From Inflation to AI: Key Trends Shaping 2Q2024 Financial Markets

In the realm of global economics and financial markets, 2024 has been shaped prominently by the overarching theme of interest rates. Since the Federal Reserve’s policy rate peaked in July 2023, higher interest rates have reverberated across various sectors, impacting investment decisions and asset valuations. The ripple effects have been profound, particularly felt in sectors reliant on debt financing and income-producing assets like bonds and real estate. For smaller growth companies, burdened by higher borrowing costs, the challenges have been particularly acute, dampening their growth prospects. But don’t despair, this blog post isn’t just about interest rates!

Resilience Amidst Headwinds

Despite these challenges, the economy and stock market have shown remarkable resilience, surprising nearly everyone with positive returns. Global stocks have surged over 10% year-to-date, a robust performance that exceeds typical annual averages. But we believe there’s more to the story, beneath this buoyant market lie nuances of correlation and concentration, primarily driven by technology stocks with significant exposure to Artificial Intelligence (AI). Today, the top ten stocks command a staggering 36% of total market capitalization, underscoring the dominance of AI-driven firms in shaping market trends. Stocks are up on average, but returns have been unevenly distributed, with stocks outside of the top 10 names delivering a minority of the market’s return.

The Markets’ Driving Force: Interest Rates

The trajectory of equity markets seems to be closely tethered to expectations around future interest rate movements. Rates likely wouldn’t matter as much if the economy hadn’t been so abruptly weaned from persistently low interest rates.  Now, with companies recalibrating to higher corporate borrowing costs and homeowners faced with record low affordability of homes, interest rates matter, and the market is looking for any sign of inflation cooling which usually happens when the economy slows.  Oddly, this puts us in a “bad news is good news” situation.

Navigating Inflationary Currents

Inflation has been a pivotal narrative in 2024, akin to navigating turbulent waters post-pandemic disruptions. The initial shockwaves of COVID-19 precipitated an inflationary surge nearing 9% in 2022. Since then, inflationary pressures have moderated, with recent reports indicating a decline below 3% and even a month over month decline in the consumer price index (May-June 2024). That’s right month over month deflation – don’t read too much into this as it happens from time to time even while prices are going up. These developments offer cautious optimism that the Federal Reserve’s tightening measures and the passage of time are proving effective in stabilizing prices, potentially paving the way for future rate cuts.  Rate cuts now seem likely in September and perhaps even later this month, though I feel more comfortable in the September camp, because the Fed is still clawing back its credibility as an inflation fighter.

The Broader Economic Picture

Amidst these economic currents, the broader economic landscape presents a mixed picture. GDP growth remains robust yet moderating, aligning with long-term trends around 2% real GDP growth. Job creation continues at a commendable pace, albeit slower than the post-pandemic boom, with unemployment hovering near the Federal Reserve’s target at 4.1%. These interconnected factors impact inflation and interest rate policies, which are crucial for maintaining economic stability.

Election Year Uncertainty

Looking ahead, the looming specter of the November elections adds an element of uncertainty. Historically, election years bring more market volatility, with average returns that remain positive and comparable to longer term market averages. The election results could shape policy directions, particularly in sectors like energy transition, where politics influence regulatory frameworks.  However, let’s not forget that many green jobs have been created in many blue AND red states.  Who wants to kill these jobs when the US is already producing more oil than any other country on the planet?  Politically risky, in my humble opinion, and I bet most politicians agree.

AI: The Game Changer

AI technology emerges as a transformative force in 2024, propelling significant advancements in stock market performance. Companies with AI capabilities, such as NVIDIA, have seen outsized returns, reflecting the burgeoning demand for AI-driven solutions across industries. Beyond financial gains, AI has the potential to streamline operations, enhance decision-making processes, and unlock new economic opportunities. Beyond the obvious opportunities of using AI, there are widespread implications on energy supply and computing power to support the scalability of AI.  While concerns persist regarding job displacement, historical precedents like the internet suggest that technological revolutions often create new avenues for employment and economic growth.

Managing FOMO and Smart Investments

Investing in tech stocks can evoke a fear of missing out (FOMO), reminiscent of previous market bubbles. But let me offer two perspectives.  After the internet bubble peaked in 2000, it took Microsoft 17 years to reclaim its peak share price and Cisco, which provided the keys to the internet through routers and modems, still hasn’t reclaimed even 60% of its all-time high price set in the same year. Generally, price bubbles are transitory and painful for those overly exposed. Secondarily, if you own a diversified global portfolio of stocks (like a typical BSW client), you already have meaningful exposure to these names and more, including companies that should benefit from the next great theme. From our perspective, a balanced portfolio not only mitigates risk, but also positions investors to capture opportunities across emerging themes beyond AI.

And now, for some asset class updates….

Fixed Income Update by Olivia O’Toole

Fear not, this section WILL be all about interest rates. At the beginning of the year, many analysts expected a series of six rate cuts as inflation appeared to cool. However, stronger-than-expected economic data and the Fed’s cautious stance led to continued higher interest rates. The Fed has kept everyone on edge about future rate decisions but has made it clear that inflation needs to be on a sustainable path towards their 2% target​. Is one month of decreasing inflation enough to prove sustainability? We will see.

In general, the US aggregate bond market ended slightly down for the first half of the year as high interest rates persisted. Yields remain attractive – municipal yields are above the 20-year historical average. Most municipal balance sheets and budgets seem well-positioned to maintain their credit quality in the event of a recession. We believe that this is an advantageous time to lock in higher yielding, investment quality bonds for the long term.

