3rd QUARTER 2024 MARKET OUTLOOK
07/08/2024
Investors may want to consider rotating from cash to Treasuries and/or corporate bonds.
Thrivent Asset Management contributors to this report: Kent White, CFA, head of fixed income mutual funds; David Spangler, director of mixed asset markets strategies; John Groton, Jr., CFA, director of administration and materials & energy research; Matthew Finn, CFA, head of equity mutual funds; and Jeff Branstad, CFA, model portfolio manager
The economy should achieve a soft landing and inflation should ease, with the Fed likely lowering interest rates later this year.
We recommend investors stay fully invested, but favor high-quality assets in both stocks and bonds.
While historically elections have little impact on market performance, we may see a spike in volatility as we approach November 5.
The U.S. economy is showing increasing signs of weakness, but we believe remains on course for a soft landing. The labor market has been strong, which creates income that fuels consumption, particularly from upper-income households, helping to bolster the services sector (which is about two-thirds of the total economy). However, consumer confidence remains tentative, eroded by concerns over high prices for both goods and services. This is understandable given that while the inflation rate is slowing, prices are still rising and remain much higher than a few years ago, stretching household budgets. Retail sales have recently weakened, job openings have fallen, and unemployment has recently ticked slightly higher. Also, the manufacturing sector has been softer, though there has been a surge of investment in technology, particularly in artificial intelligence. Overall, the economic data is mixed, as often is the case.
But, in our view, these data points confirm the economy is slowing but remains resilient without raising concerns of an imminent plunge in gross domestic product (GDP). Which is, to be somewhat simplistic, exactly what the U.S. Federal Reserve (Fed) wants to see—a slowdown in demand, helping to quell inflation, but not enough to spike unemployment.
Encouragingly, the inflation rate of price increases year-over-year is slowing. Goods prices have been deflating (prices are falling, not just rising less quickly), and we are starting to see signs of reduced inflation in parts of the services sector, particularly for core services, which is a focus for the Fed. While there are still sticky areas in services inflation, such as in shelter (which includes rent and the estimated cost of owning a home) and in wages, we have long expected the path to the Fed’s 2% long-term average target will be slow and bumpy, but currently do not see great cause for concern.
The Fed's latest projections for interest rates show only one rate cut of 0.25% this year, a significant drop from the three cuts they were forecasting just a few months ago. The delays in rate cuts are in part a reaction to the economy’s strength, inflation’s stubbornness to fall and, in our view, a reluctance from the Fed to be aggressive and risk fueling the economy too soon and, in the process, reigniting inflation.
We believe the Fed understands that current rates are restricting growth and investment (the Fed Funds rate is currently the highest it has been in 23 years), and is working to avoid a recession, which may require cutting rates sooner rather than later. That said, it is a complicated balancing act, and the Fed has been clear that its decisions will be data driven. Simply put, rate cuts will come when inflation data suggests the Fed’s long-term average target rate is within reach. The economy is clearly slowing—tighter financial conditions are having the intended effect—and inflation has been falling. In our view, this is not a question of if inflation will reach the target, but when, as failure would cause markets to doubt the Fed’s inflation-fighting credibility, something the Fed cannot tolerate.
As we enter the second half of the year, we see little to suggest that our base case for the economy, inflation and interest rates will be significantly derailed. The timing, and the degree of all three factors is uncertain, but as tricky as turning points in the economic cycle can be to time, an economy as large as the U.S. needs a substantial shock to derail it from its path. Markets today are already tolerating a great deal of geopolitical uncertainty, a slowing economy and high interest rates. Of course, we can imagine scenarios that could upset our base case, but we are also mindful that trying to precisely time the market may be more detrimental to portfolio performance than riding out some of the inevitable ebbs and flows.
We believe the current, relatively benign environment supports taking some additional risks within an already diversified portfolio of stocks and bonds. However, while we generally favor a small overweight to stocks in a balanced portfolio, we have modestly reduced our overweight allocation recommendation given the recently more mixed economic signals. To be clear, we expect to add equity risk back into our model portfolios later this year, but would like to see some re-acceleration of growth, or clearer indications the economy has achieved a soft landing and may soon be ready to accelerate. As we have often written, turning points in the economy are usually volatile, and thus a bit more caution seems appropriate, though they may provide relatively attractive investment entry points if markets correct.
The top five performing stocks in the S&P 500® Index accounted for about 55% of the total return through the first half of the year. These mega-cap stocks included NVIDIA, Microsoft, Amazon, Meta and Eli Lilly. NVIDIA alone was responsible for approximately 30% of the index’s return. These stocks possess strong earnings, margin growth and attractive price-to-cashflow ratios. That such a short list of stocks could be responsible for so much return is rare, but we do not see the usual hallmarks of a bubble. These companies generate tremendous amounts of cash, and thus should be highly valued.
But valuations have reached a point where a reversal in sentiment or earnings could result in a quick and sharp correction. It could be sparked by a surprise drop in earnings, a resurgence of inflation or a slide into an economic recession. None of which, in our view, are likely. Rather, in our base case these large companies are likely to continue to perform well. Until the environment changes, we expect the performance of the S&P 500 Index will continue to be driven by a relatively small universe of mega-cap stocks.
