In this episode of "Capital Considerations," Tony is joined by Chief Economist Luke Tilley and Head of Investment Strategy Megan Shue to reflect on the surprises of the first half of 2024—particularly around inflation and economic growth—and project their cautiously optimistic market and economic expectations through the end of the year.
References to specific securities and companies are merely for explaining the market view and should not be construed as investment advice or investment recommendations of those securities or companies and are not intended and should not be relied upon as the basis for anyone to buy, sell, or hold any security. Holdings and sector allocations may not be representative of the portfolio manager’s current or future investment and are subject to change at any time.
Third-party trademarks and brands are the property of their respective owners. Third parties referenced herein are independent companies and are not affiliated with M&T Bank or Wilmington Trust. Listing them does not suggest a recommendation or endorsement by Wilmington Trust.
2024 Midyear Market and Economic Outlook
Tony Roth, Chief Investment Officer
Meghan Shue, Head of Investment Strategy
Luke Tilley, Chief Economist
Tony Roth: This is Tony Roth, Chief Investment Officer of Wilmington Trust, and you're listening to Capital Considerations. Today we have an episode to cover the mid-year outlook for both the economy and the markets. And I have two terrific guests, which are indeed my colleagues, Luke Tilley, our Chief Economist, and Meghan Shue, our Head of Investment Strategy.
And the three of us are going to endeavor today to talk first about what's happened in the first part of the year: what went as planned, as it were; what did not go as planned, both from an economics and market standpoint; and then we'll get into our positioning in advance of the election and what we think we need to do to stay the course, which is essentially our outlook right now. And we feel pretty good about where we're going, and where, in fact, we may end up at the end of the year.
So, with that, I want to invite Luke and Meghan into the conversation. Thanks for joining us, guys.
Meghan Shue: Thanks for having us.
Luke Tilly: Thanks Tony.
Tony Roth: Luke, we came into the year and like last year, we came in with a very distinctive perspective from market consensus around what was going to happen. If you recall last year, everybody felt that we were headed for a recession, everyone but you. So, plaudits to you.
This year, we headed into the year, and there was a large groundswell of support for the idea of maybe seven Fed rate cuts, disinflation, and that we were really going to have a strong equity market as a result of those Fed rate cuts, et cetera. And I think that people were thrown off a bit at the beginning of the year when inflation came in a lot stronger than people expected.
Contrarily, we had probably weaker economic growth than people expected and the Fed hasn't cut rates yet. You actually felt that we were going to have those Fed rate cuts, and you were very consistent in your outlook for disinflation. And you felt that the 1st quarter was clearly an outlier in your mind, and that there were some clear reasons that are probably even clearer in retrospect with hindsight being what it is.
So, maybe Luke, the beginning of the conversation is to talk about what happened in the beginning of the year that caused people to be so surprised with, on the one hand, the continuing strength of inflation and on the other hand, the seeming weakness in the economy off of a very strong year last year.
Luke Tilly: That is the place to start, because in the back half of 2023, inflation had slowed so much, and it looked like it would keep slowing. And the first three readings of the year—January, February, and March—came in higher than expected, and that's what really pushed off market expectations, at some points markets pricing in six or seven rate cuts over the course of 2024, which we thought was too aggressive.
We were also too high. We had four cuts penciled in because those initial high readings really did put the Fed on its heels a little bit. Saying that, you know, they weren't confident that it was going to slow down and the economy looks strong enough that they could keep rates high and really putting them off.
But I think the more important breakdown of that is that the inflation was really just concentrated in the shelter category. Yeah, there were some other things that looked a little bit strong, but then they would ebb. And in the readings that we've gotten since we're sort of getting confirmation that inflation really is slowing. There's some reason to believe we certainly believe that there's a little bit of statistical noise in the first quarter that makes it read a little bit high, but nevertheless, the readings and the sum of data really point to that inflation is going to keep slowing.
Clearly not going to get the kind of rate cuts that we had expected, but we even think at the next meeting as they meet here at the end of July, that they would be talking very clearly that the rate cuts should start soon and starting that rate cut cycle.
I mean, the really big takeaway on inflation is that it's not going to reaccelerate. Consumer spending. I mean, the fundamental driver here is our consumer so strong that they can take on price increases on across a broad swath of items and have inflation reaccelerate and that is just not the case. And that's what we've thought the whole time, even if the Fed has been delayed a little bit.
