Update on the Markets:

Index	1st Quarter 2024	Full Year 2024
S & P 500 (Large US Stocks)	10.56%	10.56%
Russell 2000 (Small US Stocks)	5.18%	5.18%
FTSE All-World ex-US (International Stocks)	4.72%	4.72%
Barclays US Aggregate (Bonds)	(0.78%)	(0.78%)

April 2024

Key takeaways

► Stellar stock performance

► Sticky inflation

► Fewer Fed Rate Cuts (if any)

► Government debt tremors

► Add to stocks on pullbacks

Great Start

The S&P 500 rose over 10% for the quarter to finish at a record high, marking 22 record highs along the way. Market opinion coalesced around a “soft landing” – an economic slowdown without a painful recession. Investors were optimistic at the start of the year, but such a decisive move up is surprising. Data does support the mood. The good news continued despite high Fed fund rates: declining inflation (sort of), a robust labor market, high consumer confidence, strong corporate earnings, and upward revisions for gross domestic product (GDP). And to add to the enthusiasm, the Fed expects to cut rates three times this year. Recession worries are dissolving.

Large growth stocks led the way. The Russell 1000 Growth Index rose 11.39%. Again, all things artificial intelligence (AI) soared. AI darling Nvidia jumped 82.5% in the first quarter! Meta rose 38.9%. The “Magnificent 7” (Apple, Meta, Microsoft, Amazon, Nvidia, Google, and Tesla) did well as a group, up 17%. Still, it’s more like the Mag Five now as Apple (down 11.56%) and Tesla (down almost 30%) struggle. The divergent performance spells the end of the Mag 7 for now.

Other stocks did well, too. The Russell 1000 Value Index increased by 8.98%, and the Russell 2000 (small stocks) increased by 5.18%.

Stubborn Inflation

Inflation is trending down, but it’s taking its time and increasing lately. The easy part is done. Inflation reached 10% in 2022 and has since settled in the 3.5% range. The official Fed target is 2%. There are two inflation gauges to watch. The Fed prefers the Personal-Consumption Expenditures Index (PCE). The more popular index with investors is, of course, the Consumer Price Index (CPI). You can see in the graph below that both indexes have trended lower. Core PCE is getting closer to the Fed’s goal of 2.0% than CPI. Core PCE is 2.8% year over year, while CPI is 3.8%. The weighting of various components makes the difference between the two indexes. Housing accounts for 43% of Core CPI but only 17.5% of Core PCE. Fed Chair Powell stated that he’s not targeting housing inflation. Housing remains very expensive and there are other disturbing trends, such as the cost of energy. Crude oil increased 21% in the past three months, and the summer driving season is ahead. As the two inflation curves flatten, reaching the Fed’s goal of 2.0% may take a lot longer.

Does the Fed need to cut?

Not so fast with the Fed rate cuts. A lot of the move up in stocks centers around the expectation that the Fed will begin cutting rates this year. As recently as last month, the market consensus view expected seven cuts this year. Seven! Despite a very robust economy, strong labor market, confident consumers, and no sign of a recession, expectations have now dropped to three cuts this year, and that’s the Fed’s prediction too.

Inflation numbers are not going down much anymore and may be going back up. Services inflation or goods inflation change hands every month, which is accelerating. The Fed is in a quandary. If they cut too soon or too much, the economy may heat up to the point of reigniting inflation. We’ve seen this movie before, in the 1970s, when Arthur Burns was Fed Chair. Jerome Powell probably wants to avoid repeating the mistake of taking the foot off the brake pedal too soon.

On the other hand, waiting too long to cut runs the risk of a recession. With all the good news on the economy and stock market, waiting seems more prudent. How will the stock market react?

Government Debt Skyrockets

I discussed the issue of our increasingly unsustainable government debt in a previous letter. I repeat the warnings here as things continue to worsen. The debt may soon contribute to rising interest rates, despite whatever the Fed does.

According to Bloomberg analysis, US annualized debt interest payments crossed $1 trillion in October. The cost of debt has doubled in the past 19 months as federal deficits balloon. The Fed’s rate hikes have raised the cost of borrowing for everyone, including the US government.

The massive issuance of US Treasuries is starting to pressure interest rates. The size of upcoming auctions is staggering. Rates may need to go up to entice buyers. Think of higher supply and lower prices (bond prices move in opposite directions to yields).

Larry Swedroe, Head of Financial and Economic Research for Buckingham Strategic Wealth, writes: Interest costs on the debt have increased from $1 billion per day in 2020 to almost $2 billion in 2023. The Cato Institute think tank reports that the country’s ever-expanding debt is now an issue of national security and that entitlement reform is a necessity, as the current growth rate of our debt is unsustainable. The authors of the Cato Institute’s National Security Implications of Unsustainable Spending and Debt stated:

Delaying responsible fiscal reforms in the face of growing federal debt invites economic and national decline. High and rising U.S. federal debt leads to suppressed private investment, reduced incomes, and increased risk of a sudden fiscal crisis. A weaker economy and growing concerns by international bondholders of U.S. treasuries about the government’s ability and willingness to service its debt – without resorting to high inflation – will drive up interest costs and eventually negatively impact America’s international standing. … National defense is a core responsibility of the federal government. To maximize Americans’ safety and prosperity, prudence should guide both strategy and the budget. A dire fiscal crisis would erode the economic foundation of America’s strength, limiting U.S. capacity to defend its vital interests at home and abroad.

Addressing growing entitlement programs (Social Security and Medicare, primarily) and increasing tax rates are the remedies.

The increasing federal debt burden is something we’re watching. National security issues aside, our government debt will probably not lessen soon. Neither party is interested in raising taxes and reducing services, so our debt-to-GDP ratio will continue to rise, no matter who wins in November. One way to reduce the debt burden is to inflate your way out, which is called financial repression. A general increase in the level of prices shrinks the debt burden. Hence, we may have to get used to a higher level of inflation in the future.

What to do

Though, historically, we’re entering the weak season for stocks, April is usually the best month. I’m constructive about stocks, but I’m hoping for a 5-10% pullback from here before adding to stocks. Buy on dips. The base case for stocks is solid. Earnings are coming in strong. Inflation is hovering around 3.0%, and it’ll not matter much for stocks if we never reach the Fed’s 2.0% target. Good quality companies adjust and deliver. Growth stocks may be expensive, but I’m still waiting to sell. There are better values in smaller stocks and international. The rally is already broadening out after leadership by the Magnificent Seven (more like Mag Five now).

As for bonds, I’m sticking with quality and extending maturities – moving closer to the intermediate area (3-5 years). If the Fed cuts, the yield on money market funds will plummet. The longer end may suffer under pressure from higher-than-expected inflation and our growing federal debt. I am moving to lock in rates in the intermediate area. Also, I’m reducing exposure to high-yield bonds since I don’t think the historically low yield is worth the risk, especially if we get a recession or a surprising geopolitical event. A lot of cash on the sidelines will support stocks and bonds as it eventually comes back to work.

Please let me know if you have any questions or concerns.

Sincerely, 
Henry 

Henry Gorecki, CFP® 
HG Wealth Management LLC 
401 N Michigan Ave, Suite 1200
Chicago, IL  60611
312-723-5116