Major Index Performance
The S&P 500 continued to climb in Q2, albeit at a less ferocious pace than Q1, hitting multiple all-time highs and closing just 0.48% shy of another one at the end of the quarter. Surprise, surprise, the biggest reason for this positive performance is because of the ongoing excitement around artificial intelligence. This is evidenced by the tech-heavy Nasdaq Composite, which was the strongest performing index both for the quarter and year-to-date.
Meanwhile, the Dow Jones Composite Average fell and was the worst performing U.S. large-cap index, both in Q2 and year-to-date. The Dow has a heavier weighting towards “old economy” stocks compared to the S&P 500 and the techy Nasdaq. The Russell 2000, the primary small-cap index, fell 3.28% in the second quarter and was the worst major U.S. index. Small-cap stocks, being more sensitive to the domestic economy, were likely impacted by concerns over slowing growth and persistently high interest rates, which we’ll discuss further in the U.S. Economy segment of this commentary.
Looking abroad, emerging markets performed relatively well, outperforming the S&P 500 but falling shy of the Nasdaq in Q2. Since the underlying index contains a basket of different country exposures, there isn't a broad macro reason for why emerging markets performed well as each country must be analyzed on a case-by-case basis. But, generally speaking, in Q2, the divergence between winners and losers seemed to stem from country exposure to the tech sector and commodities, along with a few country-specific political developments. To round it out, the international developed market MSCI EAFE index slightly declined for the quarter but is the fourth best performing index year to date. The developed market MSCI EAFE index slightly declined for the quarter but remains the fourth best-performing index year-to-date. Since the same country-by-country logic applies, we’ll delve deeper into the countries making up these international indices in our International Indices recap.
U.S. Sector Performance
As alluded to in the previous discussion, the tech sector led the quarter’s performance. When we dig into the individual industry contribution to S&P 500 returns, the ‘Semiconductors & Semiconductor Equipment’ and ‘Technology Hardware, Storage & Peripherals’ industries were the top contributors for positive performance. The semiconductor industry, driven by companies selling GPUs (e.g., NVIDIA) and other essential chips, and the technology hardware sector (e.g., Apple) benefited significantly from AI advancements and overall positive sentiment.
Communication Services was the second-strongest performing sector, appreciating by 5.18%. This was pretty much due to AI as well. Alphabet, developing their own AI applications, was the largest contributors to sector performance, with both share classes averaging a 20.70% return in Q2. Netflix also continued to perform well, returning 11.15% as did Fox, returning 11.95%.
Finally, utilities were the third strongest performing sector, returning 4.62%. And the reason? You guessed it, AI. I’m kidding…sort of. The Electric Utilities industry led this performance. Now I know what you’re thinking, how can the same company that cools my house during the hot summers have anything to do with AI? Well, there is an enormous amount of energy needed to run AI infrastructure, so it’s not surprising that electrical companies would benefit from the AI industry rise. But, it’s difficult to tease out how much of their revenue is attributable to AI directly. After all, hotter summers increasing electricity usage likely contributed to the sector’s strong performance as well. Given my A/C is running sub optimally as I wait for the maintenance team to repair it, it’s possible that I alone am contributing to the industry’s strong performance. I’m happy to report that my A/C is now working, turns out I just needed to change out the filter. Who knew!?
Conversely, the Materials sector performed the worst, declining 4.10%. Materials companies are typically lower on the supply chain and more dependent on business-to-business sales. Therefore, it's essential to examine the businesses that materials companies sell their products to in order to understand the demand for their goods and services. To illustrate, the largest contributor weighing down sector performance was Albemarle Corp which is one of the world’s largest lithium producers. What is the primary driver of lithium demand? Batteries. What’s are hot industries reliant on batteries? Electronic vehicles (EV) and renewable energy. Therefore, any reduced expectation for demand growth with flow down to a reduced demand expectation for batteries ergo lithium. Speaking to Albemarle in particular in their Q1 earnings call, the slowing of EV transition in Europe and the United States, decreased the demand for lithium, more so than what was previously priced into their stock price.
S&P 500 Top/Bottom Performers
Second Quarter
Year to Date
NVIDIA (NVDA) – “He’s on Fire!” – NBA Jams
Even if you passively pay attention to markets, you’ll likely know that NVIDIA continued to rip, appreciating 36.74% in Q2. As mentioned in our Q1 commentary, NVIDIA has been the poster child for AI as their Graphic Processing Unit (GPU) chips are widely used in AI applications, particularly for deep learning and machine learning tasks such as training neural networks and large language models. Similar to our previous discussion about Albemarle Corp, NVIDIA isn’t an outright AI play per se, but rather sells the GPU “commodity” to other businesses that develop and/or sell AI applications.