On the growth side, it really is falling in pretty much as we expected. I guess a little bit stronger than we expected, but the first quarter, just 1.4% growth1 coming in, you know, below the “potential GDP,” what we think of as a long run trend growth of GDP of 2%.
We were expecting a slowing. The second quarter looks to be tracking somewhere between 1.5% and 2% when we finally get the data for Q2.2 So, it really is slowing as we expect, but without tipping over into a recession. So, sort of meeting our expectations and certainly very different from the latter part of last year where there were still concerns about the “no landing scenario,” oh is the economy just going to keep zooming up up and away and drive inflation higher and we've shifted to the other side, where now the base case is soft landing, I think, for most forecasters and then we're looking for risks on the downside So growth is slowing as we would expect in this high interest rate environment, Tony.
Tony Roth: Going back to the inflation conversation very much then at this point, a phenomenon in the rearview mirror.
We went through a period where we had this inflation that we haven't experienced in 40 years. Pretty unique, actually, when you think about the source of the inflation as being a very much demand-side phenomenon with massive pent up demand after the pandemic that was only fueled by the $5 trillion or so that was dumped into the economy by government here in the United States.
At this point. It's been a few years now. We're back to the kinds of trajectory that we've experienced for many decades where inflation has not been absent some other unexpected supply-chain or demand stimulus.
Inflation is not going to be a big narrative probably going forward. Fair to say?
Luke Tilly: Yeah, I think that's fair. We're back to, like you said, you point out the stimulus savings and with those having mostly disappeared, either because they were spent or because they were invested, spending growth now and consumer demand is going to rely on job growth and wage growth and people's ability and willingness to use credit.
And those have slowed and returning to normal. So we're returning to those fundamental drivers. And sometimes there's concerns about tariffs from one administration, potential administration or another, or what if there's something that drives up the price of this good or that good, but fundamentally, if consumers are constrained now, no longer with those savings, if they are constrained by just job growth and wage growth, then any price increase in one particular item or a tariff on this item or something else is really just going to take away from their spending on something else.
So our view is that we've returned to those normal inflation dynamics.
Tony Roth: Yeah, what's interesting is at the same time, even though the inflation is settled into high twos coming down slowly, et cetera, it still seems to have an outside impact on consumer behavior because there's still sticker shock.
So, as an example, I go out to the beach over the summertime and I look at restaurant menus and I don't go back to restaurants for a month, because I can't believe how expensive everything is. And it's not because it's that much more expensive than it was last year. But when you look at the cumulative effects of the last few years, just things cost so much more than they used to.
And I think that that is weighing on consumer activity in an environment where they're not as flush with cash. And that is one of the reasons why the inflation story continues to figure very prominently and and potentially in an important way as we approach the election and also has a contribution to the slowness and the consumer that we're starting to see now and why economic growth for the first half of the year is likely to come in, overall, somewhere around 1.5%, as you've already said. It’s an interesting aspect that even though the inflation has calmed down pretty significantly, the phenomenon of inflation still really very much on people's minds.
Luke Tilly: I couldn't agree more. And we see that in customer surveys, consumer surveys, customers’ reactions to prices.
The other component, of course, is that wages have had that cumulative rise as well. And lower-end consumers, lower-paid consumers, lower-income consumers have actually seen stronger wage gains over that time. If you think back to so many of the large firms and corporates that were raising their base pay for their entry-level employees, those wages have actually moved up even more than those prices.
Firms get sticker shock when they're looking at how much they're paying their incoming employees, but that has slowed down too. I think we've settled into where both of those things, prices and wages, are now growing at more normal rates. And you've got consumers, like you said, they're much more price sensitive, and we hear from large companies that people are moving down the spectrum from higher-end stores to lower-end stores, and we see credit card delinquencies and things like that starting to rise back to more normal levels, and it really has been a normalization, and I think people are much more price sensitive.
And reacting to the market environment.
Tony Roth: So, Meghan, usually you have the hardest job because you have to predict the markets going forward. You don't have the benefit of hindsight in a sense. Today, we're going to give you the benefit of hindsight, but it still seems like a hard question to answer, which is why have the markets done so well this year, if we didn't get those Fed cuts that were expected; if we are in a situation where the consumer is really decelerated significantly because they are so put off by price levels and they've run out of excess savings and cash and so on and so forth. We're up 17% year to date.3 We're at all-time highs. Why is the market so ebullient when we have that set of circumstances that Luke has just provided us?
