Major Index Performance
The S&P 500 rose to a new record, closing out a monster first quarter, the best-performing first quarter since 2019, and touching 22 new all-time highs in the process. A resilient economy, excitement centered around emerging artificial-intelligence technology, and expectations for short-term rate cuts were the primary drivers of strong Q1 performance.
"Looking further, the growth and tech-heavy Nasdaq Composite returned 9.31%, and the 'Boomer' Dow Jones Industrial Average returned 4.50%. Rounding out the major US indices, the Russell 2000, an index holding small company stocks, returned 5.18%.
Looking around the world, the Europe, Australasia and the Far East index, also known as the EAFE index, returned 5.78%. The EAFE index is a common benchmark for developed international stocks and excludes United States and Canadian companies. The Emerging Markets Index, which makes up countries whose economy and capital markets are not considered “developed” performed the worst, returning 2.37%.
U.S. Sector Performance
Energy was the strongest performing sector, which is somewhat surprising given the abundance of A.I. and tech-related headlines. The sector as a whole returned 13.51% which was largely attributable to strong energy commodity performance, particularly oil. Crude Oil rose 18.28% and Brent Crude appreciated 16.41% in quarter one. However, if a company’s production mix and asset portfolio tilts more toward natural gas, their stock likely suffered, as natural gas fell 21.32% in Q1.
Communication Services was the second-strongest performing sector, appreciating by 12.68%. This was mostly due to company specific reasons and not sector wide, macro factors like commodity performance in the energy sector that we just discussed. The top three contributors for strong sector performance were Meta, returning 37.33%, Disney returning 35.52% and Netflix returning 24.75%. Generally speaking, all these companies performed strongly due to positive re-ratings from stronger than anticipated earnings coupled with numerous analyst upgrades over the quarter.
Finally, Financials were the third-best performing sector, returning 12.44%. Warren Buffet’s holding company, Berkshire Hathaway, returned 17.91% and was the largest contributor to sector outperformance. Zooming out more broadly, positive macroeconomic news, coupled with expected future rate cuts, propelled outperformance among big banks.
Now, on the other end of the coin, Real Estate performed the worst and was the only sector to post negative returns in Q1, declining by 0.65%. Broadly speaking macro factors created headwinds for the sector. An increase in 10-year interest rates caused trouble on two fronts. One, it caused a decrease in real estate valuations as real estate are commonly priced against the 10-year rate. So as interest rates increase, if there isn't an adjustment to risk premiums, called cap rates in the real estate sector, real estate values will fall, all else equal. This particularly hit richly valued real estate properties that have high debt placed on them, particularly those in multifamily and industrial food groups. Then second and alluded to, higher interest rates increased the cost of debt capital across the industry, which is problematic for operators with floating rate debt and the transaction market as higher debt financing costs increase the required return for a deal to pencil.
Sticking with real estate, another theme emerged when diving even deeper in the sector. Telecommunications infrastructure companies were some of the worst performers in Q1. American Tower Corp, SBA Communications Corp, and Crown Castle Inc, all have fairly high debt loads and the telecom infrastructure is a fairly mature industry in terms of mobile coverage and mobile data usage, as everyone and their mother already has several mobile devices, pointing to limited future growth opportunities. In addition, American Tower Corp and Crown Castle have rich dividend yields, so as the risk-free rate increases, the attractiveness yields on risky assets falls.
S&P 500 Top/Bottom Performers
NVIDIA Corp – The A.I. “Sizzle” Stock That’s Delivering The “Steak”
NVIDIA has been the poster child for A.I. as their Graphic Processing Unit (GPU) chips are widely used in A.I. applications, particularly for deep learning and machine learning tasks such as training neural networks and large language models. And, as these A.I. models become more complex and data-intensive, there will be growing demand for high-performance computing solutions to support these workloads. Because of NVIDIA’s dominance in the GPU market and their premiere chip quality relative to competitors, they are positioned as the best “pick and shovel” play in the coming A.I. goldrush.
Meta – Crawling Out of the Abyss with Potential Legislative Tailwinds
Cost cuts and increased capital discipline after a disastrous 2022, in which Meta slumped 64.22% due to negative revenue growth and disappointing profitability, have started paying off for the company. This is highlighted by their better-than-expected Q4 earnings report, in which the stock appreciated 27.85% the day after they announced. Looking further, legislation aiming to ban TikTok will benefit Meta’s social media platforms, particularly Instagram Reels, as more eyeballs and attention will be turned to their applications. All is not green on the legislative front, however, as Meta has an FTC lawsuit pending which is scheduled to be heard in 2024. The lawsuit is centered around antitrust concerns from its prior acquisitions of Instagram and WhatsApp. And finally, excitement over Apple’s Vision Pro reignited enthusiasm over the future of augmented and virtual reality headsets. Meta is positioned to benefit on the hype, as it sells their own more affordable AR/VR headset through its Oculus business segment.
