In the first quarter of 2024, we saw a big divergence in performance between fixed income and equities. Stronger than expected economic activity and persistent inflation prompted a significant recalibration in rate cut expectations for 2024 – from six or seven cuts to just two or three cuts.
Consequently, yields rose, negatively affecting bond prices. At the same time, the economic resiliency supported corporate earnings growth and investor confidence, sparking an equity market rally. Overall, Q1 proved to be a solid quarter for balanced investors.
The Fight Against Inflation
While recent inflation and jobs data have gotten more attention, it's important to reflect on the broader trends of the past 12 months. Inflation has softened considerably, while the labor market is showing more balance between job demand and labor supply, indicating that Federal Reserve (Fed) policy has begun to make an impact.
As previously noted, addressing elevated inflation resembles a weight loss journey, where shedding the final pounds may require a prolonged effort. Similarly, we are expecting a "higher for longer" interest rate environment and, as a result, we foresee inflation gradually moderating and the labor market softening further over the next couple of years.
Our current base case is for one, 25 basis point rate cut by the Fed in 2024. However, it's crucial to note that our forecast remains contingent on inflation, jobs, and consumer spending data reported in the coming months.
While Fed members have expressed a desire to reduce interest rates, they are also waiting for a clear sign that inflation is on a sustained path towards their 2% target before pivoting to cuts. Given the resilient economic backdrop, we expect the Fed to exercise patience and avoid premature rate cuts that could reignite inflation. Lastly, according to the Fed's forecast, interest rates are projected to be approximately 200 basis points lower by the end of 2026 compared to current levels.
In this environment, we believe investors should refrain from trying to predict the timing of any initial cut or the precise trajectory of Fed policy. The focus now should be on the likelihood of lower interest rates over the next two to three years and the opportunity this provides investors.
What About the Presidential Election?
2024 is an election year and it's important for investors to differentiate between the short and longer-term impacts of presidential elections. Historically, market volatility has tended to increase as elections draw near and uncertainty becomes heightened. However, it's crucial to examine the broader picture. How have past election results influenced subsequent market returns? When analyzing the data from the past 15 presidential terms, average annual returns have generally remained positive regardless of the party or individual in power (see chart below). Furthermore, over the last 40+ years, the S&P 500 has generally exhibited positive growth throughout presidential terms.
While there will undoubtedly be extensive media coverage and discussions surrounding polls and policy platforms leading up the election, it's important not to let the noise derail your investment strategy. Expect short-term fluctuations but remain committed to your investment objectives and staying invested.
Given this outlook, we maintain a slight preference for fixed income over equities but do see select opportunities in both asset classes. In fixed income, we prefer short-term bonds, intermediate Treasuries, and municipal bonds. In equities, we favor U.S. over international equities, and within the U.S., we have a slight preference for large cap equities over small and mid-cap equities.
Fixed income and balanced investors are currently enjoying a healthy level of interest income, a stark contrast to the low yields experienced over the past decade. While rapid rate cuts by the Fed may offer capital gains, investors would then be left with the prospect of lower interest income in the future. In the near term, we believe fixed income investors stand to gain from an environment of higher for longer interest rates.
As for equities, opportunities remain but investors should focus on higher quality companies capable of maintaining revenue and earnings growth, while generating positive cash flow growth, even in a higher interest rate environment.
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