Broker Check

Stocks Gain, Bonds Consolidate as Economic Growth Continues

April 02, 2024

                The bull market continued in the first quarter with the S&P 500 rising 10.16%. In some ways, the rally looked like a continuation of the 2023 rally. The communication services sector was the best performing one in the quarter, and information technology was the third best. However, the 2024 rally has been broader based with the energy, financial services and industrial sectors also outperforming the S&P 500. And, in another sign of the rally’s strength, the strong gains occurred despite double digit losses in the quarter for Apple and Tesla, two of the formerly “Magnificent Seven” stocks that provided strong leadership last year.

                Midcap stocks almost matched the S&P 500 in the first quarter. The S&P Midcap 400 rose 9.52% while the Russell 2000 lagged but still increased a respectable 4.81%. International stocks rose but lagged the S&P 500. The MSCI EAFE Index jumped 5.06%, while the MSCI Emerging Market Index only increased 1.90%. Its performance was pulled down by China. The MSCI Emerging Market ex China Index was up about four percent last quarter.

                The aggregate and intermediate Bloomberg U.S. investment grade bond indices dropped slightly in the first quarter. The rise in Treasury rates was partially offset by a drop in spreads on investment grade bonds. Higher risk debt outperformed investment grade bonds as recessionary fears diminished amidst still strong economic data.

                Last quarter was a good one for commodities after a mostly dismal 2023. Oil prices dropped 10.73% in 2023 after a 21.08% fall in the fourth quarter, while the CRB BLS Commodity Index fell 7.94%. The first quarter of 2024 saw oil prices jump 16.08% amidst supply worries and a decent global economy, while the CRB BLS Commodity Index moved up 5.10%. Gold continued to shine, rising 8.09% after 2023 gains of 13.10%.

Rising First-Quarter Yields Slow Bond Returns

                Intermediate and long-term Treasury yields rose in the first quarter. Solid economic data combined with a couple higher inflation readings led to Treasury yields rising everywhere except the very short end of the curve. U.S. fourth quarter GDP grew at a strong 3.2% rate on a quarter-over-quarter basis. The economy still looks resilient. The Atlanta Fed projects first quarter real GDP grew at a healthy 2.33%.

                The stronger than expected economic news was favorable for investment grade corporate bonds. The combination of robust balance sheets, and higher yields contributed to their good relative performance. Spreads are tight, especially compared to recent history. However, the underlying credit quality of the investment grade index has improved compared to the recent past according to Bloomberg.

                Two months of higher inflation data contributed to the increase in yields. Two months do not make a trend, but they cannot be dismissed. There might be seasonality issues in the data reported by the Bureau of Labor Statistics. The year-over-year rate has declined, but it has been unable to get below three percent. The issue now is whether three percent is the floor for inflation, or whether the progress in reducing inflationary pressures will continue. Improving growth forecasts and a reduction in recession risks also contributed to the rise in bond yields. An improved economic outlook does not ensure that inflation must stay high, but that real activity will be better than feared.

                NPP thinks that now is a good time to be a bond investor. Investors on the intermediate part of the curve can get at least 4.2% in Treasuries, and close to five percent in investment grade corporate bonds. This is above the current inflation level and if inflation data improves in 2024, yields are likely to stabilize or move lower.

Bull Market Continues

                Equities increased despite the backup in yields. Better growth and reduced chances of a recession lead to higher revenues and profits. Changes in market multiples have an outsized impact on stock prices in the short term. We saw that in 2022 when stocks fell despite strong earnings increases and 2023 when they rose despite earnings stalling. NPP thinks profit growth is needed later this year for stock indices to sustainably move higher. One potential spark is AI-led productivity growth. This could not only be a huge tailwind for the technology companies selling it, but also for those companies implementing it. Many companies have struggled to find workers, and anything that increases productivity should be beneficial to those companies and their employees.

                After a market run as strong as this one, it makes sense to worry about what could go wrong. There are several known risks including office real estate and various geopolitical issues. Nevertheless, we are in a bull market and looking for a catalyst for a selloff can sometimes be a fool’s errand even though there are risks on the horizon. NPP is still monitoring client accounts to make sure they are balanced properly, but we are not yet ready to turn overly cautious.

                NPP thinks this year’s market advance is healthier than the one in 2023 even though earnings have not yet inflected higher. 2023 saw three sectors dominate and massively outperform the S&P 500, while the other eight lagged the index by at least ten percent. This year, five sectors have outperformed the index through March 31st. Not only have more stocks participated in the rally, but the rally has continued despite the underperformance of heavyweights such as Apple and Tesla.

Potential Economic Threats

                It still looks like the U.S. economy will avoid a recession. As long as employment continues to increase and labor markets remain tight, it is difficult to forecast an economic downturn and a resulting drop in demand that would lead to a long-term bear market. There are, however, a couple signs of weakness that must be monitored. The U.S. Household Survey of Employment peaked in November and has declined the last three months according to the Bureau of Labor Statistics. This survey often leads the more cited Establishment Survey at economic turns. The US unemployment rate jumped from 3.7% to 3.9% in February. The rate bottomed out in January 2023 at a fifty year low of 3.4% before finishing the year at 3.8%. The absolute rate is historically low. However, sometimes the rate of change is more important than the level, meaning that the uptick in unemployment can be indicative of an oncoming recession even if the level itself implies a healthy economy. NPP is not sure which is the case. We believe that the BLS has had an understandably tough time keeping all the data and surveys consistent with a dynamically changing economy. We still think the economy is growing strongly and that it is best to focus on the breadth of labor market indicators that imply strength while remaining cognizant that things could change suddenly.

                Recent inflation data has some points for optimists and pessimists alike. It has declined from around nine percent to slightly above three percent on a year-over-year basis. That is an improvement, but the fight against inflation is not complete. Inflation settling in around three percent would result in only a couple of interest rates cuts if any. The inflation rate looked like it was heading below three percent until the January and February reports. While there are reasons to believe there were seasonal distortions in the prior two months' data and that shelter inflation is overstated, there are risks that rising oil prices and sticky service sector inflation might require a recession to get inflation below three percent. NPP does not believe this, but we feel it is inappropriate for the bulls or bears on inflation to declare victory yet. The coming data will determine who is correct. We think inflation of around three percent is manageable, but rate cuts will be minimal in this scenario. Stocks and bonds are likely to tread water and digest interest rates that would have to remain near five percent for longer. Inflation falling to 2.5% or so would be bullish for stocks if it is not accompanied by labor market weakness. In our opinion, inflation inflecting higher is the biggest risk for assets. Accelerating inflation could lead to interest rate hikes which would likely lead to negative returns for stocks and bonds.

NPP Expects Moderate Equity Gains, Improved Bond Performance

                We are in a bull market for equities. Stocks are going up and it is no longer just the Magnificent Seven stocks. The rally has broadened which is bullish for equities. However, the market is due for a pause as we approach a seasonally weak part of the year. NPP expect gains for equities in the rest of 2024 but we think the gains will moderate. Positive returns for equities moving forward are dependent on inflation not reigniting. Inflation moving lower would likely see a continuation of the equity bull market. Fixed coupon investment grade bonds have struggled through the first three months of the year, but we think this should change during the rest of 2024. Investors can get close to five percent investing in fixed income without taking a lot of risk. At present, a little bit of caution is warranted with double digit gains for large cap U.S. stocks through March. Nevertheless, unless employment data or inflation worsens, an equity market pullback or correction should be bought.