Meghan Shue: It's a number of different factors, one of which being that companies continue to generate really strong profit growth and earnings have continued to come in better than analysts expected. That has helped to support sort of the earnings growth component of the price return. We've also seen valuations climb, which gets to the 2nd element of the strong market story, which is really that we have seen a continuation of much of what we saw in 2023, which was a lot of enthusiasm around artificial intelligence and technology. And that has been a very, very strong part of the market.
That's a little bit separated from what you think about in terms of trend, rate of economic growth, or consumer activity, because it is so much about companies building out their tech needs, their AI investment, moving services to the cloud, and all of these things that are really necessary structural drivers of growth going forward and have a lot less to do with how much consumers are spending.
If you look at what really the pockets of strength that we've seen in the market, it has continued to be led by a relatively few number of stocks. So, just to dimension that a little bit, the top five stocks in the S&P 500, which are names that have a lot to do with technology and the communication services sectors, they have generated more than 50% of the S&P 500 return year to date, which is very rare. There's only been a few times in history when more than 40% of the index returns have been attributable to just 5 stocks.4
So we're getting very narrow leadership, a lot of enthusiasm around NVIDIA, up 150% year to date in just six months, growing its market cap by $2 trillion in that period.5 It's a really exciting time for NVIDIA. Astronomical numbers around a few stocks. There's some strength in the rest of the market as well, but a lot of the really strong return has been coming from narrow market breadth.
Tony Roth: And that's such an important point, I think, for everyone to digest that while the market is up 17%,6 when, in fact, you take away the story that associated with artificial intelligence and all the various associated supporting kinds of technology like data centers and so on and so forth, the market really hasn't done that well.
And certainly, when you look out beyond large-cap space, you look at small cap, the performance has been fairly anemic. When you look at it from that perspective, are you disappointed with the market? And how have we been positioned throughout the year? Have we captured mainly the area that's done well, or have we dissipated sort of across the board?
Meghan Shue: One way to look at the relative strength of the market is to compare the market cap-weighted index to an equal-weighted index.
So, take the normal S&P 500, for example, where the weight of a particular company in that index is based on its market cap. You have a lot more of an influence from the largest names like NVIDIA, Apple, Microsoft. You compare that to an index where every stock gets the same weight in the index and the market cap-weighted index has outperformed the equal-weighted index by 10% in just six months.7
So, it is a little disappointing what we've seen from the rest of the market. But I also think that it's a bit of an opportunity because when you look at a lot of the people who are maybe more cautious on the market, they'll point to valuations and sure valuations for the overall market cap-weighted index are very elevated relative to history.
But if you look at that equal-weighted index, which captures more of the rest of the market, valuations are pretty much in line with the historical average. So there's an opportunity, not only for those companies in more cyclical sectors, so think consumer discretionary, materials, financials, industrials, companies that are more tied to the overall health of the economy.
There's an opportunity for them to not only grow earnings, but to also expand on valuations and sort of catch up to the rest of the market.
So how we've been positioned has really been one of our key calls for the year, just to be perfectly honest, was for market breadth to improve. And so we were expecting better performance from the value factor from cyclical sectors and that has not really materialized. It's continued to be a very big momentum trade in the market.
And as we look at that, we've been trying to really think about positioning portfolios in a bit of a sort of mitigating risk and really with a lot of attention to trying to capture the momentum of those biggest names, but also to position in case there's a reversal of that trend.
So, I mean, I think one way to think about it too, is that we use active management in a lot of our portfolios and a lot of active managers are going to be looking for stocks that are not The Magnificent Seven. They're looking for those diamonds in the rough, those other names that might be hidden gems, and they tend to be underweight versus the market to the biggest names, unless maybe they're a growth strategy.
So we've been balancing those exposures, looking through our strategies to make sure that we are balanced across style factors and industries. But also not getting too overweight or underweight to those big names because so much of the market has been tied to the performance of that handful of largest companies.
Tony Roth: Yeah, and of course, the benefit of active management is that they can be very responsive to changes in market conditions. And so when they see trends shift, they can take advantage of those trends.
