Investors have reasons to stay positive
Markets continued to demonstrate remarkable resilience and dynamism in the second quarter of 2024. Despite a significant pullback in April, U.S. and global equities rose for the quarter, bolstered by robust economic performance and impressive corporate earnings, particularly within the technology sector driven by advancements in artificial intelligence. Despite ongoing economic uncertainty, headwinds from rising interest rates, and an inverted yield curve signaling potential economic slowdowns, investor sentiment remained largely positive. Volatility ticked up slightly from the first quarter but stayed low compared to historical trends both in the U.S. and international stock markets. Emerging markets equities outperformed developed markets and large caps continued their upward trajectory, leaving smaller capitalization stocks behind. The S&P 500 Index gained 4.3% for the quarter, up 15.3% for the first six months of the year, against returns of 18.6% for the Nasdaq and 4.8% for the Dow Jones Industrial Average.
Challenging traditional 60/40 portfolio allocations
At its last meeting in June, the Federal Reserve (Fed) held interest rates steady, citing strong job gains and low unemployment as indicators of solid economic activity, while noting that inflation remains elevated despite easing. After peaking at 4.7% at the end of April, the 10-year U.S. Treasury yield closed the quarter at 4.4%, leaving the overall bond market roughly flat for the quarter. As of the end of June, the yield curve remained inverted, with the 2-year Treasuries offering a more attractive yield than longer dated issues. Bond markets recovered in the second quarter, boosted by improving inflation and a more confident outlook for rate cuts. Volatility in the bond market stayed above its five-year average and increased slightly from the first quarter as investors recalibrated their expectations for interest rate cuts from the Fed. Despite finishing the quarter narrowly in green, domestic fixed income outpaced global bonds, which posted negative returns, affected by the strength of the U.S. dollar. High-yield bonds outperformed investment-grade securities, while short-dated bonds continued to show resilience. Commodities posted positive returns for the quarter despite weakness in oil prices. The Bitcoin price fell, while gold and copper rebounded.
Recent market conditions have challenged traditional allocation models like the 60% stocks/40% bonds portfolio, and the first half of 2024 has been no different. U.S. equities have continued to drive portfolio returns year-to-date, while fixed income has remained almost flat. Artificial Intelligence (AI) stocks, especially Nvidia, have significantly boosted market gains, with the Information Technology and Communication Services sectors rising by 28.2% and 26.7%, respectively. U.S. large cap stocks, benefiting from this AI surge, gained 20.7% by the end of June. With money markets funds yielding as high as 5%, many investors have favored cash over bonds, waiting for the Federal Reserve to begin cutting rates. Consequently, a portfolio of 60% Russell 1000 Growth Index and 40% cash outperformed the traditional 60/40 portfolio during Q2 and year-to-date.
Next steps in the current environment
While replacing bonds with cash may be effective in the short term, investors need to consider more factors than just yield if they aim for a resilient, long-term portfolio. Bonds and cash serve different investment purposes; bonds have historically provided better diversification and yield potential against equity volatility, while cash primarily manages liquidity. The extraordinary performance of AI-related companies raises questions about the sustainability of their outperformance. While demand for chips used in generative AI applications remains robust, and profit growth for companies like Nvidia is strong, so far, there is little in the way of profits being generated from the numerous transformational AI applications. The rapid change in the landscape, driven by central banks' inflation-fighting interest rate hikes, underscores the importance of resisting the temptation to chase performance and the need for portfolio diversification.
In the current market environment of monetary policy tightening and escalating geopolitical turmoil, it is essential to shift focus from return generation to risk management and portfolio resilience. Higher interest rates, rising geopolitical tensions, and uncertain fiscal and monetary policy responses to volatile growth and inflation have disrupted long-held assumptions about risk factors, diversification, and expected returns. Therefore, it is crucial to adopt various strategies to navigate these uncharted waters and build resilient portfolios.
U.S. equities have been strong performers, but the factors driving their outperformance suggest the potential for more subdued returns in the coming years. With stretched valuations and slowing earnings growth, we remain cautious with U.S. equities. International equities, by comparison, appear more attractively valued due to their lower volatility and cheaper valuations. Diverse economic conditions and monetary policies globally likely create opportunities for liquid alternative strategies, such as global macro, arbitrage, and event-driven strategies, further enhancing portfolio diversification.
| Asset Class Returns | Q1 2024 | Q2 2024 | YTD |
|---|---|---|---|
| Equities | |||
| Large Cap Growth | 11.41% | 8.33% | 20.70% |
| Large Cap Value | 8.99% | -2.17% | 6.62% |
| Mid Cap Growth | 9.50% | -3.21% | 5.98% |
| Mid Cap Value | 8.23% | -3.40% | 4.54% |
| Small Cap Growth | 7.58% | -2.92% | 4.44% |
| Small Cap Value | 2.90% | -3.64% | -0.85% |
| Int'l Developed Markets | 5.78% | -0.42% | 5.34% |
| Emerging Markets | 2.37% | 5.00% | 7.49% |
| Commodities | 2.19% | 2.89% | 5.14% |
| REITs | -0.39% | -0.16% | -0.55% |
| Fixed Income | |||
| Intermediate-Term Bonds | -0.15% | 0.64% | 0.49% |
| Short-Term Bonds | 0.42% | 0.95% | 1.38% | Short-Term Munis | 0.11% | 0.82% | 0.94% | Long-Term Munis | -0.75% | 0.83% | 0.08% |
| High Yield | 1.47% | 1.09% | 2.58% |
| TIPS | -0.08% | 0.79% | 0.70% |
| Int'l Bonds | -3.21% | -2.11% | -5.26% |
| Emerging Market Bonds | 2.04% | 0.30% | 2.34% |
| Bank Loans | 2.46% | 1.90% | 4.40% |
| Liquid Alternatives | |||
| Global Hedge Funds | 2.51% | 0.37% | 2.89% |
Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, Bloomberg US Govt/Credit Interm, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, Bloomberg Gbl Agg Ex USD TR USD, JPM EMBI Global TR USD, Morningstar LSTA US LL TR USD, Bloomberg Municipal TR USD
Flexibility and a macro perspective
While substituting bonds with cash may work short-term, investors should consider bonds' diversification and yield benefits against equity volatility. The extraordinary performance of AI-related companies like Nvidia raises sustainability questions, and current market conditions stress the importance of focusing on risk management over returns. Higher interest rates, geopolitical tensions, and uncertain policies challenge traditional assumptions, necessitating diversified strategies and cautious U.S. equity outlooks, with international equities and liquid alternative strategies offering attractive opportunities.
By: Sonila Gjata, CFA, CAIA Senior Portfolio Manager
