RESOURCES

Quarterly Report: Q2 2024

Commentary from the Investment Committee of Coral Gables Trust

Q2 2024 – A Narrow Market Continues

Markets finished a strong first half driven largely by mega-cap technology companies and shifting expectations of Federal Reserve interest rate cuts. Due to a resilient U.S. economy and higher-than-expected inflation data, the Federal Reserve quickly tempered expectations from three rate cuts to potentially only one cut in 2024. The technology heavy NASDAQ led the pack with a quarterly return of +8.47%, followed by the S&P 500 at +4.28 and finally, the Dow Jones Average at -1.27%. Beneath the surface of the S&P 500 index, reveals market narrowing reaching extreme levels with a single stock (Nvidia) contributing over 30% of the index’s first half return. The chart below illustrates Nvidia’s outsized performance compared to the Magnificent Seven and the S&P 500 over the last couple of years.

This demand for chips and artificial intelligence has led to the continued outperformance of mega-cap technology companies. Currently, technology has a forward P/E over 30 times, which compares to 21 times for the S&P 500 and 16 times for the equal weighted S&P 500. The performance of today’s top technology companies has been underpinned by solid corporate balance sheets, strong earnings, and potential for robust future growth from AI-driven innovation. Today’s market concentration is not driven by the same speculative nature of market concentration during the dot-com bubble. Given the vast divergence in performance and valuation, prudent investors should consider ways to maintain a diversified portfolio to mitigate idiosyncratic risk along with a bias toward quality in their portfolio. We continue to advocate that investors look to other areas of the market that are trading at more reasonable levels. It is easy to become complacent riding the wave of exciting concepts such as Artificial Intelligence, but a swift change in sentiment can leave investors exposed.

Economic Developments: Unstoppable labor market, could downward revisions be next?

May’s employment situation smothered market expectations that the labor market may be softening. This report clearly showcased the strength of the labor force with the U.S. economy adding 272,000 jobs, marking an acceleration in the pace of hiring following the 165,000 jobs added in April. However, there were downward revisions of 15,000 combined for the prior two months. While these revisions are modest, investors are closely watching upcoming reports to see if there is a trend developing. Lagged revisions increase the risks of a policy mishap from the Federal Reserve as they are likely to believe that the labor market is stronger than it is. Furthermore, by the time these revisions come to light, it can be too late for a pivot in monetary policy before an economic downturn. This has historically been the reason why Federal Reserve hiking cycles were preceded by recessions. The chart below illustrates that job growth has slowed from peak levels but is currently at levels not associated with a recession.

Federal Reserve: Holds Rates Steady and Remains Patient

The durability of the economy has led investors to dampen their rate cut optimism and perceive it as a sign that the Federal Reserve will continue their campaign of maintaining interest rates “higher for longer.” Market participants came into 2024 expecting the Federal Reserve to cut interest rates three to four times this year for a total of 75 to 100 basis points from its current range of 5.25% to 5.50%. While key metrics of inflation have shown improvement since the hot readings at the start of the year, Chairman Powell continues to reiterate that the committee needs to see further improvements before cutting interest rates. The chart below illustrates how inflation (measured by the personal consumption expenditure) has fallen from its peak and is slowly progressing to the Federal Reserve’s 2% mandate.

Markets have been buoyant because there is still a confident majority that believes rates will be cut, but the path to lower rates is likely to remain slow and bumpy. Meanwhile, the European Central Bank has already started cutting rates and many emerging markets are well into their easing cycles. Historically, the Federal Reserve has tended to lead the global financial cycle by adjusting its policy stance before other central banks, which has substantially influenced financial conditions elsewhere. We expect U.S. interest rates to eventually move lower as the cyclical forces keeping them at their current levels abate.

