Insights

Executive Summary: 

• The second quarter of 2024 exhibited persistent elements of inflation, leading to increased treasury bond yields and decreased expectations for Fed rate cuts, which has since mostly reversed. 

• Despite modest GDP growth and overall declining inflation, softening job data and mixed economic indicators threatened the Fed’s dual mandate. 

• Over the first 8 months of 2024, volatile market movements led to positive returns on risk assets, while interest rates remained somewhat similarly valued, resulting in improved funded status for the average pension plan. 

State of the Markets 

The second quarter of 2024 began with an economy experiencing the effects of persistent inflation elements, partly due to ongoing deficit spending and rising shelter costs. Consequently, treasury bond yields increased during the second quarter. Simultaneously, both the bond market and the Fed's rate cut expectations decreased compared to the previous quarter. Recall in the first quarter, there was a regime change: initially, the expectation was for six rate cuts in 2024, but the rates market priced in fewer than two cuts, while the Fed's dot plot predicted three cuts. The market shifted from overestimating rate moves at year-end relative to Fed expectations to underestimating future cuts over a couple of months. 

In Q1, GDP grew at an annual rate of 1.4%, while expectations for Q2 stood at 1.5% according to the Atlanta Fed’s GDP Now forecast. Additionally, they characterized growth as modest, anticipating a decline in inflation. As the 2nd quarter progressed, inflation seemed to align with this sentiment, although it was apparent that it may take more time to reach the Fed’s 2% objective. Fed Chair Powell had stated that he doesn’t see any signs of stagflation, but if the current trajectory continues, growth could decline into negative territory before broader measures of inflation align with the Fed’s targets. Chairman Powell may need to closely monitor the situation for signs of stagflation. As the quarter ended, softening jobs data collided with mixed economic indicators, posing a threat to the Fed’s ability to uphold its dual mandate of price stability and maximum employment. In April, U.S. job openings dropped to the lowest level in three years, while the ratio of jobs per job seeker declined to 1.2X from a high of 2.0X. As these signs of labor market weakness persist, we anticipate a decline in consumer confidence, leading to shifts in behavior and ultimately dampening economic activity. 

During the quarter, 10-year Treasury yields rose from 4.2% to 4.4%. Broad taxable bond indexes showed total return performance ranging from -2.1% to 1.1%. Equity indices exhibited a similar range of returns, spanning from -3.4% to 5.0%. Notably, several of the largest domestic companies reported outstanding earnings, contributing to the positive performance of the S&P 500 throughout the period. This trend of positive performance has persisted in six of the last seven quarters. Upon closer examination, it’s evident that Apple and Nvidia accounted for nearly 75% of the large cap index’s returns. 

Pension Market Update 

The yield curve has maintained an inverted shape and remained in a range across all maturities since the end of 2022. Over the second quarter of 2024, discount rates increased somewhat similarly, producing an average rise of 23 basis points (bps), which caused liability values to decline. Over the same period, risk assets represented by the MSCI ACWI index performed positively with an absolute return of 2.9%.  The combined effect on pension tracking indices was on the order of +0.1 -2.4% improvement in funding.  The year-to-date progress was on the order of +2.0 – 8.1% depending on which index was referenced.  Since the end of Q2, the opposite effects have been in place with risk assets declining approximately 4.9% and interest rates dropping in the range of 15-75 basis points depending on the tenure.  The combined impact may reverse the trend of previously improving funding levels.  Perhaps this is the beginning of the end to the opportunity whereby plan sponsors could engage in derisking transactions at acceptable financial cost, a situation which we have been strongly voicing over our prior quarterly writings.  If the pivot is not now, there will certainly be a time in the near future when the cost of derisking will increase for plan sponsors. 

Last quarter we discussed the idea of the single pension discount rate increasing since year-end.  The second quarter led to an extension of that trend.  The year-to-date rise over the first two quarters now equals 52 basis points, which is an increase of 23 basis points over the first quarter.  Remember that rising discount rates equilibrate to decreasing present values or in other words, declining liability values.  The single rate exactly collaborates the effects of the FTSE Pension Discount curve we discussed earlier.  The offset to this action is in the movement of interest rates since the end of the quarter.  If we use the U.S. Treasury curve as a parallel, we see that rates have since declined by more than an offsetting amount.  In fact, since year end, rates are similarly valued, dependent on the specific maturity, therefore liabilities are generally in similar value at the time of this writing as they were at year end. Risk assets are nearly 6% higher, so at this time we would surmise that despite the volatility in rates, pension indices are still holding on to negligible to positive improvement in funding over the first eight months of the year. 

