Brian Pietrangelo:
Welcome to the Key Wealth Matters weekly podcast where we casually ramble on about important topics including the markets, the economy, human ingenuity, and almost anything under the sun, giving you the keys to open doors in the world of investing. Today is Friday, May 31st, 2024. I'm Brian Pietrangelo and welcome to the podcast. We'd like to welcome you back as we were off last week on Friday the 24th in celebration of the upcoming Memorial Day weekend, and now we are back also still reminding everybody of this past Monday, which was actually Memorial Day, where we honor those that gave the ultimate sacrifice and their families in terms of allowing our country to be the greatest country in the world. And freedom is not free, so we certainly always honor those that gave the ultimate sacrifice. With that, I would like to introduce our panel of investing experts here to share their insights on this week's market activity and more.
Steve Hoedt, head of equities, Rajeev Sharma, head of fixed income, and Don Saverno, director of multi-strategy research. As a reminder, a lot of great content is available on key.com/wealthinsights, including updates from our Wealth Institute on many different subjects and especially our Key Questions article series addressing a relevant topic for investors each week. In addition, if you have any questions or need more information, please reach out to your financial advisor. Taking a look at this week's market and economic news, we have three economic releases that were pretty important this week that we're going to share with you during the podcast and have conversation with our panelists. First, we have the beige book report from the Federal Reserve, which comes two weeks in advance of the next upcoming federal open market committee meeting, which is on June 12th. The summary of the report shows that national economic activity continue to expand from early April to mid-May.
However, conditions varied across industries and districts. Most districts reported slight or modest growth while two noted no change in activity. Retail spending was flat to up slightly reflecting lower discretionary spending and heightened price sensitivity among consumers. Tight credit standards and high interest rates continued to constrain lending growth. And again, out of the 12 districts, employment rose at a slight pace overall with eight districts reporting negligible to modest job gains. And the remaining four districts reported no changes in employment. Prices increased at a modest pace over the reporting period with contacts in most of the districts, noting that consumers are beginning to push back against additional price increases. And second, the Bureau of Economic Analysis released their update on real gross domestic product or GDP for the first quarter of 2024, and this is the second estimate. The first estimate came out last month and the first estimate last month was 1.6% for the quarter.
The second estimate just released yesterday was 1.3% for the quarter. And the lower number in the second estimate reflects a downward revision to consumer spending, and that's what we've been talking about for a while now, whether or not the consumer will continue to be an engine of the overall economy. And third, just this morning we got the update also from the Bureau of Economic Analysis on consumer spending as it relates to personal consumption expenditures, inflation, which was the key report because it is the Fed's preferred measure of inflation. Again, as we go into the meeting for the Fed coming up in two weeks. Overall, PCE inflation came in at a 2.7% year-over-year ending in April. And the core PCE, which excludes the volatile food and energy sub-components, came in at 2.8% year-over-year in April. Both of those numbers ending in April were exactly the same as they were the month before in March.
Again, 2.7% for overall PCE and 2.8% for core PCE. So even though the month over a month number for Core PCE in April did come down to 0.2%, we just discussed that the year-over-year numbers have remained consistent, which again provides that backdrop that inflation remains sticky and will have implications on Fed policy likely to hold rates higher for longer throughout the year. And we'll have that discussion here with our podcast panel in a minute. So with that, we'll go directly to Rajeev to get your thoughts on what the PCE inflation might mean for the overall Federal Reserve policy and the upcoming meeting in June as well as the entire year. And whether we're at three cuts, two cuts, one cut, or no cut at all. So Rajeev, what are your thoughts?
Rajeev Sharma:
Well, Brian, we have said in the past that the market and the Fed are both very data dependent and there's been this specific focus on inflation data. So all eyes were set on today's PCE inflation report, which is the Fed's preferred gauge on inflation. So with the April PCE data that came out, it was pretty much spot on with consensus expectations and core inflation rate was unchanged at 2.8%. So the market at best breathed the sigh of relief that we did not see an uptick in inflation, and we saw that with the treasury yields. We saw the two-year treasury yield move slightly lower to 4.9%. We saw the 10-year treasury yield move slightly lower to 4.52%. If you were an investor position for an upside surprise in PCE, you didn't get that with this report.
If you were positioned for a downside surprise, you didn't get that with this report either. So instead it was more of a status quo report. I would further add that the inflation data is really not good enough for the Fed to start thinking about multiple rate cuts in their dot plot expectations that will be released at the next FOMC meeting on June 12th. The Fed narrative will most likely just be that there needs to be more evidence to show sustainability and disinflation and more evidence to show that inflation is moving further towards the Fed's stated goal of 2%. The question, how many more months of inflation data does the Fed need to finally make that first-rate cut? We've heard from several Fed members that would likely require at least three more months of inflation data to show a downward trajectory in inflation, and that had to be sustainable downward trajectory in inflation.