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In the coming quarter, we expect growth stocks will continue to outperform value stocks. However, this view is largely dependent upon the time we think it will take for the economy to achieve a soft landing and the Fed to start cutting interest rates. If a rate cut comes sooner than we expect, we could see more of a rotation to cyclical stocks, and see value stocks start to outperform growth stocks. But, similar to our outlook on mega-cap stocks, we prefer to wait for better confirmation of a trend change rather than anticipating the timing of its arrival.
Small-cap stocks have underperformed the broader market by a significant amount for a significant period of time. But, we expect these stocks to enjoy their time in the light after the economy troughs and markets begin to see the catalysts for a rebound in growth (this could be little more than interest rate cuts). In this more optimistic environment, small-cap stocks, mid-cap stocks and lower-quality companies broadly, may begin to outperform large-cap, high quality growth companies. Small-cap stocks, in particular, could see rapid gains if only because their market capitalization is so, well, small. Only a small shift in assets from large- to small-cap stocks could have a large impact.
We continue to hold a high conviction that domestic equities are likely to continue to outperform international equities. This view is more secular than cyclical insofar as it is based on our view that many international economies face structural hurdles, including unfavorable demographics, while the U.S. economy is more dynamic, resilient and innovative than its international counterparts. There are more technology stocks, for example, in the U.S. than any other country in the world. As this is not likely to change (or may change for the better when U.S. growth picks up), we do not anticipate adjusting this view anytime soon.
Stronger employment and inflation data in recent months, coupled with growing concern about fiscal spending after the election, have increased volatility within the Treasury market. While we do not expect large gains in Treasuries in the near term, neither do we expect significant losses. However, we believe volatility is likely to remain elevated until the market becomes more certain on the path of inflation and the timing of any subsequent interest rate cuts. That said, given the relatively attractive absolute yields provided by these “risk-free” government securities, we recommend maintaining exposure. Our medium-term view remains that yields are likely to move lower as our base case scenario plays out, with shorter-dated Treasury yields following the Fed’s policy rate, steepening the yield curve.
Absolute yields in both investment grade and high-yield corporate bonds remain attractive. Investment-grade yields, currently around 5.5%, are near their highest levels in almost 15 years. High-yield bonds are now yielding around 8%—similar to the long term expected returns of equities. However, the bulk of these yields—particularly in investment-grade corporates—is the yield of the underlying Treasury bonds. As such, the spreads (the additional yield earned over the corresponding Treasury bond) in investment-grade corporate bonds is quite narrow, trading at historically rich levels. Fortunately, these relatively expensive valuations are easily explained by a combination of robust underlying fundamentals and the large demand for these bonds, which we do not expect to fade until Treasury yields fall significantly lower, eroding the income these securities currently provide.
To help us gauge the strength of the economy, we are keeping a particularly close eye on employment data. Moderating employment is key to helping inflation decline, but too much moderation risks the stability of economic growth. It is a delicate balance, and indeed the Fed’s explicit mandate is to find a balance between containing inflation and supporting employment. Unfortunately, employment data can be volatile and subject to significant revisions. As the consequences of particularly strong or weak data could have a significant effect on markets, volatility around economic data releases, especially on employment and inflation, is likely to remain high.
The upcoming presidential election also remains a factor that could, as we get closer to election day, increasingly inject additional volatility into financial markets. Historically, the results of presidential elections have rarely been a significant determiner of financial market direction, though the S&P 500 Index has risen in 18 out of the last 24 presidential election years. In the six years they declined, four of those included the Great Depression, the early stages of World War II, the dot-com burst and the Global Financial Crisis. Exogenous shocks, not the winning political party, seem to be the primary cause of anything other than a solid market in an election year.
But elections can have a significant impact on certain industries that are impacted by tax policy or the party’s approach to regulation, such as energy or health care. While the impact on sectors is difficult for the market to price at this early stage in the election process, we expect more focus on sector implications as policy platforms become more concrete.
However, the largest (though least likely) risk to our generally positive outlook for stock and bond markets in the months ahead is a more rapid erosion of economic strength. Not because of an endogenous shock (like bank failures as a result of commercial real estate lending) or an exogenous shock (such as a widening of conflicts in Ukraine or the Middle East), but simply because weakness can rapidly beget further weakness. For all our optimism about the resiliency of the U.S. economy, there is some chance that unemployment rises, begetting more consumer caution, retail sales slump and, ultimately, corporate profits decline. While such an outcome is far from our sanguine base case, neither is it an insignificant risk. We believe investors are best served by considering all the possible outcomes and ensuring they maintain a diversified investment portfolio. In the meantime, we are all waiting for the Fed.
Media contact: Callie Briese, 612-844-7340; callie.briese@thrivent.com
All information and representations herein are as of 06/30/2024, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
This article refers to specific securities which Thrivent Mutual Funds may own. A complete listing of the holdings for each of the Thrivent Mutual Funds is available on thriventfunds.com.
The S&P 500® Index is a market-cap weighted index that represents the average performance of a group of 500 large-capitalization stocks.
Price-to-cashflow is a stock valuation indicator or multiple that measures the value of a stock’s price relative to its operating cash flow per share. The ratio uses operating cash flow, which adds back non-cash expenses such as depreciation and amortization to net income.
Past performance is not necessarily indicative of future results.
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