Market Commentary Q1, 2024

The K-Shaped Income Driven Expansion

Income, productivity, and nominal GDP are booming. Government debt is soaring, but corporate debt is not expanding at the level most have grown accustomed to seeing in the last few decades during economic expansions. This leaves macroeconomists scratching their heads.

After a weak earnings quarter, markets have rallied back to all-time highs. We entered 2024 expecting 7 rate cuts and a wide range of analyst forecasts for S&P 500 performance in 2024. As expected, most have capitulated, and now most expect 2024 to be rosy with increasing price targets on the S&P 500. All the while, rate cut expectations have all but disappeared. We are riding the wave of income and productivity growth the AI boom has granted us. Earnings season was a story of strong top and bottom-line results, but ultimately still “a miss” primarily due to increasing R&D guidance. We just received the expected bill for the AI boom to continue at such a rapid pace. Innovation is expensive!

Earnings expectations have risen significantly for the S&P 493 that will have to come to fruition by the 4th quarter (with 17% earnings growth expected from this group in the 4th quarter) or else forward-looking earnings multiples will start appearing exceptionally expensive (currently just VERY expensive). The US government continues to run at record deficits, and most assets are heavily correlated with changes in treasury yields.

It’s a vicious cycle that could lead to continued pain in both stock and bond markets (or neither) and stocks can continue to climb upwards until yields say otherwise, which is the investment landscape we find ourselves in today! Consensus believes there is a “third rail” 10-year treasury yield rate that could cause pain for all risk assets. Most believe it is somewhere in the 5-5.25% range. We’ve been on the never-ending hunt for $250 dollar earnings on the S&P 500 and we are finally at the point where it is priced in for NEXT quarter, after years of being just around the corner. Buybacks don’t boost earnings on the S&P 500 Index.

Inflation is not Transitory, Round 2 (but may become transitory again soon, round 3)

Outside of shelter, much of the inflation story can be tied to lagging categories such as auto insurance.  We still believe the high inflation days are in our past, but that could obviously be changed with any number of bills the government may release to appease voters heading into an election. That doesn’t mean we will automatically return to a sub 2% inflationary environment. Inflation could very well remain elevated above 2% for quite some time, but is unlikely to reaccelerate on the upside without additional fiscal or monetary stimulus.

Commercial Real Estate is running on fumes, with regular new stories of buildings across all cities trading at eye-popping discounts. Residential Real estate is trading well above rent equivalents (which is a phenomenon found in most developed markets across the globe, and rental prices are either expanding or about to collapse, depending on what your data source is). If there is any takeaway from this commentary, it is that the data is providing noise on many fronts and not a lot of clarity.

Chinese real estate is facing a US 2008-like housing market moment, and the government is stepping in to buy homes directly. Unlike the US, the banks are basically state owned, and this is unlikely to lead to a wider Chinese banking collapse. Freddie Mac just made a new proposal to try and securitize second leans on home mortgages. This is very stimulative for housing markets over the next decade if passed. Other ideas such as tax credits for first time buyers, downpayment assistance and more are all meant to assist the millions who can’t afford housing. This could also be the exact reasons for housing to irrationally trickle higher over the next few years, making the unaffordability crisis even worse for future first time buyers.

Mid and Small Cap Companies Continue to Underperform

While much can be attributed to sector weightings (large cap indexes have significantly higher exposures to technology companies), it is really the improvement of large cap companies over the last 20 or so years that has caused the outperformance. You can see below, large cap percent of unprofitable companies has fallen to 10%, while small caps still hover around 42%. Interest rate coverage ratios have improved significantly for large caps, even after a drawdown with yields increasing, while small caps are below their EBIT/interest expense averages. Mid and Small caps are very dependent on rates. Higher for longer makes financing much easier for mega caps vs small caps.

Wacky Fixed Income Markets

Duration has been a huge drag, while credit risk has been a huge reward. Defaults started to tick up and have since rolled back over. There is potential of a pending credit event that many have been expecting for years now, but there are also many variations of the future where it just doesn’t occur any time soon. Much of the high yield market has rolled over its debt, either in public or private markets. The high yield debt maturity wall does not become a substantial risk until 2026. There are many theories as to why high yield has performed so well – its concentration in the energy sector for one, and the proliferation of private credit, making debt available via private capital in a process that ends up cleaning up the quality of high yield debt.

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