak, but the ongoing economic expansion in the U.S. and interest rate cuts in foreign countries have provided a fresh boost to our currency. Looking forward, we expect the economic expansion and the Federal Reserve’s emphasis on fighting inflation to keep the dollar at a relatively high level.

Asset class outlook for Q3 2024

Cash/Money Market Instruments

At its most recent meeting in June, the Federal Reserve maintained the target range for the federal funds rate at 5.25 to 5.50 percent. Looking ahead to the second half of the year, our central bank is now guiding to just one interest rate cut by December and a review of their long-term projections points to a terminal rate of 3.1 percent. In our view, this implies that while the Federal Reserve may be uncertain on the pace of rate cuts, the end goal remains the same: It expects to gradually lower interest rates to a neutral level over the next 12 - 36 months.

Intermediate Government/Credit Bonds

With potential interest rate cuts on the horizon, we believe opportunities are most attractive in intermediate-term U.S. investment-grade bonds relative to short-term debt and cash-like instruments. While the yields on short-term bonds and cash are attractive today, these investments carry greater reinvestment risk and longer-term bonds allow investors to lock in today’s higher rates for longer periods of time.

Within the investment-grade bond universe, we continue to emphasize high-quality corporate bonds balanced with a mix of government debt securities. The economy has been resilient, and the outlook for corporate bonds remains positive despite credit spreads that are at historically low levels. Government bonds are additive as they offer excellent liquidity and diversification.

Tax-Exempt Municipal Bonds

The municipal market has experienced a significant uptick in issuance this year, with tax-exempt supply reaching levels not seen since 2007. This marks a departure from the below-average supply over the last few years, a period when state and local governments benefited from federal stimulus funds and a better-than-expected recovery from the pandemic. On the demand side, the market has responded with a continuation of strong inflows as interest rates remain at multi-year highs. Municipal market fundamentals continue to show strength as we approach the second half of 2024. Tax revenues and reserves have moderated but remain well above pre-pandemic figures and are not far from historic highs.

U.S. Equity

The S&P 500 Index generated a strong gain in the first half of the year with a total return of approximately 15 percent. Stocks in the growth segment continued to be the best performers driven by the companies that provide the infrastructure for artificial intelligence (AI), such as those in the semiconductor industry or cloud services.  

In the second quarter, growth stocks led the major indexes to record highs. However, the returns across the market were mixed. While the Russell 1000 Growth Index generated a return of more than 8.0 percent, stocks in the value and small/mid cap styles declined. These performance disparities have been a persistent theme during this bull market, and they are indicative of the variation in growth trajectories for industries across our economy. 

On a positive note, earnings growth is accelerating after two years of modest increases. To date, a large percentage of that improvement has been generated by the stocks in the artificial intelligence ecosystem. However, profit growth is expected to increase in the second half of the year fueled, in part, by more broadly-based participation, with companies outside of the technology sector generating higher profits.

In the coming quarters, we will be watching for a continuation of the recent inflection in earnings growth. Solid earnings, coupled with the ongoing economic expansion, provide a positive backdrop for equities. However, the market may struggle to generate unusually strong performance from current levels given today’s high equity valuations.  Currently, the market is trading at a multiple of approximately 21x forward earnings, which represents a premium to the long-term average of 16x. 

International Equity

Foreign stocks participated in the rally with solid performance in the first half of the year. In fact, returns were exceptional in local currency terms, but the appreciation of the U.S. dollar created a headwind for domestic investors in foreign stocks. Equities in the emerging markets outperformed those in the developed countries, given strength in most regions outside of Latin America. Within the developed markets, European and Japanese stocks were the best performers.

In the second half of this year, we expect foreign economies to experience modest improvement while also being positively impacted by sustained growth in the U.S. This should provide a positive tailwind to equities. In addition, valuations remain attractive in foreign stocks, providing a wider safety margin relative to domestic markets. However, many of the world’s major regions or countries are dealing with issues that may limit their upside or lead to bouts of volatility. For example, China is struggling with a multi‑year bubble in its real estate markets and the economies in both Europe and Japan continue to be characterized by low rates of growth.

Commodity

Commodities generated solid performance in the first half of the year with broadly-based gains across the energy and metals segments. However, returns were mixed last quarter. Oil prices declined from their April high given increased production in the U.S. and other countries. Gold continued its ascent and set a record given expectations for an eventual reduction in interest rates, rising government debt, and elevated geopolitical risks. Industrial metals generally increased with copper reaching a record high last quarter, but agricultural commodities bucked that trend and were broadly lower.

We continue to have a favorable view of commodities. The U.S. economy is generating solid growth, in aggregate, and there is potential for foreign economies to follow suit, placing upward pressure on demand. In addition, heightened geopolitical risks provide the potential for energy prices to rise. Gold has rallied, but the drivers of the recent price increase remain in place and continue to provide support for precious metals.

Potential opportunities & risks for Q3 2024

Opportunities

The emergence of artificial intelligence and other new technologies—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes such as the growth of artificial intelligence, Big Data, quantum technologies, and cloud computing. 

A productivity boom—According to some estimates, technology was pulled forward two to three years during the pandemic. That development coupled with a persistent shortage of labor is leading companies to invest in new technologies with the goal of boosting productivity, automating processes, and adapting to today’s constrained labor markets.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.

Expansion of robotics—Recent technological breakthroughs are taking advantage of 5G communications, sensors, and artificial intelligence providing for an expansion of robotics in healthcare, restaurants, construction and other industries. Some estimates project total global robotics spending will jump from $40 billion last year to $260 billion in 2030.

Personalized healthcare—Advancements in technology support tailoring treatments to each patient, streamlining the drug discovery process, providing continuous data analysis in real time, and improved clinical trials through digitization. Investment opportunities across the healthcare spectrum have been enhanced as artificial intelligence and machine learning increasingly result in better healthcare experiences.

Risks

Rising Government Debt—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt outstanding has increased 57 percent since the end of 2019 and that trend shows no sign of reversing course with persistent budget deficits. While the short-term implications of higher debt levels are manageable, the long-term impact may be substantial as rising interest costs burden taxpayers.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring the wars in Ukraine and the Middle East along with the relationship between the West and China. 

Inflation—Given the unparalleled amount of fiscal and monetary stimulus in previous years, persistent federal budget deficits coupled with high government debt, the wars in Ukraine and the Middle East, reduced investment in production capacity for some commodities, the trend towards deglobalization, and a shortage of labor, there is a risk that inflation may remain above the average of the last thirty years.

Deglobalization/Protectionism—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions, upward pressure on inflation, a rising cost structure for some industries, and the potential for moderation in the rate of economic growth.

Political risk and increasing government regulation—Our historical studies show that the average stock market return over presidential terms is similar regardless of which party holds the Presidential office. However, elections can generate risks for specific industries if they become the target of a candidate’s proposed legislation. For example, some of the leading technology companies are facing increased scrutiny as their business success has resulted in dominant market positions.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.

 

Originally posted on July 18, 2024

Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable. However, Badgley Phelps cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Badgley Phelps does not provide tax, legal, or accounting advice, and nothing contained in these materials should be taken as such.

 

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