by Jordan Hucht, CFP®, ChFC®, AIF®

Q1 Review: Riding High         

The momentum that propelled financial markets higher at the end of last year continued in the first quarter, with the S&P 500 setting new records on its continued ascent. Even in the face of higher bond yields, stickier inflation, and a pending presidential election, the trifecta of strong economic growth, the promise of AI, and expected rate cuts from the Fed had the stock market riding high into the second quarter.

But it wasn’t that long ago – actually, less than six months ago – that the market was reeling as it digested strong economic growth, higher interest rates, and headlines from Washington. That should serve as a reminder of how quickly sentiment can change and the impact that momentum can have on short-term returns.

In fact, we’ve already begun to see a shift in sentiment and momentum from the time I began writing this newsletter to now.

What’s changed?

If you’ll recall, I suggested in my last newsletter that the burden of proof needed to keep the market smiling was on corporate earnings to deliver and on the Fed’s actual rate path to generally track the market’s expectations. And beyond fundamentals, heightened geopolitical tensions posed a threat for conflict escalation that could disrupt financials markets.

As it happens, these pots have somewhat boiled over in recent weeks. Let’s look at the economic fundamentals first.

Conventional wisdom among the Fed and economists is that tightening monetary policy (i.e., raising rates and reducing the money supply) will slow growth, increase unemployment, and tame inflation. The risk, of course, is that if the dosage isn’t just right, the side effect of monetary medicine will be economic recession. Enter the widespread predictions of recession we saw heading into last year. But as you know, last year’s story was one of strong economic growth, continued low unemployment, and declining inflation. Where many expected the Big Bad Wolf, instead Goldilocks arrived. And she brought with her the gift of a 24% rally in the S&P 500.

The groupthink as this year got started was that the Fed has more-or-less won its battle against inflation and that the time to start cutting rates would soon be here. Specifically, after Fed Chair Powell’s dovish December dialogue, the futures market was pricing in six 0.25% rate cuts in 2024, with the first expected to come this spring. Those expectations were evidenced by the interest rate complex at the beginning of the year – the Fed funds rate was (still is) at 5.25% and the 10-year Treasury yield was just shy of 4%. This expectation of rate cuts was supportive of a stock market that had rallied more than 20% over the past year and, from a valuation perspective, was on the expensive side.

As economic data started to roll in this year, inflation readings proved to be sticker than hoped, and the market’s expectations for rate cuts began to wane. As such, the yield on the 10-year Treasury began to rise. At first, the stock market shrugged it off – as the 10-year yield rose from 3.8% to 4.2% during the first quarter, the S&P 500 rose 10% on the back of the strong economy and the idea that, even though the Fed may not cut as much or as quickly as hoped, rate cuts were still coming.

In the opening weeks of the second quarter, however, the consistently higher-than-expected inflation readings began to take their toll. Notably, the 10-year Treasury yield spiked from 4.2% to nearly 4.7%, with the biggest jump happening after the March inflation print, the third disappointing print in a row. As the declining-inflation trend stalled, expectations for this year’s Fed rate cuts have gone from 6 (beginning in the spring) to 2 (beginning in the fall). Naturally, this has had a cascading effect on the stock market – as of the time of this writing, the S&P 500 has declined almost 5% from its recent all-time high.

In my opinion, we shouldn’t be surprised or alarmed by the recent pullback in stock prices. Considering the market’s gains over the past 18 months – more than 35% on the S&P 500 – a reset is warranted, and the spike in rates is a logical catalyst. Perhaps more concerning, though, is the recent escalation of conflict in the Middle East, which has surely been somewhat of a contributor to the recent reversal in sentiment and markets (though I’d argue less so than the fundamentals we discussed). Frankly, I’m of the opinion that heightened geopolitical tensions around the world pose the strongest short-term risk to financial markets. Add that to the upcoming US presidential election and I think the next 6 months will likely bring a higher level of volatility than we’ve seen over the past year.

We’re in a tug-of-war market. A strong economy and strong earnings are pushing the stock market in one direction while sticker inflation and higher rates are pulling in the opposite direction. Coincidentally, I just caught a headline out of the corner of my eye:

“Fed Chair Powell says there has been a ‘lack of further progress’ this year on inflation.”

Surprise, surprise. That’s the story of the year, though it didn’t manifest itself in the financial markets until this month. As we get further into the quarter, we’ll see and hear from Corporate America as first quarter earnings are released. If earnings results remain strong and forward guidance doesn’t deteriorate, I’d expect the tug of war to continue. But outside forces – namely, geopolitical risks – remain an overhang that need to be considered.

In this type of environment, I’d focus carefully on risk management. Whether the recent pullback in stock prices is a short-term reset or the start of a more prolonged downturn is to be determined. What works in investors’ favor is that diversification can win in the current environment. What do I mean by that? With short-term interest rates remaining relatively high, cash equivalents continue to yield in the 5% range. Going a little further out on the risk spectrum, most fixed-income investments are yielding a real return (interest in excess of inflation) and could see price appreciation if rates decline later this year and into next year. On the equity side, it’ll likely be a much bumpier ride, but equity investments should be long-term oriented, and big gains have been made over the past 18 months. Add in alternatives, which can reduce overall correlation, and investors should have the seeds needed to plant this spring for a fruitful future harvest.

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Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.