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The Current State of the Markets

The Good

The state of the U.S. economy is quite healthy. Since October of 2023, we have seen a notable shift in sentiment as the fear of a potential recession ebbed, replaced by the hope of an economic soft landing. To achieve the soft-landing scenario, the Federal Reserve needed to thread the needle by raising rates just enough to moderate inflation without pushing the economy into a recession. Despite inflation remaining above the Fed’s target of 2%, much progress has been made in achieving the soft-landing investors were hoping for.

The jobs report in March continued the strong trend that had been in place as we added more than 303,000 jobs in the month and saw the unemployment rate tick down to 3.8% (from 3.9% in February). The unemployment rate has now been below 4% for more than two consecutive years, the first time this has happened since the late 1960s. This is a key factor for the ongoing strength of the U.S. economy and is likely why we have avoided a recession for so long.

Manufacturing activities showed unexpected strength in March with the Purchasing Managers Index (PMI) moving in to expansionary territory for the first time since September 2022. Production and new orders both increased and serve as harbingers of continued economic strength. We expect this trend to continue as reshoring activities and attempts to improve our domestic supply chains ensue.

While we are seeing an inflection in manufacturing activities, growth in corporate earnings is set to accelerate as well. Following a flat year in 2023, earnings growth for the S&P 500 is forecasted to increase by more than 10% in 2024 and 13% in 2025. These growth rates in corporate earnings are quite healthy, especially in the face of higher interest rates.

Stock markets across the globe are trading near all-time highs. Importantly, participation in the upward movement in stock prices has expanded beyond just the Magnificent 7 which dominated performance in 2023. Both growth and value styles, as well as domestic and foreign stocks, increased during the first quarter. Expanding breadth and broader participation across sectors is a healthy sign for markets. Notably, after 8,383 days (or about 34-years), Japan’s Nikkei 225 Index finally surpassed its previous peak last seen in 1989!

When we combine each of these factors together; an economic soft landing, strong labor market and low unemployment, an inflection in manufacturing, expanding market breadth, and strong corporate earnings, the foundation for continued strength in the economy is in place. Longer-term, a handful of powerful structural themes centered around technological advancements in Artificial Intelligence, digitization, automation, and cloud computing, combined with further efforts around de-globalization should continue to drive future growth opportunities.

The Bad

In October of last year, Federal Reserve Chairman Jerome Powell indicated that there were growing signs that inflationary pressures were easing, and rate cuts were likely in 2024. Markets quickly priced in potential Fed easing ahead. By January, market expectations were for six separate 25 basis point rate cuts, or 1.5% in total. This led the S&P 500 to surge, rising more than 27% between October 27, 2023, and March 31, 2024, reflecting the possibility of low interest rates amidst a strengthening economy.  

Fast forward to today: on the heels of three consecutive monthly inflation data points that came in higher than expected, inflation remains stickier than expected and sits well above the Fed’s target of 2%. The fear that higher inflation forces the Federal Reserve to keep interest rates elevated and financial conditions tighter for a sustained period, leading to the dreaded “higher for longer” scenario, has resurfaced. Higher rates for a longer period would likely result in slower growth prospects in the future and would have an impact on longer-term asset prices and overall valuations.

The market began the year with consensus expectations for six rate cuts in 2024, which quickly declined to three cuts as inflation stayed high and economic growth remained resilient. Now, it appears one or two cuts are the more likely scenario (if at all). The risk of a second wave of inflation is a growing concern. Whereas, the path of interest rates was previously assured (lower), the pace and the magnitude of Fed Fund cuts now seems much less certain. Ultimately, higher levels of inflation will keep interest rates higher, which will cause greater austerity and slower growth.

Within the context of the broader inflation theme, we should be mindful of rising commodity prices. Geopolitical concerns in Europe, the Middle East, Russia, and China have driven the cost of oil back above $85 per barrel. Gasoline prices are on the rise and are forecasted to reach nearly $4 by summertime on the East Coast. Copper prices have risen around 10% this year given growing global demand and spending on infrastructure projects, and gold prices have spiked nearly 14% year-to-date, reflecting demand for safe-haven assets and the recognition of an increasing federal debt and a growing deficit.