Economic Outlook 

By the end of the second quarter, consumer expectations had declined significantly, with only 12.5% of consumers anticipating business conditions to improve in the next two quarters. This reading is the lowest since 2011. We attribute this decline to higher borrowing rates, which are impacting consumer spending patterns. Specifically, we expect decreased sales in consumer durables such as automobiles and major appliances. However, sustaining a stretched consumer, which is vital for the current Fed posture, will rely on robust job growth and real wages. Unfortunately, these consumption factors currently appear unlikely. 

The service sector, as measured by the ISM Non-Manufacturing index, has contracted in half of the past four months, following a 15-month period of consecutive growth. Similarly, the manufacturing sector, as indicated by the ISM Manufacturing Index, has generally been contracting over the past couple of years. These recent contractions in both sectors do not bode well for job growth, which will likely influence the timing of when the Fed rate cuts occur in this economic cycle.  We anticipate that the market’s response to a determined Federal Reserve and a weakening consumer will lead to a decline in bond yields. Historically, this pattern occurs prior to a Fed easing cycle and before an official recession is declared. It’s possible that the market is currently just beginning to react to this new regime at the time of this writing. 

The geopolitical and domestic political landscape will significantly influence whether near-term gains in Treasury yields, especially at the long end of the yield curve, are sustainable. Recently, Treasury Secretary Yellen expressed concern about managing deficits and interest expenses amid their long-term outlook for higher interest rates. She emphasized that if inflation-adjusted interest payments relative to GDP exceed 2%, it could burden the U.S. with additional interest costs. Although this ratio spiked last year, the Administration expects it to stabilize around 1.3% over the next decade. This suggests that the neutral rate of interest rates may be higher in the future compared to the recent past and so the amount of necessary cutting by the Fed may be lessened. 

"The real risk of deficit expansion lies in a wave election."

Our increasing borrowing costs nationally are well deserved. The ongoing political circus, which will dominate the news cycle until minimally November, obscures the fact that we’ve become oblivious to our national debt levels. Government revenue is a precious resource, and we’re in trouble if we don’t return to fiscal sanity. The best hope for fiscal discipline in the next election may come from gridlock. If the Harris (Biden) Administration remains in power, the 2017 tax cuts are likely to begin expiring in 2025. While this could raise revenue, the propensity to spend over the past three plus years poses a substantial offset. Former President Trump also had a penchant for spending. If he wins the race, there’s a scenario where gridlock leads to the expiration of the 2017 tax cuts, while new tariffs generate additional revenue. Tariffs, though essentially trade friction and a form of tax, might offer more broadly distributed streams of revenue than is politically feasible. The real risk of deficit expansion lies in a wave election. If that occurs, we’re pessimistic about the performance of long-term bonds, especially if it results in prolific government spending.  

Much of last quarter’s strategy aligns with our current thinking. The yield curve may steepen as short rates fall due to the anticipated policy shift. Politics will determine if adding duration (longer-term bonds) ahead of that move is merely a trade or a position that takes advantage of historically high interest rates. We continue to emphasize a quality bias in fixed income, as widening risk spreads could erode returns in 2024 or 2025, especially if bankruptcies rise. With yields near their highest levels in 15 years, our longer-term bond strategy is built on assumptions of a normal political environment and traditional economic slowdown where starting yields often predict performance over the bond’s lifespan. Lastly, this quarter marks the final time we can conclude with the following sentence: a wave election represents the most likely “known unknown” that could significantly alter our bias and market assumptions. 

Investment advisory services are offered through Advanced Capital Group (“ACG”), an SEC registered investment adviser.  The information provided herein is intended to be informative in nature and not intended to be advice relative to any specific investment or portfolio offered through ACG.  The views expressed in this commentary reflect the opinion of the presenter based on data available as of the date this was written and is subject to change without notice.  Information used is from sources deemed to be reliable.  ACG is not liable for errors from these third sources.  This commentary is not a complete analysis of any sector, industry, or security.  The information provided in this commentary is not a solicitation for the investment management services of ACG and is for educational purposes only.  References to specific securities are solely for illustration and education relative to the market and related commentary.  Individual investors should consult with their financial advisor before implementing changes in their portfolio based on opinions expressed.