Capital markets perspective: On investors’ minds

Capital markets perspective: On investors’ minds 


If investment returns are a constant war for the hearts and minds of investors, the first quarter of 2024 was a battle between "recessionary concerns" on one side and "artificial intelligence" on the other. 

Spoiler alert: AI is currently winning.

But first things first. Equity market performance was exceptionally strong during the first quarter, with U.S. large-cap stocks up nearly 11%. For the record, a 10%-plus advance during any given quarter is relatively rare: The S&P 500® index is able to put up those kinds of numbers only about once in every six quarters or so. But during the post-pandemic era, it’s already happened five times – roughly twice as often as history would suggest. Moreover, the first quarter of 2024 represents the fourth-best start for the index in any year so far this century – something that has tended to translate into relatively strong full-year performances in the past.

When questions abound

But with a difficult April now behind us, there are plenty of reasons to question whether the tendency of markets to follow through after a strong opening quarter will hold true this year. If not, the macroeconomic situation will probably be at least partially to blame. In fact, last quarter’s upbeat tone was somewhat at odds with a darkening macroeconomic backdrop that hardly seemed conducive to a risk-on rally like the one we enjoyed.

Much of that angst can be traced to the fact that inflation has proven far more stubborn than markets had hoped. Initially, progress was dramatic: As supply chains naturally began to heal after the pandemic, so-called “cost-push” inflation – the tendency of prices to rise in response to scarcity brought on by some sort of shock to the system (COVID certainly qualifies) – eased considerably. That helped year-over-year growth in the consumer price index (CPI) drop from a peak of 9% in June 2022 to its current rate of around 3.5%. But it’s this “last mile” – the stubborn gap that exists between 3.5% and the Fed’s target of 2% – that’s proving to be the most problematic, mostly because it involves the much trickier task of controlling things like wages and consumer demand.

Reported inflation figures have therefore repeatedly disappointed to the upside so far in 2024, with monthly CPI data coming in higher than expected during at least three of the four inflation reports we’ve had so far this year. The bond market took notice, and inflation data led to higher interest rates and a re-setting of expectations regarding both the start and the depth of Fed-sponsored rate cuts this year: As 2023 drew to a close, rates traders expected the rate-cutting campaign to begin no later than May – a date that has now been pushed back to June at the earliest. Similarly, a few short months ago, markets were expecting at least 6-8 rate cuts during calendar 2024. That’s now been pulled back to only 1 or 2.

Another notable feature of the first quarter was a continued split, both in markets (as smaller stocks continued to lag bigger ones) and in economics (small firms struggling against the environment to a far greater degree than larger peers). One reason for this probably stems from the fact that smaller firms tend to rely on debt to finance their operations to a greater extent than larger ones, which can place greater stress on small firms’ finances during extended periods of high interest rates. Small companies may also feel the pain of a slowdown in demand more acutely than their large-market peers, which are somewhat more insulated from economic uncertainty by things like powerful branding, operational scale and strategic flexibility. Little wonder, then, that small-caps have continued to underperform large-caps and small business owners are far less optimistic than large-company CEOs.

How can we reconcile these challenges to continued economic growth to the first quarter’s exceptionally strong performance for risk assets? Maybe the answer lies here: Markets try hard to anticipate big inflection points rather than just react to them, which means they can be at risk of giving too much weight to an imagined future and not enough to cold, hard facts like an uncertain economy.

So, when something comes along and captures the market’s imagination as fully as AI has in recent months, it can paper over a whole lot of economic weakness in the process.

Have you heard? 

And that brings us back to our first point: If today’s market performance is a battle between recession and AI for the hearts and minds of investors, AI is winning. On average, the word “recession” was mentioned roughly 1,000 times per day in news outlets and social media platforms monitored by Bloomberg, rising steadily beginning in about mid-2022 as the Fed continued to raise rates, economic fears increased, and markets declined. The recession story count ultimately peaked well above 15,000 in the summer of that year before declining steadily as the “soft landing” narrative took over and markets healed. 