So, Luke, what do you expect going forward? And specifically, once the momentum shifts, and you reach an inflection in the economy from accelerating growth to decelerating growth, which is where we are today. We had very strong economic growth last year. Economic growth is slowing and we expect a soft landing.
What causes us to not see growth inflect across the zero line to contraction. Is it just that the data you look at the, the labor market data, for example, and you see that it's holding up so well, and that gives you confidence that we're not going to see a recession anytime soon? But we've clearly seem to have past the peak growth rate of the cycle. What gives you the conviction that it's going to be a soft landing and not a continued deceleration into contraction?
Luke Tilly: Our baseline is to maintain that soft landing and to avoid a contraction. The most important thing here is to sort of look around and try and find a reason for a recession.
I think that there is a tendency, understandable to assume that there is a cycle that's going to happen in the way that you're phrasing in the way that we talk about it. You've passed that peak. You're going to start slowing down. It's almost like an assumed the economy is going to tip into recession.
Therefore, you have to look for reasons that it might not happen. If you look at it from the other side and say, well, what would cause a recession? If you're looking for something that would cause it to happen. The most recent recession, obviously Covid was caused by something that was incredibly exogenous, disease coming from the outside and sort of a self-imposed economic shutdown.
You look for, outside of that, recessions that are caused by something. Usually something in the economy has gotten a little bit too big. Think housing market or high-tech stocks. And when something gets big, there's a lot of euphoria about it. A lot of investment rushes there.
It turns out to be too big. It needs to be written down in terms of its value. And then a lot of things around it need to be written down in value as well. The housing market from, let's say, ‘04 to ‘06 and ‘07 is a prime example. Too much euphoria there, too many assets, whether it was land movers, real estate workers and construction, all of those things need to be written down in value.
It starts a cycle. Tech stocks the previous. So, you're looking for something that has gotten so big that it needs to come down in value and therefore trigger more things to come down in value. And we spend a lot of time looking for something like that. You know, clearly a big issue has been commercial real estate over the past year, year and a half now, ever since some of the events in in that sector and as much as we look at it, we try and find a ripple effects and sort of the magnitude that would lead to and a recession and we can't find it.
And now they could be that it ends up being bigger. There's more ripple effects than you expect. But if we look at that and we look at elsewhere, we're not finding anything that is sort of endogenously has built up so much and needs to come down and value and lead to a recession. So that's the framework and sort of looking around for something that that could cause that to happen.
Now, that said, one of the, I think, biggest changes for the market, not as much for us, because we didn't think that there was going to be runaway growth and that reacceleration, no landing, is looking at all of the things that are the risk to the downside. When we look at the labor market, job growth right now is pretty strong, but we do see the number of people who are unemployed.
That's sort of mounting. It's getting higher and it's in, it’s positive year-over-year terms. And that usually doesn't happen during expansions. It's still low in terms of level. The unemployment rate is low, but in a, in a, you know, first derivative sense, it's rising. And that deserves attention. We see businesses cutting back on capital expenditures (Capex).
And I think that this would be the biggest risk is that businesses end up slowing their Capex more than we expect in the face of these higher rates and maturing debt and the maturity wall and that sort of thing would lead to less Capex and less hiring. And that's the most likely candidate for a recession.
But as we look at that and analyze it, we don't see that that's our baseline expectation, but that's the risk. So we're always looking at those possible triggers, possible things that would lead to a recession right now our base case is that we would have this soft landing, but of course, there are some risks to the downside, Tony.
Tony Roth: So, Luke, it's, it's great to hear that there's no obvious bubble or area of extreme excess, if you will, someplace, whether it's in the real economy or the financial economy that needs to be corrected, that could trigger the ripple effect into the rest of the economy and throw us into contraction. No obvious one, at least. Having said that, how unusual would it be to have an economic cycle where you start a new cycle, you grow, you decelerate and you have a soft landing, and then you reaccelerate essentially and create a new cycle that could last again for quite some time without going through the actual contraction and cleansing and purging that businesses go through when they actually have negative growth in their employee base, which is to say they're laying people off, et cetera, which is its own salve for the economy over a longer period of time.
If we're correct, and we go into this soft landing and then eventually reaccelerate out, I know a lot of this will depend on what happens to the election and what fiscal policy looks like next year, but how unusual would that be?
Luke Tilly: It would be extremely unusual for the economy to hit a high point and then be slowing down and have such strong rate hikes and not tip into recession.