Tesla – Slowing EV Growth with Growing Elon Risks
In the first quarter of 2024, Tesla's deliveries were hit by soft orders in China and increased domestic and global competition in an electric vehicle market that’s seeing waning demand for EVs. Speaking to China specifically, I’m assuming more Chinese consumers prefer their domestic electric vehicle counterparts, like BYD company, whose electric vehicles may at-par or exceed Tesla’s cost/benefit, value proposition.
Then Elon. Elon Musk, for better or worse, but mostly better in my opinion, is a significant key man risk for Tesla. Investor sentiment has soured on him after the Wall Street Journal published an article over his drug usage. In addition, Elon has endured increased regulatory scrutiny over concerns on Tesla’s board independence. Finally, he’s spending an increased “mind” share on his latest business, X (formerly known as Twitter) versus Tesla. When you have to spend more time, energy, and attention across more businesses, you’re diluting the human capital allocated to any one business, like Tesla.
International Indices
Developed Markets
Looking abroad, Japan was the best performing country in the EAFE Index in Q1. The country returned 11.24%, which was largely attributable to macro-economic factors. The Bank of Japan, their Federal Reserve, announced that they will end their 8 years of negative interest rate policy by increasing their short-term interest rate range to 0-0.1%. They also announced that they would abandon other unorthodox capital intervention policies such as yield curve control and buying up risky assets to boost asset prices. The pivot in the BofJ’s policy was largely due to inflation and labor market strength. As an example, Japan is currently facing a labor shortage which contributed to labor unions and the largest Japanese companies agreeing to the biggest wage hike in 33 years. Now, digging deeper into individual Japanese stocks, auto manufactures and tech companies largely outperformed largely because of an increase in domestic consumption growth and stronger than expected global growth. To illustrate, Toyota Motor Corp was the largest contributor to stock market performance, returning 37.75%, alone contributing 16% to the MSCI Japan’s 11.24% return.
Australia was the worst performing country in the EAFE Index, returning 1.31%. Australia’s stock market is highly dependent on industrial metal commodity prices, particularly iron ore, in which Australia is the leading producer and exporter of the commodity. Well, iron ore dropped 27.17% in Q1 which negatively affected Australia’s largest diversified natural resource companies, like BHP and Fortescue, which declined 13.83% and 8.92% respectively. However, despite this, we can see Australia still squeezed out a positive return. This was mostly due to the strong performance of Australia’s big banks, suggesting better than previously expected economic activity in the country.
Emerging Markets
Taiwan was the strongest performing emerging market country, returning 5.76%. This is pretty much because of Taiwan Semiconductor Manufacturing Company's stock performance, which returned 31.34% in Q1 and makes up 25% of the index. Broadly speaking, so goes the demand for semiconductor manufacturing and foundry needs, so goes Taiwan’s stock market, sans any China related geopolitical risks.
Brazil was the worst performing Emerging Market index declining 7.27%. Brazil’s story is similar to Australia’s as Brazil is the 3rd largest producer and 2nd largest exporter of iron ore. Vale, a multinational mining company and the largest company in the MSCI Brazil index, gets approximately 2/3rds of their revenue extracting and selling iron ore. As a result of this negative commodity price development, Vale’s stock dropped by 19.72% in Q1, causing a significant drag on Brazil’s market.
U.S. Fixed Income
The Federal Reserve held rates steady at the current 5.25%-5.50% range in Q1. However, rates rose across the yield curve for the quarter, with the 3 Month Treasury rate rising 6 basis points to 5.46%, the 2-year Treasury rate rising 36 basis points to 4.59%, and the 10-year Treasury rate rising 32 basis points to 4.20%. Focusing on the 10-year Treasury 32 basis point increase in particular, the rise was due to a 16 basis point increase in inflation expectations and an implied 16 basis points in real, inflation-adjusted, rates.
Credit spreads decreased across the board, as better-than-expected economic strength and corporate profits reduced perceived credit riskiness. The most significant decrease was for high-yield CCC-rated bonds, with spreads decreasing by 44 bps, and the least for AAA bonds, which decreased by 2 bps. Generally speaking, when the economy and corporate profits are strong, spreads decrease, benefitting low quality bonds the most, and when the economy is weak and companies are under duress, spreads increase, typically leading AAA bonds to outperform lesser quality fixed income securities.
So, given these results, in Q1, it paid to be in lower duration, lower credit quality securities. If you were on the other end of the spectrum, holding long duration, high-quality bonds, your fixed income holdings likely lost value.
