As we preview the quarter ahead, will we continue to see mixed economic signals? Coming up, we will find out.

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From Thrivent Asset Management, welcome to Advisor’s Market360™, a podcast for you, the driven financial advisor.

Global elections and conflicts in the Middle East and in Ukraine. Tech and AI dominance. With so much happening in the headlines, investors want to know how their investments are impacted. It’s been a year filled with mixed economic signals, and the future seems hard to predict. Is inflation going to stick around for longer than expected? Will there be a recession? How should investment portfolios be positioned to accommodate for the uncertainty of tomorrow? To help us interpret the data and analyze the markets, we have three Thrivent experts: Steve Lowe, Chief Investment Strategist, David Spangler, Director of Mixed Asset and Market Strategies, and Kent White, our Head of Fixed Income.

Let's get into it…

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Looking back at the second quarter, equities had a mixed but generally positive quarter. Fixed Income was a little more subdued. Based on those two facts, we wanted to get a fix on some of the key trends and key themes over the last quarter. Here’s Lowe:

Lowe: “I think one of the key themes is Goldilocks. So, markets want the economy not too hot and not too cold. Too hot risks higher inflation and higher rates, which could slow the economy and cause a recession. Too cold hurts growth, and you're not getting earnings, and markets do not like that either. I think the economy remains solid overall, but it's a bit of a two-speed economy. Lower income tiers are struggling. Their savings are largely depleted, if not completely. The higher rates are biting, too, because they're more dependent on credit, such as +20% credit card rates and auto financing. But the upper income segments are doing really well. The top 20% drive the economy, essentially, or in a significant way. They account for more than half of spending, so by definition, more than the 80% below them. They are doing quite well.”

We also wanted to know Lowe’s opinion on the risk of recession and the role that the Federal Reserve, or Fed, plays in that risk.

Lowe: “We expect a soft landing. The risks are growing a little bit that the economy could slow the longer the Fed keeps rates high. But overall, the market's doing quite well. Breadth is a little bit poor, meaning a handful of stocks are still driving most of the equity market returns.”

Inflation has been a persistent issue. Here’s Lowe’s thinking on where we are now:

Lowe: “Inflation is slowing, but it's far from dead. The year started off with hot inflation, meaning that it was beating expectations, coming in hot. That trend has flipped recently, and inflation is now decelerating, coming under expectations. Goods prices remain in deflation, which they have been for a bit now. But we're starting to see encouraging signs in parts of services, particularly core services, which is a focus of the Fed. But there are still sticky areas like what we call shelter, which is rent and the imputed cost of owning a home, and wages are still somewhat sticky. We expect progress; it's going to be a bumpy path. And getting down to the Fed's 2% goal is going to be hard, that so-called last mile. Markets remain hyper-focused on inflation because inflation is driving the Fed, and the Fed has a large influence over markets and the economy.”

The actions of the Fed drive the markets. We wanted to get White’s take on what he’s seen from the Fed and what he is anticipating:

White: “There's no question that markets, both the equity and fixed income markets, have been really focused on what the Fed is planning to do with policy rates going forward. The Fed has really been very data dependent this year, especially now that every economic release carries a lot of weight, not just for the Fed, but for the markets as well. The Fed has been adjusting their views accordingly as each of these has been released. And as Steve just mentioned, the first few monthly inflation readings this year came in stronger than expected. So, the Fed began to delay and push out the start of any of the planned rate cuts for this year. So, the Fed's latest projection showed a median cut of only one rate cut this year, compared with three cuts in their prior economic projections. So, they've definitely been adjusting their outlook as inflation has taken longer to return to their target and the economy has remained fairly strong. I think the bar for raising rates is pretty high right now.”

Lowe had this to add…

Lowe: “The Fed has a dual mandate that is somewhat in conflict, it’s maximum employment and low inflation. So, too strong of an economy risks fueling inflation. You know, a really tight labor market. On the other side, higher rates to control inflation can cause a recession and hurt employment. So, it's sort of this balancing act between defeating inflation and not choking off the economy and triggering a recession.”

Looking at the Treasury market in the second quarter, White had this to report:

White: “The Treasury market was pretty weak in most of the second quarter on the back of those higher inflation trends and stronger labor markets. We saw 10-year Treasury yields hit their highest level of the year during the quarter at around 4.7%. However, we've seen some recent data that is a little bit more supportive on the inflation front, and we might be seeing some looser conditions in the labor market as well. Yields have since retreated back to where we started the quarter. Treasury volatility has also picked up again recently around these economic releases and ‘What is the Fed doing next?’ narrative.”

