Equity markets delivered another strong performance in the first quarter of 2024, bolstered by an improving economic outlook, moderating inflation, and investor expectations that the Federal Reserve’s next action will be a rate cut. Stock market returns continued to be fueled by optimism surrounding the potential benefits of artificial intelligence (AI). In January, the S&P 500 Index made a new all-time high, its first in more than two years. The other equity indices shown in the table below are still trading below their previous record highs. Despite positive performance in the quarter, the small-cap Russell 2000 Index is currently 12.5% below its all-time high recorded in October 2021. The MSCI Emerging Market Index is still in bear market territory, trading 25.5% below its record high made in February 2021.

Equity Performance for Periods Ending on March 31, 2024

Total Return Index Market Sector Quarter 1-year 3-year 5-year 10-year
S&P 500 Large U.S. Companies 10.6% 29.9% 11.5% 15.1% 13.0%
Russell 2000 Small U.S. Companies 5.2% 19.7% -0.1% 8.1% 7.6%
MSCI EAFE Developed Int’l Markets 5.8% 15.3% 4.8% 7.3% 4.8%
MSCI EM Emerging Int’l Markets 2.4% 8.2% -5.0% 2.2% 2.9%
BB US Agg Bond US Investment Grd Bonds -0.8% 1.7% -2.5% 0.4% 1.5%

Over the past year and a half, a number of indicators were signaling that a recession was likely. The Conference Board Leading Economic Index is comprised of 10 economic indicators designed to predict the future direction of the economy by detecting upward or downward trends before they occur. Prior to turning positive in February, this index had declined for 23 consecutive months. In each previous instance when the index declined for 12 months or more, the economy slipped into a recession. Recent positive trends in housing, manufacturing, and employment contributed to the improving economic outlook. In late March, the Federal Reserve increased its estimate of real GDP growth for 2024 to 2.1%, up from 1.4% in December.

Equity markets rallied in late 2023 when it became obvious that the Fed was done raising interest rates as the inflation rate progressively moderated. At its December FOMC meeting the Fed signaled through its “dot plot” that it would cut interest rates by 0.25% three times in 2024. Fixed income trading at the time reflected expectations that six rate cuts were more likely. With the recent improvement in economic indicators, the need for future interest rate cuts to provide economic stimulus may have lessened. The Fed is still signaling that it will cut rates by 0.25% three times before the end of 2024, but the rate cuts will most likely be skewed toward the second half of the year. Considering a stronger economy and the possibility of fewer rate cuts in 2024, the Fed is still projecting that it will achieve its goal of a 2.0% inflation rate. The current inflation rate is 3.2% as measured by the Consumer Price Index.

Disruptive technologies have had significant impacts on the economy and markets throughout history. In the past 40 years, personal computers, the Internet, smartphones, social media, e-commerce and online retail, and biotechnology and genetic engineering have helped change our world, culture, and our lives, and have generated significant returns for investors. Many observers attribute the current bull market as beginning with the launch of ChatGPT, an AI software application, on November 30, 2022. While AI has been a potentially disruptive technology for most of the past 20 years, its practical application was seemingly not apparent to investors until ChatGPT provided a glimpse into the future.

There is little doubt that human productivity will be enhanced with the use of AI. The companies producing chips and servers to provide AI computing power have skyrocketed in market value as their infrastructure products have enjoyed strong demand. Many companies are in the process of developing their AI capabilities, but few are currently deploying them. It may take years before the benefits become apparent on the bottom lines of companies utilizing AI technology.

A recent report by Goldman Sachs estimates that AI will result in a loss of 300 million jobs globally and eventually replace 25% of the work force. Not that one should fear, the same report forecasts AI related productivity improvements will add 1.1% annually to global real GDP over the next 10 years. That translates into a narrative that we will all work less as powerful computers and software do more of our tasks. However, many experts have cautioned that AI, if not deployed in a highly secure and ethical manner, could be used for malicious purposes.

The other major disruptive technology to emerge in the past year has been in healthcare. The approval of GLP-1 drugs for weight loss treatment in late 2023 is likely to have dramatic impact on the economy and companies beyond its health benefits to individuals. Analysts predict that GLP-1 drugs will have a significantly positive impact on U.S. GDP due to lower obesity-related health complications. However, their forecasts of GDP growth are highly dependent on the total number of individuals that will use these medications, with estimates of between 15 and 60 million Americans eventually taking these drugs. Some analysts are predicting lower earnings for companies in the restaurant, snack food, and beverage businesses. There could be less need for heart surgeries, dialysis, and knee and hip replacements as more individuals lose and maintain lower weight. One analyst predicted airlines will be more profitable since they will save fuel due to lighter-weight passengers. The most significant benefits to companies are expected to be derived from a healthier workforce and enhanced productivity. However, as with all new medications, there could be longer-term risks that currently are not apparent.

While excitement over new technologies was a key determinant that propelled the S&P 500 to record levels, it has also predominantly made large company stocks very expensive by historical standards. The S&P 500 now trades at a price-to-earnings (P/E) ratio of 21.1 according to Yardeni Research, based on estimates for the next 12-month earnings. This compares to historical averages for 5-year (18.9), 10-year (17.7), 15-year (16.1), and 20-year (15.6), according to FactSet Research. Higher P/E ratios can be justified when interest rates are low since fixed income investments and cash do not offer an attractive alternative to equities. However, with most taxable fixed income securities now offering yields above 4%, fixed income securities have become more competitive, especially on a risk-adjusted basis.

As noted previously, small companies and international equities have not fully recovered to their previous highs. These sectors of the market are perceived to be more economically sensitive, and their valuations remained constrained as investors worried that a recession would detract from performance. With the outlook for economic growth improving, investors might find these sectors to be more attractive in 2024. In addition, their valuations look more reasonable compared to large companies, with P/E ratios of 15.4, 14.5, and 12.1, respectively, for U.S. small companies, developed international markets, and emerging markets.

Although the economic outlook has improved, many of the same risks that were present last quarter still exist. Geopolitical tensions remain high, the U.S. budget deficit needs to be dealt with, and inflation could reaccelerate. The upcoming presidential election adds uncertainty as well.

The Bloomberg Aggregate Bond Index produced a 0.8% loss during the quarter. This index measures the performance of all investment grade taxable bonds in the U.S. During the quarter, the interest rate on the 10-year Treasury note increased from 3.87% to 4.21%. The yield curve remains inverted, meaning that shorter-maturity fixed income securities have higher interest rates than longer-duration securities. We have maintained a relatively short average duration for the fixed income segment of our managed portfolios to mitigate the risk of rising interest rates and because short-term interest rates are relatively high compared to long-term rates.

Twelve months ago, the market was quite worried that a recession was most likely at hand. Today, the U.S. economy reflects a level of resiliency and improving growth. While large companies have benefited significantly from the improved outlook, their valuations need to be supported by strong future earnings growth. At the same time, fixed income investments have become increasingly more attractive compared to equities as interest rates have risen over the past two years. For the foreseeable future, it seems that the direction of the markets will continue to be dependent on the strength of economic growth, the rate of inflation, and political factors both domestically and abroad.

John D. Frankola, CFA      Lawrence E. Eakin, Jr.       Matthew J. Viverette       Dylan C. T. Dunlop

Vista Investment Management, LLC is a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.