Meanwhile, the phrase “artificial intelligence" rarely captured much more than a few hundred mentions per day until late 2022, when the popular AI-chatbot ChatGPT was released to the public. Since then, it has seen a steady increase, peaking at roughly 16,000 mentions per day late last fall.

In fact, if you overlay a chart of how often the two words are mentioned, what you’ll find is that they are very nearly the same chart – but recession hits its peak a little more than a year before AI does. And that corresponds quite well to what was top-of-mind for markets: Recession dominated the buzz throughout much of 2022, while AI has dominated ever since.

Quite often if you follow the buzz, you’ll find where the markets’ hearts and heads lie. But financial market performance is obviously more complex than just capturing the buzz, so to connect the dots between AI enthusiasm and the first quarter’s strong risk-on performance, we probably need some corroborating evidence.

And as it turns out, we really don’t have to look much further than the continued outperformance of the Magnificent Seven – the group of seven stocks that have come to characterize the new economy for investors. During the first quarter, these seven stocks jumped 17.1% – tamer than previous quarters, perhaps but still ahead of just about everything else in the domestic stock universe. Maybe even more impressive, the combined market capitalization of these seven standouts stands at approximately $13.5 trillion.

While it’s not impossible that other companies will grow into such lofty valuations, the history of the Internet bubble should serve as a cautionary tale to those who are too aggressive too soon: While some companies will almost certainly live up to the hype, many others probably won’t.

Make no mistake, the transition from Web 1.0 to a fully AI-enabled economy holds enormous potential for markets and society in general. But that transition will be non-linear, and in the meantime, the here-and-now feels particularly unsettled.

To cut or not to cut

For example, anyone interested in understanding where markets might go from here probably has to start the analysis with a frank assessment of whether progress against inflation will resume, remain stalled, or reignite. That makes the next several inflation releases (the next CPI and PPI prints are due in mid-May) required reading for professional and novice economists alike. If the recent plateau in price growth persists (or, even worse, if inflationary pressures pick back up), the Fed’s long-awaited cutting cycle will be delayed again, interest rates will likely rise, and equity markets will almost certainly come under pressure.

Obviously, the preferred route would be for inflation to resume its decline, but for that to happen the U.S. consumer will likely have to slow. With the easy work of supply chain repair already complete, inflationary pressures are currently skewed to the demand side, which makes any data surrounding consumer spending nearly as important as inflation itself. Items like retail sales, retailer earnings, and next month’s income and outlays report should provide insight. 

But the key to that dynamic is to see demand weaken, not collapse. That’s the scenario most likely to keep the Fed comfortably out of the way, patiently watching the clock until the time to begin cutting rates finally arrives. But if the economy weakens too much or too fast, that could force the Fed to start easing before inflation is truly tamed, and that’s a scenario that markets might react to intensely. For that reason, we’re also watching the way Fed expectations evolve in response to incoming data, especially weaker data: Ironically, a big shift lower in Fed expectations might be just as frightening as a big shift higher because it suggests that the economy is tipping over too fast.

For what it’s worth, it would square well with history to see the economy soften in the near future: Both recessions and labor market softness tend to appear only many months after the Fed stops increasing rates, meaning we are only now beginning to reach the window where recessionary concerns peak. There have already been signs that the labor market is softening – layoff announcements are rising, hiring plans are falling, and cyclically oriented sectors like manufacturing are beginning to shed jobs at a faster pace. Just like consumer demand, some softness in the labor market would indeed be welcome because it should help keep the Fed on the sidelines and allow progress against inflation to resume. The problem comes, however, if weakness turns into collapse. That makes upcoming data surrounding labor markets particularly important at this juncture.

The bottom line

Regardless, we remain firm believers that the best way to respond to any environment is to stay thoughtful and calm no matter how emotionally charged things become. For investors who might otherwise be tempted to make wholesale adjustments in response to a shifting environment over which they have no control, that very likely means sticking to a disciplined and well-defined strategy that was designed with a cooler head when times were more serene. 

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Tom Nun, CFA


Tom Nun, CFA, Portfolio Strategist at Empower, works alongside teams overseeing portfolio construction, advice solutions, portfolio management, and investment products and consulting.

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