Perspectives

Domestic equities continued their upward march in the first quarter, extending their monthly winning streak to five and posting their fifth gain in the last six quarters. The quarter’s gains also represent the best start to a year since 2019. The market was able to post gains despite a rise in interest rates, as stubborn inflationary readings were offset by solid economic news, upside surprises to corporate earnings, and dovish comments by the Fed as to the timing of rate cuts.

Sectors

The S&P 500 posted a second consecutive quarter of double-digit gains, rising 10.6%, while there was also broadening participation in the rally. This was evident in the eclectic mix of outperforming sectors, ranging from the higher growth Communication Services and Information Technology sectors to more cyclical Energy and Industrials, to interest-sensitive Financials. On the flip side, Real Estate was hurt by higher interest rates and weak commercial office space, while the more defensive Utilities and Consumer Staples sectors lagged. Consumer Discretionary also lagged on Tesla’s weakness. Small cap stocks could not keep up with large caps, although the Russell 2000 still posted a respectable 5.2% gain. Unlike large caps, the small cap Financials and Communication Services sectors performed poorly, led by renewed concerns over regional bank stability, and a decline in smaller media and telecommunication stocks.

Styles

Growth stocks again maintained their relative advantage versus Value. In large caps, this was driven by the Communication Services, Information Technology and Health Care sectors, especially names driven by AI and GLP-1 excitement. While Information Technology was also a primary driver of small cap growth outperformance, it was substantially driven by the performance of two outlier stocks: Super Microcomputer, a $60B “small-cap” company, and MicroStrategy, whose value is driven almost exclusively by its “bet-the-farm” investment in bitcoin. Unlike last quarter, the market’s gains did have a quality bias, with attributes such as high ROE and low beta outperforming.

Outlook

The Fed should be given credit for sustaining economic growth while inflation continues its somewhat stubborn decline toward the Fed’s stated 2% target. While a recession still can’t be ruled out given the lagged effect of restrictive monetary policy and an inverted yield curve, the evidence suggests the length and severity of any recession will be minimal.

The primary risk to the economy appears to be the rather sticky inflation readings, especially on services and some commodities, which may delay the timing of Fed rate cuts. Nonetheless, it appears it is a question of “when” rather than “if,” as multiple rate cuts are still the consensus expectation for 2024. Yet, while the bias is for a positive economic outlook, we are carefully watching several conflicting indicators, including the still only modestly positive ISM Manufacturing data, some areas of softer retail spending, weak commercial real estate, and slower bank lending trends. And then there are the imponderables that seem to have moved to many investors’ back burner, including hostilities in Ukraine and the Middle East, and several important elections around the globe.

Stocks have become more expensive in 2024, as the S&P 500 now sells at nearly 22x earnings expectations, representing an earnings yield of 4.6%. With the increase in 10-year Treasury yields to 4.2% during the quarter, the ratio of equity-to-bond yields has fallen to a well-below average reading of 1.1x. When combined with the strong momentum of equities over the past several quarters, a contrarian might suggest the market is due for a much-deserved rest. However, there are still pockets of value in the market, as smaller-cap equities remain relatively inexpensive when compared to large caps. The broadening of participation in the market rally late in the quarter suggests these smaller stocks are finally catching a bid.

While we are optimistic about prospects for equity markets and the economy in 2024, we remain diligent in looking for factors that could undermine our favorable outlook, with both a slower economy driven into recession or a hotter economy bolstering inflation still in play. But as always, we remain focused on investing in quality companies that have strong management teams and solid market positions that should successfully guide them through any economic scenario.

Read GW&K’s full Quarterly Investment Review for the first quarter here.

With contributions from members of our Domestic Equities Team