Regarding what happened on the equity side in the second quarter, we got this update from Spangler:

Spangler: “Equities had a pretty good quarter and a pretty good year to date. But on the quarter, the S&P 500 is up about 5%, whereas on the year to date, it's about 15% for the S&P 500. But it's been really more of the same, which is to say that it's been very concentrated and very concentrated in large-cap tech in particular. By example, the small caps are down about 4% on the quarter. And relative to the S&P 500, that's about a 900 basis point or 9% difference in terms of performance just on the quarter. And for the year, small caps are barely even, maybe up 1% versus 15% for the S&P 500. Again, also, too, growth is outperforming value by a wide margin, so about 15% on a year-to-date basis so far.”

As Spangler mentioned the mega cap names have been the drivers of the equity market. What’s surprising is by how much:

Spangler: “The top five stocks have contributed about 60% of the overall return of the S&P 500 year to date. You can imagine the stocks: Microsoft, Nvidia, Google, Amazon, Meta. But Nvidia in and of itself is one-third of the total return of the S&P 500 so far this year. It's deserved, though. In the first quarter, the earnings per share or EPS growth of the mega-cap tech is about 84% or 80%.”

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Now let’s turn our attention to the third quarter and the rest of the year. We wanted to know what is leading our experts to be comfortable predicting the soft landing. Here’s Lowe talking about the gross domestic product, or GDP:

Lowe: “Overall, the economy is solid. The data is a little bit more mixed, but still strong. You can look at GDP, which is a broad measure of economic growth—that slowed in the first quarter. But underlying that, it was really good domestic demand, which really drives the economy, was very strong. I think the crux of it is the job market is strong. If you have a strong job market, people have income, and if people have income, they can spend.”

While that news is mostly positive, we had to ask if there was still any chance of a significant slowdown or even a recession. Here’s Lowe:

Lowe: “Yeah, absolutely there is. There are numerous signs of slowing. You know, the jobs data overall is good, but it's a little more mixed. Payrolls are solid. But if you look at unemployment, that's starting to rise, there are fewer job openings. Retail sales have been somewhat weaker recently. Manufacturing is weak. And in particular, consumer confidence is not great. It depends what you ask them about, but they're very concerned about high prices. Inflation is slowing, but the price level is still super high and that has an impact. And the other item is that economies are non-linear, meaning that a slowdown can snowball very quickly into a recession.”

Next, we wanted to step away from economics and focus on elections. Obviously, we have a presidential election coming up in the U.S., but many countries are dealing with wild swings all along the political spectrum. In our last episode we discussed the potential economic impacts of the U.S. election, so now we will focus on foreign elections especially those in emerging markets, or EM. Recent elections in India and Mexico have shaken the status quo and so too have some European elections. Here’s Spangler on European elections:

Spangler: “Recently we've had some issues with elections, which is to say that both the far right and the far left have gained on the centrists within Europe and, within France and in general in Europe. And this is causing some significant sentiment deterioration. So, more recently, Europe has really underperformed the, the S&P 500 domestic equities. You know, one could say that it's a bit of an overreaction. Or it could be. But it is a concern at this point.”

We also wanted to get a read on the global economy, particularly Europe and the European Central Bank, or ECB; China, and EM. Here’s what Spangler is watching:

Spangler: “Europe has been improving. And in fact, they were showing some improvement in corporate profits. And in general, it was doing as well or even somewhat better than the S&P 500 on a year-to-date basis, despite not having anywhere close to the same type of tech representation. It's a little more value, a little more cyclically oriented. And that was being reflected in the fact that they were beginning to show little signs of improvement. What we are seeing is that EM economies were beginning or have been reducing rates, in advance of the U.S. That is also true with the ECB in Europe too. And that causes some rate differentials and rate differentials can be reflected in a stronger dollar. A stronger dollar is not great for EM economies that are especially sensitive to dollar-denominated debt. And so, overall, we're not constructive on EM either, on a relative basis to domestic equity. But China has structural issues itself, very high debt, demographics and other areas.”

Lowe added his perspective…

Lowe: “Europe is deindustrializing. They got strong structural impediments, rigid labor markets, declining population. Same thing for China. Domestic demand is very muted. Their population is shrinking, too. They've been unwilling to really throw a lot of stimulus at it. And part of that, I think, is ideological basis. They don't want to stimulate the consumer part of the economy. So, they focus, as you mentioned, on exporting goods, which creates a lot of tension in the world because they're undercutting prices in domestic economies.”

Spangler agrees with Lowe’s assessment of China:

Spangler: “More historically, China has driven growth through exports. But more recently, global economies have been pushing back on that. So, if they think their ‘out’ is exports, it may not be the case this time. If they're unwilling to stimulate on the consumer side, then China is likely not to have the same type of growth that they've had in the past. On an overall basis, we're still much more constructive on the U.S. economy and domestic equity.”