The expectation of multiple rate cuts for 2024 is starting to wane. We should have seen more progress in this inflation to support these multiple rate cuts that the market was anticipating in the beginning of the year. And right now pricing is calling for one rate cut at best for 2024. Now what we can expect from the June FOMC meeting is that the Fed will stick to that narrative that more work needs to be done to get inflation to the 2% point, and that keeps the market in a higher for longer stance for now. We will get to see dot plots at the FOMC meeting, we'll get to see the Fed's summary of economic projections. Core PCE is so far this year has averaged 2.9%. The Fed is likely to revise inflation expectations higher in their forecast, and the market senses that, and that's why front end treasuries, they're going to have a really hard time rallying in this environment.
We've also had auctions all this week, which did not do very well. There hasn't been a lot of demand for treasuries right now based on where we are in this expectation of what the Fed's going to do next. Obviously, many investors are waiting for more data. Today's data at the PCE was very important, so nobody really wanted to get in front of that. So we have seen rates being a little higher for longer. Meanwhile, we have an expected rate cut by the ECB next week and two cuts expected by the European Central Bank. I don't think that will have much impact on the Fed's decision of when to cut, but it certainly is very interesting to see another central bank cutting before we do, and I think that's going to weigh on some sentiment in the market as well. So we're going to have to keep on watching and learning from this inflation data and other data points before we get to really this feeling of when exactly we'll have the first-rate cut.
Right now, as I said, expectations are for one rate cut that's likely in December, but there's a huge popular list that is thinking that we won't see any rate cuts at all in 2024, and it's understandable. We just have not made that progress on inflation that was expected. And I would really think that when we see the summary of economic projections by the Fed in June, you're going to see again a revision of where they think inflation is going based on the fact that we still haven't got to the Fed's mandate right now.
Brian Pietrangelo:
So Rajeev, why do you think the ECB might cut before we do? What's behind that?
Rajeev Sharma:
It's a different world for them really. I mean, if you look at their inflation numbers, they're not at 2% at all. They're about 2.4% or so. So what they're doing is I think they're thinking that we will have one rate cut and then maybe pause and see. I think a lot of people, investors in Europe are thinking that it's not going to be a sustained rate cut environment for the ECB. I think they'd like to do one they've seen some deterioration in their labor market, so their economy is slowing down quite a bit and they're kind of anticipating more of a downturn, so they're having a much more different situation than we are. Economy is much stronger and much more diversified than theirs is. But I think what they'd like to do is kind of get in front of any type of economic downturn that would further exacerbate what's happening there in Europe right now. And that's why they might just go with one rate cut and then see what happens with it.
Brian Pietrangelo:
Great. Thanks, Rajeev. Turning back to the US, Steve, what do you think's happening in the stock market in terms of the reaction to the inflation numbers and Fed policy?
Stephen Hoedt:
It's been an interesting week, Brian, because we're coming in to today's session where with those important inflation numbers, and we've had three consecutive days where we've had the close lower than the open. And while I know that gets kind of inside baseball with how the market is behaving, really since we had the magnificent one, namely NVIDIA, report earnings last week, the market has been trading really heavy. And you had a really rough day last Thursday, and we've been down every day since then, saved for last Friday. So it feels to me here that we've got a bit of a rotation or a bit of a pause again coming in. We had a really nice bounce off of the mid to late April lows after we had that shallow correction of almost 6%, and we moved to a new high post the NVIDIA numbers. And since then we've been in a little bit of a retrenchment.
Earnings numbers have continued to go up. So as we talk about the long-term direction of the market, we remain pretty favorably predisposed to things because as long as the earnings numbers go up, that's kind of like the all clear signal for equity investors in terms of the long-term outlook. When the earnings line turns down because there's something going on in the economy, then we get concerned about what's happening with stock prices. But this just looks to us like the market's digesting the recent gains and not much more than that. Something interesting that caught my eye this week too is that if you go back over the last few months, we did start to have a rotation into cyclicals, probably it started right around the end of February, it ran through April, and then over the last five or six weeks, we started to see cyclicals come off the boil relative to defensives.
But if you take a look at a couple of things, namely cyclicals relative to defensives or discretionary relative to staples, those two things, the cyclical components have really started to outperform during this five or six-day long pullback again. So what that tells me is that underlying the current conditions in the market, you do have people who believe that things are going to continue to be strong. When this market is pulling back, if investors were glomming on to buying staples and defensive names, think of things like large cap pharma, utilities, that kind of stuff. If they were buying those instead of buying the traditional cyclicals, then I would tell you, okay, maybe there's something a little bit more problematic for the market going on. But when you've got cyclicals moving to a new high, relative to defensives, and you've got discretionary outperforming relative to staples for the first time in a couple months, to me, that bodes well for the market as we head into midsummer.
