Equity markets had a stellar run in the first quarter, with the S&P 500 up over 10% and nearly 30% from the October low. Improving economic fundamentals such as moderating inflation, a resilient labor market, and strong GDP growth propelled risk assets higher, with recession fears fading into the background. Confirmation from the Federal Reserve of an end to interest rate hikes created further momentum as idle cash got pulled into the market. Lastly, a continuance of the “AI trade” has driven tech stocks higher, particularly semiconductors, as strong earnings from bellwether Nvidia confirmed accelerating demand for AI applications.
Whereas last year was dominated by talk of an impending recession, markets seem to have begun to conclude at this point that it’s not coming, at least not in the near term. Economic data have actually strengthened recently after slowing last year as interest rates rapidly rose. While rates have yet to meaningfully come down, the simple fact they are no longer rising has benefited the market by reducing uncertainty and creating space for further multiple expansion. The dovish shift from the Federal Reserve to talk of interest rate cuts has further underscored this more supportive interest rate environment in 2024.
An encouraging sign as we start the second quarter is that market breadth is expanding, meaning more stocks and sectors are participating in the rally. This is important because it suggests that economic fundamentals are creating a base of support for the rally, rather than just relying on the momentum of a few winners which could rapidly reverse. This is illustrated by the equal weight S&P 500 index outperforming the main index over the last month, reversing the trend from January and February, when just a few tech stocks accounted for most of the market gain, most notably Nvidia, which accounts for a third of the S&P return to date. Seeing this broadening of the rally should continue to protect on the downside when volatility inevitably returns.
Nevertheless, the concentration in the market continues to be a hot topic of debate. From the “FAANG” group of a few years ago to the now “Magnificent 7”, a relatively small group of stocks at the top of indices continue to drive the market. While its true prior periods of such high concentration reverted over time, data shows that markets actually tend to deliver above average returns for a period of time. Fundamentally, the stocks at the top now also differ from prior periods in that they trade at more reasonable valuations in relation to their higher profit margins and strong growth rates. This is in many ways a reflection of an increasingly “winner take all” economy, where rapid technological changes tend to reinforce competitive moats of the most dominant and profitable incumbents. We see this trend likely to continue barring new more aggressive regulation. Lastly, historical data also shows that years where Q1 performance exceeded 10% tend to have above average performance for the rest of the year.
While these are all reasons to be cautiously optimistic, there are several important risks that warrant close attention. First, such a large move is typically associated with a subsequent increase in volatility as markets digest and reprice assets that may have moved too quickly. The momentum of a handful of stocks driving the market means that any reversals to the downside are likely to be amplified as well. Being a presidential election year might also amplify this, as markets start speculating on the post-election environment. Together, these factors underscore even more than normal the importance of having a steady and long-term perspective.
We are also closely monitoring macroeconomic and monetary policy risks. With market multiples above long-term averages, any material deceleration of economic data or hawkish tilt from the Federal Reserve has the ability to trigger volatility. While the Fed has communicated an end to interest rate increases, the timing of when cuts may come is very much an open question. A strong economy means there is a fair chance markets may have to adjust expectations and accept a “higher for longer” scenario, particularly if the inflation trend peters out. Lastly, we are watching the geopolitical factors still percolating in the background, such as the slowdown in China, escalating trade war in Semiconductors, the war in Israel, and the war in Ukraine.
You can be assured that we will continue to monitor these developments closely and stand ready to act in portfolios as opportunities present themselves.