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Earlier we talked about the big tech names that have been driving the equities market. We wanted to know, one, if that can continue, and two, whether there is potential for a broadening of this part of the market. Again, here’s Spangler:

Spangler: “We could get either, which is to say that, yes, it can broaden, but it can also continue to be very narrow. Historically, this is a very narrow market. The one- and two-year, for example, difference in returns, from a capitalization weighted index or the S&P 500 versus its equal weight, are at the widest they've been since 1999 and 2000.”

What sort of event could cause these big tech stocks—often referred to as the Magnificent Seven, or Mag Seven, to come back to earth?

Spangler: “So, I think that some of the things that could cause it to reverse would be a reduction in earnings within the Mag Seven or within the large-cap tech. It could be a resurgence of inflation, or it could be a recession. Those would cause a reversal, I would think. But if we do have more of the soft-landing scenario, if we see a moderation in inflation, continuation towards a 2% target, if we see the Fed is more likely to reduce rates and enter into a rate cutting cycle, those are conditions where we might expect to have a broadening out. We would see a broadening out, I would think, within mid caps and small caps. They should have some catch up in that type of scenario. And value overgrowth, as well. But I think that, generally speaking, as it stands now, a continuation of what's been working should continue to work, which is the more narrow, large-cap tech area of the market until we see the conditions change.”

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Turning to the fixed income side, we were interested in White’s thoughts on credit valuations, which are rich right now, and whether those valuations are sustainable.

White: “Right now, we find absolute yields in both investment grade and high yield credit attractive at these levels. Investment grade yields at around 5.5% are nearly as high as they've been in almost 15 years, and high yield corporates are currently yielding nearly 8%. However, most of this increased yield is due to higher yields on U.S. Treasuries. The additional compensation that we receive as credit investors over Treasuries, referred to as spread, is at very rich levels—in some areas of credit, historically rich levels. So, these tight spread levels can be justified for now just because of reasonably healthy balance sheets and fundamentals in an environment where we see a relatively low level of defaults in high yield. And technicals are also very strong. The demand for yield is keeping spread levels very compressed. We've seen just a huge amount of supply come to the market and it's absorbed very quickly. That demand has kept spread and yields within our markets pretty attractive.”

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With levels so rich, we wondered what might trigger higher spreads. Again, here’s White:

White: “At this point, I think one possibility would be if rates actually did come down quite a bit because the yield buyer would then probably step back. What I was just referring to is that demand for credit spreads would then probably widen out a little bit. That's one scenario. Then just simply a weaker economy overall.”

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Now, it’s the moment you’ve all been waiting for—we ask our experts their outlook for the coming months. Let’s get the ball rolling with equities. We want to know Spangler’s thoughts and what equities he sees leading the way.

Spangler: “Really, it's likely to be more of the same, which is to say momentum. And momentum now is characterized as large-cap tech. It's large companies, mega-cap tech, which have very strong earnings growth and margin growth. On a relative basis, their margins are actually not overly valued. Their earnings are so strong, their margins are so strong, that they're not necessarily overvalued for what they're producing. We do have risks, of course, with concentration and crowding into these areas, but until there's a reason why they don't work, we believe that they will continue to work.”

Clearly, Spangler still likes growth stocks…

Spangler: “We are still overweighted to growth and still expect growth to continue to outperform value. If we do have a softer, inflation-type of a scenario and we do see Fed rate cuts, in that situation, we could see a bit of a rotation more to the cyclical side, and you could see value outperforming growth. But until we have that change, we do believe that we're still going to continue to see growth outperforming value.”

We also wanted to hear about small caps which have been underperforming for quite some time:

Spangler: “We believe that we're still going to continue to see large caps outperform small caps, and large caps outperform mid caps as well. Small caps typically aren't going to perform until you see a troughing of the economic data or a troughing of the economy overall, and then a catalyst for resurgence of growth. So, it's typically between when the Fed stops raising rates, and then when the Fed cuts, small caps will underperform. But, as we get into a rate cutting cycle, we could then see small caps begin to outperform large caps. But, what we would then also expect is that from a secular standpoint, from a long-term standpoint, small caps would underperform in the intermediate and longer term for structural reasons. So, whatever they might gain in a shorter period of time, if we were to see a Fed rate cutting cycle, they're going to give back, we would expect.”

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So, what is the outlook for fixed income? Specifically, we are interested in White’s thoughts on interest rates and the treasury market for this quarter and the rest of the year.

White: “The market is looking for some rate cuts from the Fed. It'd be pretty supportive for the market overall and certain asset classes. But one thing we have to be careful about is why the Fed is cutting and how much are they cutting. Too many rate cuts could send a signal that the economy is really falling off cliff or weakening more than we would like it to. We'd like the economy to be supportive and the Fed just going in and doing some fine-tuning with their policy rate. But our expectation is that the Fed will eventually begin making some adjustments to its policy rate. Until we see a few more months of supportive inflation data, the Treasury market is likely to remain somewhat volatile, like we've seen it pick up here again. But our more intermediate term view remains that yields are likely to move lower. Inflation is slowing, even if it's still above target, and the labor market has shown some signs of loosening. We believe that should give the Fed some room to begin cutting rates before the end of the year, whether it's one or two cuts.”