While the economy is strong and earnings are growing, the strength in the stock market appears to reflect much of the anticipated good news. Currently, the price-to-earnings ratio for the S&P 500 is just above 19x 2025 estimated earnings, or a 2-turn premium to the 10-year average of 17x. Valuations are lofty for the market-capitalization weighted S&P 500. In our view, higher valuations for the index reflect the better profitability profile for the larger companies at the top of the index, even still, there is little margin for error or disappointing news given elevated valuations.

Individually, none of these issues appear to be fatal for the market, yet they cannot be ignored as potential risks to our outlook, and each adds an element of downside risk that must be considered.

Further Issues for Consideration

The Federal government has a serious spending problem. The longer-term implications of the U.S. budget deficit are problematic. At the end of 2023, the Federal Budget Deficit as a percentage of gross domestic product was 7.7%. The average deficit as a percentage of GDP dating back to 1960 was a more reasonable 2.9%. The only time in the last 65 years that the deficit has been at similar levels was during the Great Financial Crisis (GFC) in 2008 and following the COVID spending spree in 2020. The current deficit is unprecedented given the strength of the economy.

The fiscal policy responses to the GFC and the pandemic were rightfully aggressive and the surge in spending seemed justifiable at the time. That said, since 2008, Federal net debt as a percentage of GDP has surged from under 40% to over 100%. Debt-to-GDP is now as high as it was during World War II. Further, given the higher levels of interest rates, the interest expense on our outstanding debt is expected to surpass defense spending within the Federal budget this year. Higher net interest costs are likely to begin to squeeze out other government programs, leading to a period of greater fiscal austerity.

Speaking of wars, we have two active wars happening today across the globe. Geopolitical tensions are running extremely hot, especially in the Middle East where we see escalation in Israel from Iran and throughout the region.  

Putting it all Together

Investors always have reason to be worried or concerned; it is second nature to focus on the risks and what could go wrong. Eighteen months ago, it was trendy to be a bear and to believe that 9% inflation and an aggressive Federal Reserve rate-hiking campaign would crush the U.S. economy. Yet, the economy remained at full employment, we digested the rate increases, inflation began to fall, and corporate earnings have rebounded. The U.S. economy and consumers are resilient, jobs are plentiful, and asset prices remain firm.

Higher interest rates are having an impact on certain areas of the market, specifically, housing. Housing turnover is down, and mortgage rates are hovering around 7%. To their credit, consumers (and corporations) did well to lock in lower interest rates before rates began to rise and termed out their debt burdens in fixed, 30-year mortgages. This has softened the impact of higher interest rates on consumers and has led to a more muted effect on the broader economy. At least so far.   

The three consecutive months of higher inflation numbers are concerning and require adequate attention, yet we must also remember that these data points do not always move in a straight line. It is not unusual to see fits and starts within the monthly and quarterly economic data sets. For now, we are comfortable with the stance that the U.S. economy is strong despite inflation running a bit hotter than expected. Manufacturing is beginning to rebound and there is major capital spending on reshoring and bringing supply chains back to the United States, which should continue to support growth in the economy.
Following a 10% increase to start the year, the S&P 500 has pulled back to begin the second quarter. Realistically, the stock market had become tactically overbought and a period of consolidation following these kinds of gains is healthy and not unusual. We do not believe this to be the end of the stock rally and would likely use further weakness to add to some of our favorite equity positions. Given the breadth of the current rally, we believe this is a fantastic time for active management.

Turning to our own actions, Cambridge Trust client portfolios have been fully invested with modest cash positions to cover upcoming distributions and any cash needs. Portfolios have benefited from the rise in equity prices, but we have also taken advantage of higher interest rates to increase our fixed income positions at more attractive yields. For the first time in almost 15 years, bonds are back to paying a reasonable coupon rate and are providing predictable cash flows for client portfolios.

There are plenty of talking points for both the bulls and bears in today’s market. As a result of these offsetting factors, we believe it is prudent to maintain our neutral stance across our asset allocation targets. Much like the Federal Reserve, we will remain data dependent on the future path of changes and will be monitoring the geopolitical issues across the globe, the upcoming Presidential election, and the inflation trends to determine if and when to adjust our strategic targets.


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