As we move into the second half of 2024, we believe the potential for significant returns in fixed income exists, especially if the Fed begins to cut rates. However, exact timing and extent of these cuts remain uncertain.

Diversified Growth Update by Dmitry Popov

The stock market’s going wild over AI right now. And it’s not just the stock market. My social media feed is filled with AI content related to new large language models and AI agents. Sometimes I wonder whether the technology is genuinely exciting enough to inspire so much innovation and creativity, or if it’s just an algorithm pushing that type of content on me because I previously clicked on similar links. But the more I learn about AI’s capabilities, the less it feels like hype and more like the real deal.

Tech companies are throwing crazy money at AI, building massive data centers, and beefing up their computing power. It reminds me of the tech revolutions I’ve read about in books when studying similar past market behaviors, but this one appears to be happening way faster.

Here’s the thing though – in my opinion, we’re just getting started. I believe the real transformation will happen when AI starts boosting productivity across the board. At this point, the return on investment (ROI) is still in question, which can lead to overpromises and bloated company valuations, but the potential does seem to be huge.

It’s clear that 2023 and 2024 are the years of hardware. A handful of the largest US companies that can afford large upfront expenses to build out necessary infrastructure are currently winning the AI race. But we expect the markets to broaden as vast amounts of data will need to be properly stored, processed, and protected. The US economy is consumer-driven, and the hardware is useless without proper software for most consumers.

Long-term, we’re keeping our eyes on infrastructure and industrials. All this AI stuff will require a ton of energy and logistics support. And with populations aging, healthcare is looking ready for disruption as well.

Just remember – not every company’s going to win big here. The gap between winners and losers could be massive. Focusing on quality companies with solid fundamentals will be the key.

Nobody knows exactly how this will play out, but one thing’s for sure – it’s an exciting time to be an investor. Stay nimble, stay informed, and get ready for an exciting ride!

Real Asset Update by Elias Bachmann

High interest rates plus shifts in property usage (i.e., office) seems to have caused investor hesitation across many real asset fund categories. However, when investor appetite wanes, the capital that can commit often earns higher returns.

Remote working has decreased office space demand, increasing vacancies and lowering lease rates which negatively impact values. One of many examples include the recent sale of a Portland, Oregon office building at an 85% discount to its 2019 sale price. Lenders may see some loans not fully repaid. Prices seem to have accounted for much of this, but could there be more to go? We remain cautious.

The shift to online retail has changed the need for physical stores, resulting in a slowdown in new retail development. Meanwhile many obsolete properties were demolished or repurposed, further reducing supply. Occupancy and rents appear to have stabilized and even increased for some properties. Contrarian opportunities may appear in retail.

Residential housing seems to be in short supply, with single- and multi-family starts declining and higher interest rates making homes even more unaffordable. Meanwhile, household formation marches on.  Amidst this dynamic, more Americans are choosing to rent, nudging rents and renewals higher. We see strong tailwinds in this sector.

A data revolution driven by cloud computing, cryptocurrency mining, algorithm-based decision making, and AI, requires access to data, advanced chips, servers and gobs of electricity to power it. We believe the electricity production and storage, and data center sectors are benefiting from these demands, presenting opportunities for forward-looking investors.

Private Equity Update by Aaron Deitz

Entering 2024, dealmaking activity was dormant due to the high interest rate environment.  Market participants eagerly awaited signs of a potential turnaround.  Fortunately, green shoots are beginning to emerge.  In the first half of 2024, dealmaking activity was up 12% year-over-year, and valuations moved higher.

The slowdown in activity was primarily attributable to:

• The higher interest rate environment, creating valuation pressure and eroding portfolio company fundamentals.
• A large buyer/seller valuation gap, leading to muted deal activity.
• Reduced distributions, impairing fund managers’ ability to raise fresh capital.

Conversely, the recent pickup in activity has been driven by several factors:

• Fund managers are selling their most prized assets, which in part may be lifting valuations more broadly.
• The broadly syndicated loan (BSL) market rebounded strongly, creating more financing opportunities.
• Interest rate stability improved, providing more conviction about their future path.

While it remains to be seen if this trend will continue for the second half of the year, it is anticipated that a stabilized path to lower interest rates and resilient economic growth could help break up the logjam. As the average holding period of portfolio companies extends, there is significant pent-up demand for company exits, coupled with historically high levels of dry powder.  This could reignite the private equity market, boding well for long-term growth.

At BSW, we strategically position client portfolios with the goal of navigating challenging periods.  With diversification and a perpetual investment program, the aim is for portfolios to continuously move along the continuum of funding new investments, creating value, and ultimately, exiting investments.

A Balanced Approached

In conclusion, while 2024 has been marked by the challenges of relatively high interest rates, the global economy and stock markets have shown resilience. The significant gains driven by AI-focused technology stocks highlight the transformative power of innovation amidst economic uncertainties. Inflation appears to be stabilizing, and with potential rate cuts on the horizon, the outlook is cautiously optimistic. As we move through the year, we believe maintaining a balanced investment approach remains paramount. This helps ensure exposure to both current market leaders and emerging opportunities. The interplay of economic trends, technological advancements, and political developments likely will continue to shape the landscape, underscoring the benefit of remaining invested for the long term. As always, we are here to answer any questions you may have about the current environment or your portfolio.