U.S. Economy
The United States grew at a 3.40% annual rate in Q4 2023, down from the 4.90% annual rate posted for the 3rd quarter. This was primarily driven by a 3.30% increase in personal consumption, which accounts for approximately 2/3rds of US GDP. However, personal income increased by an average rate of 0.53% over the past three months, ending February, which equates to a 2.13% annual rate. Pair this with dwindling excess savings, high consumer debt levels, and increased interest costs beginning to cause a rise in credit delinquencies, maintaining a 3.30% personal consumption growth rate may prove difficult going forward.
As mentioned previously, the Federal Reserve held rates steady in their 5.25%-5.50% target range, and 10-year treasury rates increased by 32 basis points to 4.20%. Therefore, we’re still in this awkward inverted yield curve environment, where it pays more to keep money in cash versus investing in longer-dated bonds. Inverted yield curves have historically been a reliable indicator of a soon-to-be recession, but based on what we’ll go over shortly, this time may be different. Famous last words, I know.
Digging into the inflation numbers, over the past three months ending February, the Consumer Price Index increased by 0.98%, which annualizes to 3.93%. Looking at the Federal Reserve's preferred inflation gauge, the Personal Consumption Expenditures Index, it increased by 0.83% over the same period, annualizing to 3.33%.
When looking at Core inflation numbers, which strips out the more volatile Food and Energy categories, over the past three months, Core CPI increased 1.03% which is an 4.11% annualized rate and the Core Personal Consumption Expenditures Index increased 0.87%, which annualizes to 3.46%.
Looking at labor markets and income, the unemployment rate crept up to 3.90% in February, compared to 3.70% in January. While slightly concerning if it starts to become an upward trend, keep in mind that this is far below the long-term average unemployment rate of 5.70% (although times of economic distress skew that average upwards a little bit). Average hourly earnings over the past three months grew at an 0.99% annual rate. However, after accounting for inflation, average hourly earnings over the same period were literally flat.
So, with these developments in mind, the Federal Reserve stated that they expected to cut rates three times in 2024, likely down to the 4.50-4.75% range. However, they also stated that they are in no rush to do so until they are sure inflation is on track to meet and sustain a 2.00% rate. Looking at implied probabilities, the first-rate cut is expected to occur in June, but as we can see based on current inflation rates, inflation for March through May needs to fall further to justify a rate cut. This, paired with strong employment numbers gives the Federal Reserve some breathing room to undergo a wait and see approach as it pertains to future interest rate decisions.
Looking Forward
Inflation Data and Rate Cuts?
The Federal Reserve’s next interest rate meeting is in May, and then they meet again in June. It’s currently expected that they will keep rates steady in May and, as previously mentioned, begin cutting rates in June. The expected June rate cut will be heavily dependent on the inflation and labor market readings that occur before then, however. And when looking at the CPI and PCE readings, we seem to be a way away from their 2.00% goal, so higher than expected inflation could lead to the Federal Reserve keeping current rates steady for longer. If this occurs, this could cause some downward price pressure in financial markets.
Q1 2024 Earnings Releases. Will A.I. Continue to Deliver or Disappoint?
With the S&P 500 trading at a richly valued 27 P/E (versus the historic average of 20 P/E), future stock performance will be sensitive to any Q1 earnings disappointments, especially in the A.I.-hype-driven technology and communication services sectors. To illustrate, out of the top 10 companies in the S&P 500, 7 of them are in the tech and communication service sectors and make up a little over 25% of the entire S&P 500.
So, I would especially be on the lookout for earnings announcements on the week of April 22nd, when Microsoft, Meta, and Google are expected to report earnings. Also, that week, look out for CPU chipmaker Intel, who reports on April 26th. Intel’s results could be “canary in the coalmine” of sorts in providing a sense of whether the A.I. hype is overblown or if there’s room for it to keep running. Keeping with the A.I. theme, keep an eye out for the rest of the major semiconductor companies like Advanced Micro Devices (AMD) which is expected to report May 2nd, NVIDIA which is expected to report May 31st , and the dominate chip foundry company, Taiwan Semiconductor Manufacturing Company, which is expected to report April 19th.
Finally, given the strong Q1 return performance of Netflix and Disney, I’m interested to see how they continue to perform based on their Q1 earnings. Netflix is expected to report April 18th and Disney reports May 10th. Disney in particular is interesting, given that, similar to Netflix in 2020-2021, are pulling back on pouring money into any and all content which resulted in crappy T.V. shows and significant IP brand dilution, particularly in their Marvel and Star Wars assets. Instead, recently Disney has signaled that they are going to be more disciplined with deploying capital by concentrating their creative firepower on less content which should lead to better content. We’ll see. I’m not even a big comic book guy but I always perk up when I see battles between the creatives and the suits.
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