2024 Market Trends – Unraveling the Impact of AI, Fed, and Inflation.

• Three themes continue to dominate markets in 2024:
  •  Artificial Intelligence
  • Federal Reserve
  • Inflation
• The S&P 500 had its best start to the year since the first quarter of 2019 (+13.6%).
• Valuations remained attractive for small caps and stocks outside the “Magnificent 7” heading into 2024. While certain Big Tech stocks stumbled in Q1, (i.e. Tesla, Apple), the S&P 500 index rallied 10.6%. Small Caps were also positive (+5.2%) on the hopes
  for a “soft landing.”
• After a dramatic fall in yields late last year, we expected yields to rebound as inflation remained sticker and the Fed pushed out rate cuts. The 10-year treasury yield rebounded from 3.9% to 4.2%.
• Equity volatility remained very low in 2023, with only two trading days that saw +/- 2% moves for the S&P 500. This trend surprisingly continued in the first quarter of 2024, with only one +/- 2% trading day (the S&P 500 was up +2.1% on February 22nd). The S&P 500 has not had a one-day decline of 2% or worse since February 2023.
• Stickier inflation and rising yields led to underperformance of core Fixed Income
  versus High Yield and shorter-duration bonds in Q1. The Bloomberg US Aggregate
  Bond index finished down -0.8% in Q1.

• Yet, the biggest recession risk continues to be a re-acceleration in inflation which could result in no rate cuts in 2024 or even additional rate hikes. This remains a lower probability event but our main tail risk for the markets
• If we are indeed in this “Delayed Landing” scenario, the economy would be exposed to higher rates and higher inflation for longer. In turn, this would increase the probability of an eventual landing to be a “hard” one
• Another cause for concern is the strong correlation between persistent budget deficits and rise in unemployment and the significant increase in public debt (see below)
• Geopolitical shocks (e.g. War in the Middle East) also could tip the US into a Recession

Source: JP Morgan

• Despite stickier inflation and a resilient economy, the Fed reinforced they still expect rate cuts in Rate Cuts in 2024 (basis points) 2024 after their March FOMC meeting. Fed provided its updated “Dot Plot” – which summarizes where FOMC members expect the Fed Funds Rate to finish in 2024:
• As shown to the right, a majority (9) of FOMC members expected 75 basis points of cuts in 2024. The Fed also provided a rosier forecast for the economy in 2024. GDP forecasts were raised to 2.1% from 1.4%, while forecasts for the Unemployment Rate were slightly lowered to 4.0% from 4.1%
• Yet, after the March CPI data surprised to the upside, a number of Fed officials including Chair Powell have changed their tone:* Powell said at a panel discussion that restrictive policy needs more time to work since recent data has not shown progress on the inflation front
• The market has also changed rate cut expectations for June and the Treasuries have sold off

1. Be prepared for higher rates for longer: Despite the recent sell-off in Treasuries, the market has not quite adjusted to the increased probability for stickier inflation and higher rates for longer. Potential softer earnings growth and continued adjusting to structurally higher long-term interest rates may challenge all risk assets
2. Recommend OW US Large Caps during a Fed pause, leaning into AI… US Large Cap stocks with high quality earnings and AI exposure remain our favorite, particularly sectors like IT and Telecom/Media. A Fed pause is historically a positive environment for equities, with Large Caps outperforming Small Caps and International equities. Growth outperformed Value in every previous “Fed Pauses” except for the Dot-Com Bubble (dating back to 1995)
3. … But recent divergence in “Magnificent 7” will likely continue: The release of ChatGPT in late-2022 led to outperformance of all “Magnificent 7” stocks in 2023.
   Entering 2024 we believe investor focus will turn from “hype” to “results.” Specifically which company will be able to best monetize AI (or least show a clear path to monetization)? Early winners in 2024 include Nvidia and Meta, while the early losers include Apple and Tesla. We expect divergence in Big Tech performance to continue. As a result, investors should have some level of active management in equities
4. Be selective in Fixed Income: We continue to prefer short-term government bonds in-line with the “higher for longer” theme. After a ~65bps widening across the yield curve, we are constructive in intermediate bonds and neutral in the long end, where we expect significant volatility. We are less excited about credit risk, with both investment-grade and high yield spreads trading at tight levels. (See below) We don’t think we are getting paid well enough for the increased risks inflation and continued high rates pose to corporate balance sheets. We would recommend high yield municipal bonds to diversify and increase yield in portfolios
5. Cash remains king: Uncertainty around inflation and Fed policy has increased with the latest inflation data. With cash earning a ~5% yield, we like having above
   average cash balances as dry powder to opportunistically deploy when there are market dislocations without denting returns
6. Commodities and Private Credit as diversifiers: Economy and inflation that refuse to slow down as well as geopolitical tensions have lifted oil and gold, while green infrastructure investments provide growing demand for industrial metals. Commodities can be a solid portfolio diversifier at this juncture. Private Credit remains attractive with strong demand, limited supply and high yields, particularly for 2023/24 vintage loan portfolios that have been underwritten at the current high-rate environment.