Performance report: Uncovering what shaped markets in the first quarter of 2024

Stocks got off to a solid start in 2024 as global growth indicators improved.

The Morningstar Global Markets index rose just under 8% for the quarter. 

Meanwhile, those same signs of stronger economic growth pushed bond yields higher.

The US Treasury yield for 10-year bonds rose 0.33% to 4.20%, resulting in the Morningstar Core Bond index ending the quarter slightly negative.

Here is our analysis of what happened and what it might mean looking forward.

Earnings growth powers stocks higher

Profit growth appears to be accelerating, based on the financial results companies reported over the last couple of months.

In general, companies not only posted better-than-expected profits for the current quarter, but management teams expressed increasing optimism about the remainder of 2024 being strong. This combination was the main reason why stocks reached all-time highs in March.

A few notable themes emerged from these company reports. For consumer-based firms, we heard many companies say they could no longer raise prices as rapidly as in 2022 and early 2023. The days when companies could boost profits simply by raising prices seem to be over. To compete now, they will have to shift their focus to selling higher volumes of goods.

This is a very positive development for the broader economy. First of all, it suggests that inflation pressures are subsiding. But just as importantly, when companies grow profits by raising prices, that has little ancillary benefit to other businesses. 

Conversely, when a company increases the amount of goods it sells, the benefits are spread wide. It means more business for suppliers, transportation companies, retailers, advertising, and so on. 

In other words, when a company raises prices, it is the only one that benefits. However, when it sells more products, multiple businesses benefit.

In 2022, the economy was characterized by high inflation and low sales volume. In 2023, that flipped to a lower-inflation, higher-volume sales economy - a much healthier environment that we believe increases the odds of a sustained period of strong economic growth.

An investment boom?

Another central theme of this earnings season was the acceleration of business investment, which occurs when firms spend money to expand production, improve productivity, or invest in research and development. 

Accelerated business investments indicate that companies are becoming more optimistic about the economy in the short term. This can create a positive feedback loop, where one company’s investment spending is another company’s revenue. 

Put simply, when optimistic companies ramp up their spending, it often sparks a ripple effect, prompting other companies to do the same.

Investing in productivity enhancements has a significant positive impact on the economy in the long run. It allows companies to produce more with the same number of workers, increasing broad economic productivity. 

Artificial intelligence (AI) investments were an important factor in the first quarter. The semiconductor industry reaped the most reward from the AI boom, returning over 39.2% as the best-performing segment in the S&P 500.

However, the benefits have had a widespread impact. Take, for example, the manufacturing industry: Construction spending by manufacturers was roughly flat from 2014 to early 2021 but has more than doubled in the last two years.

Source: Census Bureau

The pivot to volume sales growth and increased business investment have resulted in a fairly broad market rally. Of the 68 industry segments in the S&P 500, 52 were positive this quarter, and 25 returned at least 10%. 

Facet’s ETF mix benefits from an overweight of quality

Facet’s main equity ETF allocation benefited from being overweight “quality” companies.

"Quality" companies have relatively low debt burdens, fairly high profit margins, and more consistent revenue than others. 

This overweight resulted in Facet’s portfolios having more of our technology weighting in semiconductors, which benefited from the AI spending boom. We were also overweight online advertising providers and underweight debt-heavy traditional telecommunications companies. 

Those companies benefited from increased ad spend by consumer companies looking to accelerate sales growth. These two weighting differences added approximately 0.3% to Facet’s results relative to the Morningstar Global benchmark.

In addition, we modestly increased our allocation to US mega cap growth companies. By “mega cap,” we generally mean companies with a market value of $50 billion or more, or approximately the 250 largest US companies. If this investment boom continues, we think larger companies in faster-growing sectors (e.g., technology and telecommunications) will benefit most.

Could optimism turn into “irrational exuberance?”

The swift surge in stock prices over the last six months has sparked concerns that the market may be overly optimistic.

To some, the recent surge, coinciding with AI enthusiasm, is reminiscent of the 1990s technology bubble, which led to a three-year equity bear market.