Brian Pietrangelo:
Great, Steve, and thanks for those observations. As we talk about rotation, one of the opportunities we have today is to have Don on the podcast with us where we talk about the rotation between US and non-US investing. So Don, thanks for joining us today, and we'll throw your first question, which is over the past several years, US markets have continued to significantly outperform international markets. What do you think explains this dynamic? And given how much the US has outperformed, why should investors allocate to overseas markets at all?
Donald Saverno:
Thanks, Brian. So I'll answer the first part of that question in two different ways. One, a little bit more qualitative, one a little bit more quantitative. In qualitative aspects, basically, within the US, there's been a great corporate backdrop. Basic legislation is on the side of companies. There's a low corporate tax rate. There are strong corporate rights over the past 15 years, and that reinforcement has not been available in most of the rest of the world. It's a little bit more combative over the past 15 years in the rest of the world. In a more quantitative approach, price multiple expansion is higher in the US than it has been in the rest of the world. There's been stronger earnings growth, and that's just a good combination that leads to a recipe for outperformance. And when you add a strong dollar off of its cyclical lows over the past 15 years, you have a Michelin star recipe for success within the US. The second part of that question is, so why should we invest internationally?
Basically, trends change. It has not always been like this. In fact, since the start of 2023 earnings growth has been just as strong outside of the US as it has been in the US. US has continued to outperform, but that has been almost entirely due to the stronger dollar and to price multiple expansion. There's a limit to that price multiple expansion, though we don't know exactly where that limit will be, but historically, it has always come. The US is significantly above its long-term averages when it comes to price to equity multiples. While the rest of the world is around its long-term averages. Historically, these things tend to revert to the mean. They tend to approach their long-term averages over time. We don't know when it'll happen, but we know that historically it has happened. So this cyclicality in the ability of price to equity multiples getting higher or lower is what makes diversification important.
Brian Pietrangelo:
Great. Now, I know you have an analogy that we've talked about before that I think our listeners would really enjoy about how you remain diversified and why you should remain diversified. Why don't you share that with our listeners?
Donald Saverno:
Sure. So first of all, diversification is tough. It's really difficult. You're always going to see something in your portfolio that's outperforming and something that's underperforming. The reason you have diversification is to get that average, to keep your variance or your volatility of your portfolio down over time to allow you to build upon higher and higher floors. But the analogy that I like to use is being stuck in a traffic jam. There's always a slow lane, there's always a fast lane, and if you're stuck in traffic, you're always daydreaming about being in that faster lane. But you know, you know in your heart that as soon as you move into that faster lane, it's going to turn into the slower lane. And if you keep chasing that faster lane, moving back to the faster lane and it slows down, moving back to the faster lane and it slows down, moving back to the faster lane and it slows down. You lose ground to traffic as a whole.
You don't do as well as if you stayed the course and had some combination of factors working in your favor. So this is kind of like investing. This is investing with diversification. You know that over the past 10 years or 12 years, that the US has outperformed international markets, and it's tempting to put all of your eggs into that faster lane, that faster basket, in the US. But we know that over time, historically things tend to even out and leadership does change. And we don't know with perfect clarity when those roles will reverse. We just know that keeping the lower volatility of the combined portfolio tends to do well over longer time periods.
Brian Pietrangelo:
Great. I like that analogy, Don. So let's finish with what's one additional thought you think your listeners would like to know about investing internationally?
Donald Saverno:
Okay. And I'll actually leave you with two. The first is right now in global equity markets, the US is at a larger percentage, a larger weight than it has been over the past 60 years. It's up to 63% of common global indices. And to put that in perspective, that's about 7% higher than it was at the height of the dot.com boom. And the other little tidbit I'll leave you with is a bit fewer than half of the top 100 performing stocks in major global indices over the past year have been in international and emerging markets. The trend over the past decade has been closer to a third. The last time that so many international companies were kind of the cream of the crop was at a time when international markets were outperforming. So while not calling a trend change, there are a couple anecdotal things that may lead to us thinking that there may be a trend change coming in the future.
Brian Pietrangelo:
Well, thanks for the conversation today, Steve, Rajeev and Don, we appreciate your insights. In addition, a reminder or program note for next week for upcoming on June 5th, we're holding our national client call where we're going to discuss the mid-year outlook and update for both the economy and the markets. So if you have an opportunity to register and attend the call, that would be fantastic. Again, Wednesday, June 5th at 1 PM, Eastern. Well, thanks to our listeners for joining us today. Be sure to subscribe to the Key Wealth Matters podcast through your favorite podcast app. As always, past performance is no guarantee of future results, and we know your financial situation is personal to you. So reach out to your relationship manager, portfolio strategist, or financial advisor for more information, and we'll catch up within next week to see how the world and the markets have changed and provide those keys to help you navigate your financial journey.
Speaker 5:
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