However, when a company is highly profitable and has a key supplier, that supplier has significant leverage to raise prices. This appears to be the case with NVIDIA and Taiwan Semiconductor Manufacturing Company (TSM), NVIDIA’s main supplier. TSM began raising the price of their wafer chips (used to make NVIDIA’s GPUs), which is logical and justified given their competitive position in the AI market. This price increase should, in theory, cut into NVIDIA’s margins, although NVIDIA will likely be able to pass this cost down to their customers.
First Solar (FSLR) – Make Money While the Sun Shines
First Solar’s stock boomed in Q2 due to, checks notes, AI. Yep. First Solar designs and manufactures solar panels, modules, and systems for use in utility-scale development projects. Many large tech companies have pledged to match their nonrenewable energy consumption with renewable energy sources, and since AI applications consume a significant amount of energy, this pledge should create a boom for First Solar’s solar panels. It's somewhat odd that this dynamic is only now being reflected in First Solar’s stock price, given that AI has been a hot topic for over a year. So, stock pickers, it appears there’s still hope for you yet. Start coming up with your own AI narratives.
Walgreens (WBA) – Dealing with Serious Withdrawals
I think everyone is familiar with Walgreens, but in case you’re not, Walgreens is one of the largest retail pharmacy chains in the U.S., with over 8,500 locations. If you don’t know Walgreens, you certainly know their direct competitor, CVS. Much of Walgreens' recent woes stem from declining reimbursement rates that pharmacy-benefit managers pay them for prescription drugs. So basically, without getting into the nitty gritty of our healthcare industry, Walgreens is receiving less money for each prescription they fill. As a result, Walgreens missed on their Q1 earnings. To compound this negative news, during their Q1 earnings call they also provided negative guidance and announced plans to close many of their underperforming locations. All of this led to Walgreens' stock being cut in half in Q2, bringing its drawdown from all-time highs to 82.73%. Yikes.
International Indices
Developed Markets
Looking abroad, our friend from across the pond but 1783 loser was the strongest performing country in Q2, returning 3.96%. Looking macro, Prime Minister Rishi Sunak called for a snap election on May 22nd to be held on July 4th. A snap election is essentially an immediate election, instead of waiting for the regular election time interval (e.g., every four years in the United States). However, this election call had no noticeable impact on the MSCI United Kingdom’s index performance, suggesting that micro and company-specific news drove strong Q2 performance. Looking at individual company performance, the primary contributor to U.K. stock market performance came from AstraZeneca (AZN), a British pharmaceutical company. CEO Pascal Soriot recently appeared on Jim Cramer’s Mad Money show to discuss positive developments in cancer treatment, which could potentially lead to a cure. If these developments come to fruition, it would be highly beneficial for the company’s earnings and society as a whole. AstraZeneca alone contributed approximately 30% to the U.K.’s 3.96% return. Other major contributors to positive performance included Shell (SHEL), which appreciated 11.65%, and HSBC (HSBC), which rose 14.48%.
The lovely French unfortunately had the worst performing developed international country, declining 6.65%. Poor performance from luxury goods retailers Moet Hennessy Louis Vuitton (LVMUY) and Hermes International (HESAY) were major contributing factors, with declines of 14.17% and 10.31%, respectively. But notably, neither company’s stock moved significantly on their earnings announcement dates. Instead, their stocks declined steadily throughout the quarter, indicating a possible macroeconomic reason for the decline. The most likely macro explanation is President Emmanuel Macron’s decision to call for snap elections on June 9th, creating significant uncertainty around France’s legislative and economic policies. Given the notable market shift after the snap elections were called, it’s reasonable to attribute the decline in the MSCI France index to this political development.
Emerging Markets
South Africa was the strongest performing emerging market, with Taiwan closely behind. Both countries were largely driven by their largest holdings which are, unsurprising given everything we’ve discussed thus far, in the technology sector. South Africa's Naspers (NPSNY), which makes up 17.77% of their index, rose 18.66%, while Taiwan Semiconductor Manufacturing Co. (TSM), making up 23.34% of their index, rose 28.17%. As for macro events, South Africa re-elected Cyril Ramaphosa as its president on June 14th, after which the MSCI South Africa rallied a cumulative 5.04% to end Q2. No notable macro events occurred in Taiwan.