Fortunately for investors, there aren’t many strong parallels between today’s market and the 90s bubble, at least not at the later stage. Recently, we wrote an article examining whether today’s market is a bubble. We found that neither the level of speculative market activity—nor the kind of widespread unsustainable valuations that marked the end of the 1990s bubble—is present.

In other words, the market is expressing a lot of optimism right now, but that is justified by a very good economic environment. For the most part, the stocks that are outperforming right now are the ones producing very strong revenue and profit growth. With the possible exception of cryptocurrencies, we aren’t seeing many examples of truly speculative behavior.

That said, Facet’s investment mix will remain focused on more profitable and stable companies. We are underweight smaller, high-valuation stocks, such as unprofitable technology or pharmaceutical companies. If speculative fervor builds over the coming months, these low-quality companies may outperform, but we don’t think the risk is worth the reward.

Inflation rebounds

Amid all the positivity of the first quarter, inflation stood out as the one major negative piece of news.

Using the Core Consumer Price Index, inflation increased by 0.4% in January and February, 4.1% annualized over the last three months.

Source: Bureau of Labor Statistics

Analysts were caught off guard by this lurch higher in inflation, leading many to question whether some temporary factor is driving the loftier measures. Chair Jerome Powell responded, “There’s reason to think that there could be seasonal effects.”

The key question for inflation is whether consumer spending is accelerating or not. Inflation is fundamentally caused by spending outstripping the economy’s ability to produce. Therefore, if we’re going to see a lasting inflation increase, it will have to be accompanied by more consumer spending.

Unfortunately, the data on this question is mixed. Spending on physical goods—from toasters to automobiles to smartphones—is relatively weak. We can see this by looking at retail sales data, which covers spending in stores, online retailers, and restaurants.

Source: Census Bureau

However, spending on services—such as travel and housing—has been robust. Going forward, a key question will be whether this unusual divergence in household spending will normalize and, if so, how it impacts inflation.

Fed still on track for cuts

Despite the relatively high inflation figures, the Fed seems to be on track to cut its interest rate target later this year.

At the March 20 meeting, the median Fed Committee member projected three rate cuts of 0.25% each by the end of 2024.

This suggests that most Fed officials think inflation will resume its decline in the coming months. If the last couple of months’ higher readings turn into a trend, the Fed will certainly not cut rates. However, it suggests that the Fed is unwilling to damage the economy to get inflation down more quickly. 

Based on the Fed’s Summary of Economic Projections, the median Committee member thinks inflation will end at 2.6% in 2024 and 2.2% in 2025. Note that this is above the Fed’s official 2% target. And yet, most Fed officials expect to be cutting rates in both 2024 and 2025. In other words, as long as inflation moves in the right direction, the Fed will be satisfied.

Source: Federal Reserve

The Fed will always have some influence over the stock market, but it wasn't a dominant factor in Q1. 

Remember that, at the start of the year, futures markets projected six rate cuts from the Fed throughout 2024. That number has been downgraded to three, but even that number is doubtful. Yet stocks have surged because of the strong earnings growth. As a stock investor, I’d prefer a strong economy and no Fed cuts to a weak economy and several Fed cuts.

Another key point is that the stock market doesn’t like inflation because it forces the Fed to hike rates which, in turn, creates recession risk. If the Fed is willing to let inflation come down slowly, this will probably eliminate a Fed-induced recession scenario, which is good news for stock investors.

Bond yields are on the rise again

All of this economic strength was bad news for the bond market.

As inflation picked up and the market began anticipating fewer Fed rate cuts, bond yields generally rose. As bond yields rise, prices fall, so bond portfolios produced slightly negative quarterly returns. Over the quarter, the 10-year US Treasury increased from 3.88% to 4.21%. 

Facet’s bond mix outperformed slightly during this period. We were positioned with slightly less interest rate risk than the Morningstar benchmark, meaning our portfolio did not lose as much as the index when rates increased. In non-tax-paying accounts, we were also overweight corporate bonds, the best performing sector this quarter.  

Strong dollar holds back non-US stocks

The US is not the only country that has gained momentum over the past few months. 

The Japanese economy is a particular standout. Growth has accelerated there to such a degree that the Bank of Japan (the Japanese equivalent of the US Fed) hiked interest rates for the first time in 17 years. According to Morningstar, the Japanese stock market has advanced more than 18% this year.