We also wanted to get White’s views on the credit side:

White: “In credit, we're likely to be in a pretty tight trading range here, I think, for the next few months, through the summer. Maybe we see some volatility pick up as we get closer to the election. But credit spreads should be supported by solid second-quarter earnings. We've got really good credit fundamentals in the market right now, stronger balance sheets. So much of our new issue supply was front loaded this year to get in front of the election and any other volatility that might arise. So, in the second half of the year, we should see lower supply, too, which will be a positive impact on technicals. But like we referred to earlier, credit spreads are already pretty tight, so there's limited opportunity for price performance from spread compression going forward. Fixed income, whether it's IG, investment-grade credit, high-yield credit, it remains attractive for the total yield.”

Looking at mixed asset positioning, we wanted to get our experts’ broad view. Here’s Lowe:

Lowe: “We’re modestly overweight risk, overweight equities versus fixed income. Our long-term strategy is to overweight equities, but we dialed it back a little bit recently because there's more mixed economic signals. As talked about; to get more aggressive, we want to see some re-acceleration in growth and an upward turn of the cycle to get cyclicals going.”

Next, we asked Spangler for his mixed asset positioning:

Spangler: “We're somewhat overweight risk to assets, somewhat overweight equity. We're not all the way to our strategic long-term overweight in equity, but we have capacity to add if we were to see market weakness. But overall, generally a little bit overweight public equity. Within equity, we're overweight large caps, we're overweight growth, we’re most overweight domestic over international. That's the higher conviction area for us, where we have about a 4% overweight, domestic versus international. And that's a secular overweight. It's one that we've held for a long period of time, as much as five or six years at this point. We see ourselves generally in a late cycle area of the economic cycle. If we were to have the soft landing, we believe that we will continue to see support to the equity markets. But we are taking a little bit of caution at this point, giving ourselves the opportunity to increase risk if the opportunity presents itself, but a little bit more cautionary overall.”

And finally, we asked White where he’s overweight and underweight on the fixed income side:

White: “Because spreads are so tight right now, valuations aren't particularly attractive. We're picking our spots in fixed income. Specifically, we're a little bit more up in quality and taking more of our duration from the right place, the Treasury market. Right now, 30-year corporates is one of those areas that I referred to earlier as being at historically tight levels. So rather than buy 30-year corporates, we've been taking our duration in the Treasury market, 30-year Treasuries, as opposed to 30-year corporates, to get most of our exposure to longer-date of maturities. There's some other pockets of value that we found, one of them being the—moving down capital structure—in the preferred and hybrid debt markets. We usually do that in really high-rated quality issuers like banks and utilities. We've seen a little bit more issuance there, and we've got yields anywhere from 7% to 8% in the preferreds space, which is pretty close to where the high yield market is right now. Apart from that, we're also modestly long duration, waiting for the right time to get a longer duration, just waiting for more signs that the Fed is ready to begin to pivot a little bit more and begin to start fine-tuning their policy rate. Then in high yield, we remain underweight. The lowest quality segment, that's one tricky part of the high yield market that is populated with a lot of distressed issuers and really stressed balance sheets. So, we've been avoiding that spot, that space. And we're overweight the more mid-quality segments of high yield. It's either two ends of the spectrum. High yield is trading like it's an investment-grade market at the very tightest end, and then distressed at, say, the 20th percentile. So, we find our sweet spot to be more the mid-quality segment of the high yield market.”

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Beyond the specifics outlined earlier, our experts are focusing their attention on these areas which could meaningfully impact the markets:

One, a weakening in employment which could lessen inflationary pressures.

Two, a broadening in equities so there’s less need for the tech giants to grow.

Three, geopolitical risk from turmoil in Europe be it war or elections.

And four, consumer sentiment which has shown signs of weakening.

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We hope you enjoyed this third quarter overview and outlook. Once again, we would like to thank Steve Lowe, David Spangler and Kent White for their insights. What did you think of this episode? Email us at podcast@thriventfunds.com with your feedback or questions for our experts. Want more episodes of Advisors Market360™ and other market and investing insights? Visit us at thriventfunds.com, where you can learn how we can partner with you, the driven financial advisor. Bye for now.

(Disclosures)

All information and representations herein are as of 6/24/2024, unless otherwise noted.

Past performance is not necessarily indicative of future results.

Investing involves risks, including the possible loss of principal.

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 podcast 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.

Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.

Asset management services provided by Thrivent Asset Management, LLC, an SEC-registered investment adviser. Thrivent Asset Management, LLC is a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.