Mexico was the worst-performing country, with its market dropping an eye-popping 17.64% alongside the peso suffering its worst performance since the pandemic. This was largely due to leftists capturing a supermajority in Mexico’s Congress and fears over enacting legislation that could undermine existing checks and balances on the Mexican government. According to a New York Times article, “The proposals were first introduced by Andrés Manuel López Obrador and include plans to eliminate independent regulators and to appoint judges and election officials via popular vote, which critics warn could make them more susceptible to political pressure. Among other concerns, investors fear that upending the judiciary could make it less certain that they’ll get a fair hearing in disputes.” These actions would ultimately increase corruption risks in a country already dealing with significant corruption concerns stemming from drug cartels.
U.S. Fixed Income
U.S. Yield Curve
Credit Curve
The Federal Reserve held rates steady at the current 5.25%-5.50% range in Q2. However, rates continued to rise across the yield curve during the quarter, with the 3-month Treasury rate rising 2 basis points (bps) to 5.48%, the 2-year Treasury rate rising 12 bps to 4.71%, and the 10-year Treasury rate rising 16 bps to 4.36%.
Focusing on the 10-year Treasury's 16 basis point increase, this rise was largely attributed to an approximate 25 bps increase in the Treasury Inflation-Indexed Security Rate. This suggests that fixed income markets adjusted their forecast for the timing and frequency of Federal Reserve rate cuts. The differential between the 25 bps increase in real rates and the 16 bps increase in Treasury rates implies that inflation expectations for the future are lower than previously imbedded in treasury yields at the beginning of the quarter.
Credit spreads were uneven in Q2, with investment grade bond yields (BBB or better) increasing across the board, subpar credit BB and B spreads decreasing, and speculative junk bond yields (CCC or below) increasing significantly.
This uneven behavior makes it difficult to pinpoint a primary reason for the movement in credit spreads. However, we can reasonably assume that the belief in “higher interest rates for longer” significantly negatively impacted the speculative sector of junk bonds, given their relative high debt burdens and interest costs.
So, putting it all together, it generally paid to be in cash and high yield bonds. Although this may seem confusing given the previous discussion, remember that the SPDR Portfolio High Yield Bond ETF has a high distribution yield. The income yield received was enough to offset the decline in the ETF’s price due to increasing interest rates and credit spreads. Notably, high yield continues to be the best-performing segment in the fixed income market year to date.
Long-duration securities performed the worst, with the longest duration securities, like the Vanguard Extended Duration Treasury ETF, dropping 3.17% in Q2. This ETF continues to be the worst-performing fixed income security year to date but will benefit from any decrease in interest rates, particularly at the long end of the curve, going forward.
U.S. Economy
The United States grew by 0.35% in Q1 2024, down from 0.84% in Q4 2023. These rates annualize to 1.40% and 3.36%, respectively. While markets largely shrugged this off, slowing growth is a troubling development that market participants should monitor.
This slowdown was primarily driven by a modest 1.45% annualized real personal consumption expenditure figure, down from 2.16% year-over-year. As a reminder, personal consumption accounts for approximately two-thirds of US GDP. When we look at the other GDP drivers, we see that all metrics are trending in a concerning direction as well, especially net exports. Net exports track the amount we import versus what we export. Since this number is negative, it means we’re importing more than we export, which creates a drag on GDP growth.
Adding to economic concerns, unemployment rates rose across the board. The most reported unemployment rate is now 4.00%, up from 3.70% a year ago, representing an 8.11% increase. This translates to approximately 536,829 more people who lost their jobs and are looking for work.
However, the economy is also adding jobs, but just not enough to offset the rise in unemployment. This is consistent with the increase in claims for unemployment insurance.
If you do have a job, you may be receiving a pay bump, both nominally and after adjusting for inflation. But this depends on your job and how much you’re making. I say this because the ADP median pay numbers indicate that this increase in pay isn’t felt evenly across the labor market. It’s the already highly compensated who are receiving the most significant raises and not those who are at or the bottom 50% of the pay scale.
Fortunately, prices are falling across the board, getting closer to the Fed’s stated 2.00% goal. However, given the increase in unemployment and slowing GDP growth, the Federal Reserve is nearing the point of having to balance tolerating higher inflation against constricting growth and causing pain in labor markets.
When looking at the residential real estate market, we can see that more inventory is coming online, but homes aren’t selling. This is likely due to a mismatch between buyer affordability and sellers' unwillingness to lower prices. If mortgage rates decrease, this should theoretically make housing more affordable. However, this highly depends on the economic outlook when rates start falling.