Unfortunately, the weakening yen has erased almost half that performance for US-based investors. When you buy a foreign stock, even through an ETF, you functionally convert your US dollars into that foreign currency to make the purchase. Because of this, your net return on that investment becomes a function of not only the stock price but also currency movements. 

This quarter, the dollar advanced against the yen and most other major currencies, boosted by strong US economic data and rising interest rates. However, this generally weighed on returns for non-US investments. Below are a few major world markets’ 1Q results measured in both local currency and US dollar terms.

Source: Morningstar

Some of our non-US allocation decisions moderately boosted our relative return. We have been underweight emerging markets generally (China specifically) for over a year now, marking the fourth quarter in a row in which China has underperformed the US. 

We also added an overweight of growth companies within developed markets. In non-US markets, the growth category tends to have fewer cyclical businesses, which means they are less exposed to the macro-cycle of recessions, recovery, and expansion. 

On the other hand, non-US value companies only consistently outperform during the recovery phase after a recession. Since we aren’t currently in a recession, the economy has no opportunity to enter a recovery phase. 

That allocation change was timed well. After making the change in January, the growth fund we added outperformed the general developed markets fund we reduced 9.65% vs. 8.01%.

What might be coming next?

There is a lot to be optimistic about this quarter. So, what could upset this positive environment?

One risk is that inflation continues to be too high for the Fed’s comfort. At the last Fed press conference, Fed Chair Powell said, “Our policy rate is likely at its peak for this tightening cycle.” 

This suggests that if inflation is running a little too high, the Fed would simply not cut rates. 

However, inflation may become so bad that the Fed will start hiking again. If that happens, it would introduce a new risk: a potential recession.

Another risk is that too much optimism has already been priced into the market. We mentioned earlier that we don’t think the market is in a bubble now, but it is true that companies are under more pressure to deliver now that markets have higher expectations.

But while there are no guarantees, historically, buying an expensive market when conditions are good has generally been a winning strategy. As we wrote in a recent article, the S&P 500 has actually had higher returns in the one year following hitting a fresh all-time high than at any other time. 

So, we think if something is going to put a stop to this bull market, it will most likely be something that causes company profits to slow. Since 1990, the average S&P 500 return in years when company profits grew was 15.6%. If profits contract, that drops to 0.4%. We are less worried about other factors like interest rates, inflation, or the impending election.

Short-Term Strategy

Facet’s Short-Term Strategy (STS) is designed to produce stable returns commensurate with the yields available in shorter-term bonds. 

The STS’s performance was slightly behind the Morningstar Cash T-Bill index. This quarter, short-term interest rates rose modestly as the market priced in fewer near-term Fed rate hikes. 

In terms of absolute performance, this slight negative was overwhelmed by the strategy’s strong income generation. However, it did weigh down performance relative to the benchmark.

See our recent article for more details on your different short-term investing options.

ESG

Facet’s ESG equity strategy was marginally better than the Morningstar Global index for the quarter. The strategy utilizes a set of ETFs that screen out stocks based on certain ESG criteria. As a result, it tends to significantly underweight energy, utilities, and heavy industrial companies. 

This quarter, that underweight had a mixed effect. On one hand, both energy and industrials outperformed, which weighed slightly on returns. However, utilities was an especially weak performer relative to other sectors, and this underweight was enough to offset any detraction from energy and industrials.

Retirement Strategy

Facet’s Retirement Strategy is meant for members who are either already in retirement or close to it. The strategy utilizes ETFs that we expect will have relatively less volatility than our traditional growth model. 

Generally speaking, Facet expects this strategy to lag the equity benchmark a bit during big up quarters. Adding lower-volatility funds to this ETF mix should protect against the downside while giving up some upside. This was true this quarter, as the iShares MSCI USA Min Vol fund and the iShares MSCI EAFE Min Vol funds used by this strategy both lagged the broad US and developed markets.

However, some of our other allocations compensated for the low-volatility positions. This includes some of the things we highlighted above, such as an overweight of quality and an underweight of emerging markets.