But I think everything has been pretty atypical since, since March 2020, since the, the pandemic with stimulus and everything. We continue to look for the endogenous factors that would lead to a recession. We look for those things, has something grown so big that it would bring down the entire economy or not.
We look and we can't find any items like that, but, uh, but there are certainly some, there's some things that we're monitoring closely. You know, the labor market looks to be adding jobs at a headline level. And still pretty strong, but the number of people who are unemployed is rising. It's risen over the over the past year at a pretty healthy clip, something that usually doesn't happen during expansions.
The unemployment rate is still at a very low level, but it's, it's, it's rising, which is deserves a lot of attention. And if businesses were to cut back more than we expect in terms of Capex in the face of these rising rates, and they cut back on hiring, then that would be the natural tip over into into a recession.
So that's what we're watching most closely, Tony.
Tony Roth: Thank you, Luke. So, Meghan, understanding that we're not forecasting a recession right now, one of the aspects of our positioning, which I think is so interesting and difficult, but I think that we’re in the right place. And I often say that right now, the hard part is not to decide to overweight equities because we have pretty strong conviction that economic growth is not slowing below 1%.
We're going to continue to grow the economy. Companies continue to increase productivity. So even at a lower growth rate, they continue to grow profits and profitability. So being overweight equities in that environment makes a lot of sense. The hard part is to figure out where within equities to place that overweight.
And you could be overweight both on an absolute basis. It can't be overweight both on a relative basis, of course. Can you just talk to us a little bit about that distribution in your mind? And what would lead you to want to take those overweights and make them more concentrated on one or the other?
Meghan Shue: Yes, we almost have a little bit of a barbell in the portfolio. So we are still retaining, basically full exposure market weight, if you will, to those biggest momentum names that have driven the market. But we are also positioning with a healthy weight to the value style and companies that are a little bit cheaper, maybe even, you know, a little bit higher leverage.
And so having both of those exposures on and maybe being a little bit underweight, kind of the middle of the market, allows us to capture both trends. It is a challenging environment because we're really at extremes when you look at the market representation and how top heavy it is, how much of the index are just a few of the largest names, that makes it very important to get that call right on what those few names will do.
I think in this environment, you've got two sort of forces at play and what could ultimately change the direction one way or the other really comes down to the economic outlook and interest rates. So we have an outlook that interest rates will maybe move a little bit lower, but really not that much, especially on the long end of the curve.
We also expect growth to moderate and kind of run basically at trend or slightly below trend rate of growth. That is an environment where, without interest rate volatility, you could continue to see momentum of those largest names because they're not going to, hopefully, get hit on the valuation side of things because of interest rates moving higher.
I would get a little bit more excited about those cyclical names if we were expecting economic growth to reaccelerate. We do have a slight overweight on small cap, which is very much a cyclical story, but our call is really a little bit more based on valuation and the opportunity for that part of the market to catch up.
Again, if we were expecting above-trend rate of economic growth. And really a re acceleration there without having inflation also reaccelerate, then I'd get a little bit more excited about the smaller names, the lower quality names. We continue to be very focused on quality, which we define as companies that when you look through their metrics, they screen very well on profitability, steady and recurring profits, as well as low leverage, which in an environment where interest rates are coming down, but they're not coming down that quickly, and they're still going to remain elevated relative to history, you want to be continuing to capture the higher quality companies, especially in small cap, where about half of that index, the Russell 2000 generates, no profits and higher quality also captures some of the tech names, which carry very high levels of cash and basically no leverage.
So the quality is a really good kind of sweet spot as it relates to style factors.
Tony Roth: Unfortunately, we're out of time, so we're going to leave things, I think, there, and we will certainly be back in touch as we approach the fall and the election season, and we will be reacting to each new development and twist and turn in the narrative of the quite unusual presidential election cycle this year.
So with that, I want to thank everybody for joining and point everybody to Wilmington Trust dot com for our latest thought leadership in both the investment space, as well as in the general wealth management planning and banking areas. So thank you so much for joining and we'll talk to you all soon.
Sources:
1 Source: Bureau of Economic Analysis.
2 Source: Bureau of Economic Analysis.
3 Source: Bloomberg, WTIA.
4 Source: Bloomberg.
5 Source: Bloomberg.
6 Source: Bloomberg, WTIA.
7 Source: Bloomberg, WTIA.
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