If rates fall because we have a healthy economy and low inflation, the outlook is positive. If rates fall because we’re in a recession with investors rushing into treasuries, it’s very problematic. In the latter case, mortgage defaults would rise, flooding housing supply, and now unemployed first-time homebuyers won’t have the income to support a mortgage payment, decreasing homebuyer demand. This would drive residential real estate prices downward, making properties attractive only to those with cash reserves and a stable source of income. Worse, this scenario could provide major investment firms an opportunity to buy single-family homes and then rent them out, further shutting out first-time homebuyers from achieving the American Dream and exacerbating wealth inequality.
So, we’ll have to see; the economy is very fragile, and the real estate market is definitely off-kilter at the moment. The Fed has its work cut out trying to achieve a soft landing.
Looking Forward
Are Persistently High Interest Rates Beginning to Take Their Toll?
Despite inflation decreasing, a majority of this drop came from the May release, which indicated essentially a zero-price increase for goods and services. The previous two months still showed significant inflationary pressures. Pair this with rising unemployment and subpar GDP growth, I think it’s fair to say high interest rates are beginning to impact the economy. After all, personal savings rates declined 20.83% from a year ago and credit card/auto-loan delinquencies are rising at a troubling pace. This implies that American’s are drawing down on their savings and turning to debt to make ends meet, which they’re beginning to default on. Given this, it’s no wonder why consumer sentiment is falling off a cliff.
So, the Federal Reserve’s next interest rate meeting is at the end of July, with the following meeting in September. It's currently expected that they will keep rates steady in July, with a decent chance of a rate cut occurring in September. As always, the expected September rate cut will heavily depend on the inflation and labor market readings leading up to the meeting. While CPI and PCE readings seem closer to the Fed's stated 2.00% goal, the Fed has stated they want persistent signs of inflation trending toward and staying around 2.00%, so we shouldn’t read too much into May’s inflation readings. Additionally, core inflation numbers, while declining, have not decreased as much as overall inflation rates, implying that there may still be some way to go before rates start getting cut.
That being said, while rate cuts didn’t make sense in the past given high inflation readings and strong labor market, the higher probability of rate cuts now makes much more sense given the dynamics just discussed.
Q2 2024 Earnings. All about A.IIIIIIIIII.
The S&P 500 is trading at a richly valued 29 price-to-earnings (P/E) multiple, compared to the historic average of 20. As an aside, this is up from the 27 P/E multiple reported in our Q1 commentary. As is always the case, the higher the valuation, the more stocks must deliver on earnings to justify their price. Currently, earnings are expected to accelerate by 1.11% in Q2, but this seems questionable given the economic backdrop we just discussed and the preliminary report of a 0.57% decline in Q1 S&P 500 index earnings.
So, we’ll see. After all, technology companies are behemoths with plenty of cash to invest, so their fates aren’t as closely tied to macroeconomic developments than, say, a small-cap construction company. But, as mentioned during the Q1 commentary, and even more so now, future stock performance will be sensitive to any Q2 earnings disappointments. After all, the AI-hype-driven technology and communication services sectors are driving much of the stock market performance, with the tech sector alone contributing over 50% to the S&P 500’s returns, and NVIDIA alone contributing over 25%. Any troubling developments in these sectors in particular should change the S&P 500s trajectory.
Speaking to NVIDIA specifically, it appears the market is realizing it may have gotten ahead of itself, as the stock is currently down 8.88% from its all-time high achieved on June 18th. Insiders seem to be aware of this as well, with significant insider selling of a little more than 3 million shares in the last three months, mostly in June. For context, this is approximately 2/3rds of the past twelve months’ insider selling.
To wrap up, AI is the hottest topic right now, with anything directly or indirectly related to it causing rapid gains in stock prices. While this may make sense given the demand for AI and its wide-ranging applications, it’s reaching a point where even tangentially AI-related stocks, like First Solar, are appreciating based on the expectation that they will benefit from the AI boom. While the narrative around First Solar makes sense, the rise in price implies that this thesis will come to fruition, which introduces risk. Whenever stocks raise above their current fundamentals, reversion to the mean is in play.
If more stocks start to appreciate significantly due to AI growth expectations based on questionable theses, the stock market will begin to resemble an earnings bubble. If these narrative-driven stock pops cause herding behavior, particularly among retail investors, this could lead to a full-blown price bubble.
All of this to say is that while I don’t think we are in a bubble currently and believe markets typically learn from past mistakes (i.e., The Dot Com Bubble), it certainly is starting to feel and little frothy.
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