Break vs. Economy Point: Inflation - 2nd Quarter 2024

ACWI (All-Country World Index) rose over 3% during the quarter, lifted by a resilient U.S. economy, softening inflation, and a continued enthusiasm for everything AI. In fact, Nvidia’s rise alone was responsible for 35% of the S&P 500’s gain. Small cap stocks as measured by the Russell 2000 index, on the other hand, lost ground during the quarter and are now lagging the S&P 500 by nearly The 15% year-to-date. Foreign stocks also finished the quarter lower, while the U.S. Bond Aggregate index was flat. To state it simply, nearly all public investments outside of large cap technology companies produced flat or negative returns for investors in the second quarter. Investors with exposure to private equity or real estate in the first half of the year generally saw no benefit to their diversified portfolios.

The valuation discount of small caps versus large caps has reached a level not seen in 25 years, and market concentration is now at its highest in 60 years. The largest 9 companies in the S&P 500 account for nearly 36% of the index.

The current AI boom is not, at this stage anyhow, easily equated to the dot-com bubble. There is reason to believe, however, that we could be approaching a tipping point when either a soft economic landing is achieved, or an economic recession of some magnitude ensues. It is a question of which will break first – inflation or the economy. Either result, in our view, will alter the current trajectory of investor returns.

To date, economic data has supported risk assets. Growth has slowed in recent months but is not yet a cause for concern. The labor market has gone from a very tight supply to something more in balance, and the unemployment rate is still low at 4.1%. At the end of June, the latest PCE (Personal Consumption Expenditures Price Index) reading confirmed further improvement on the inflation front, declining to a rate not seen since March 2021. These data points support the soft-landing narrative which may support lower interest rates without triggering a recession. This scenario could disproportionately bolster small cap stocks that tend to rely more heavily on access to capital; something that has been both expensive and scarce since the Fed began its tightening campaign two years ago.

Other economic indicators suggest the Fed may once again be behind the curve, this time with reducing interest rates. The amount of U.S. consumer credit card debt, for example, continues to hit new records, while consumer sentiment has slumped to its lowest level since July of 2022. With borrower delinquencies on the rise as well as unemployment inching higher, an economic recession would likely cause a market correction.

The last 8 recessions in the U.S. began, on average, 10 quarters after the Fed’s first adjustment in the rate hiking cycle. At this point in time, we are 9 quarters past the initial rate increase. This historical rule of thumb, of course, is not necessarily predictive of the next recession and is not immune to structural changes in the economy. It does, however, allude to the lagging nature of interest rate changes. The U.S. economy is beginning to feel the full effects of this rate hiking cycle, and the Fed is attempting to thread the needle of breaking inflation while avoiding a recession.

As we enter the second half of a Presidential election year, there is no shortage of political, economic, and market concerns that could have a material impact on the pricing of financial assets. We anticipate that volatility in stock prices will increase, making any short-term pricing movements very difficult to predict.

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