Fixed Income Markets: Eyes on the Fed

The resilient economy has kept the Federal Reserve from transitioning to an easing stance; thus, acting as a headwind for bonds. As such, the Bloomberg Barclays Aggregate Bond index posted a quarter return of +0.07% but remains slightly negative for the year with a return of -0.71%. Despite the muted first half performance of domestic bonds, foreign bonds significantly underperformed with a second quarter return of -2.84% and are down -6.17% for the year. A deeper look into fixed income reveals corporate bonds outperforming treasuries supported by higher income payments and declining spreads. Furthermore, high-yield and preferred securities outperformed investment grade corporate bonds as investors were comfortable with more risk.  High-quality investment-grade corporate bonds continue to be attractive and provide investors with relatively high yields and low-to-moderate credit risk. Despite concerns regarding high borrowing costs, corporate fundamentals remain sound. Short-term Treasury bills or cash equivalents have been a popular asset class lately due to 5.00% yields and low risk.   Once the Federal Reserve begins to cut interest rates, short-term cash investments will begin to lose their appeal and reinvestment risk will become an issue.  Bonds have reasserted their value proposition both in terms of their starting real yield and as a diversifier to more adverse economic scenarios.  We recommend investors take a serious look at extending duration to lock in bond yields now in advance of any rate cuts by the Federal Reserve. The chart below illustrates how intermediate investment grade corporate bonds provide investors with yields higher than Treasuries.

International Markets: Baton Exchange?

The outlook for international markets continues to brighten as inflation tracks toward central bank comfort levels, industrial activity picks up, and bank lending growth improves. As such, the European Central Bank delivered its first 25 basis point rate cut in June and the market anticipates a further 100 basis points of easing over the next 12 months. International equities look attractively valued compared to U.S. equities and can rebound once the political drama subsides. Earnings for European companies are expected to rebound from their earnings recession and outpace U.S. earnings beginning in the third quarter of this year. The chart below illustrates how international equities started outperforming their domestic peers at the beginning of the bull market (October 2022). The total return of the MSCI EAFE Index has outperformed the S&P 500 total return by 4%. Furthermore, if the performance of the Magnificent 7 were excluded, the MSCI EAFE’s outperformance is closer to 20%.

Further outperformance of international equities can be supported by the ongoing economic recovery in Europe, faster earnings growth, and attractive valuations. Emerging markets remain largely overshadowed by doubts surrounding China’s growth trajectory. While these concerns are soundly supported, Chinese policymakers have become actively engaged in trying to turn the nation’s property market around. Additionally, Chinese companies have become more focused on governance and shareholder returns. We are seeing an increase in share buybacks and dividends as they respond to the reform efforts witnessed in Japan and South Korea. Ultimately, this will allow for better economic activity to flow through more meaningfully. Regardless of performance, we believe international equities play an essential role in portfolio diversification. The MSCI ACWI ex-US index returned -0.38%, the MSCI EAFE index returned -0.20%, and the MSCI Emerging Markets returned +5.03% for the second quarter of 2024.

Thoughts on Asset Allocation

The positive momentum experienced in the first half can be attributed to better-than-expected corporate earnings and positive guidance.  As we head into the second half, we expect market volatility to rise as we approach the U.S. election, but regardless of the outcome, the removal of uncertainty should eventually calm markets. The bottom line is that election outcomes over the long-term have not driven market outcomes. While there may be volatility leading up to Election Day, there has not been a long-term impact on market performance. 

The Investment Committee is having extensive discussions regarding the strategic positioning of our portfolios for the remainder of the year. We will place particular importance on what we want our allocations to focus on and how they can best navigate the investment landscape. We are confident that our present investment managers are well positioned to capitalize on attractive long-term investment themes. Our managers remain dedicated to selecting strong companies with durable earnings growth, pricing power and the resilience to sustain market share irrespective of conditions. Listed below is a subset of our equity and fixed-income managers that performed exceptionally well during the quarter against their benchmarks. 

*Returns are from actual portfolio results.  Results may vary. Past performance is no guarantee of future returns.

We look forward to speaking with each of you about our investment philosophy and strategies and your portfolios performance.

Share the Commentary:

For additional information, please contact:

Mason Williams

Managing Director

Chief Investment Officer

Michael J. Unger, CFP®

Vice President

Investment Officer