Quarterly Perspectives: Q2 2024

Published July 24, 2024.

Transcript

Hello. Welcome to Quarterly Perspectives second quarter 2024.

My name is Josh Ernst, and I am a member of the investment strategy team at Buckingham. I'll be your host for this presentation.

This presentation details quarterly equity and fixed income performance along the framework of absolute returns, relative returns, and future expectations for market performance.

We will then go on to discuss recent interest rate movements and inflation expectations.

Last, we examine how different asset classes contributed to an overall portfolio return.

We hope you enjoy today's presentation.

Now let's get started.

We begin our discussion with a high level look at a collection of major asset classes.

As we can see from the illustration, US and emerging markets stocks were up during the second quarter, continuing their positive trend from the first quarter.

However, developed international stocks were slightly down during the second quarter, reversing their positive trend from the first quarter.

Returns for US and global ex US bonds were slightly up for the quarter.

Next, I'll draw your attention to the upper right hand portion of the graphic.

The United States dollar was up 1.3% percent for the quarter and up 2.9% over the last twelve months.

Now let's look a little deeper at what was driving the returns of stocks and bonds.

We'll start by taking a look at how global equities performed for the quarter, and we'll isolate the performance between US and developed international stocks.

The two charts show the performance of different investment styles between the US and international stocks.

The bright blue bars represent the performance of different investment styles, and the dark blue bars represent the total market performance for the region.

US returns are measured with the Russell indexes, and international market returns are measured with the MSCI World ex US Index Series, which represents global developed market performance, excluding the United States.

As we can see from the dark blue line on the chart on the left, the US market was up 3.2% in the second quarter compared to slightly down 0.7% for developed international markets from the chart on the right.

Large neutral stocks and large growth stocks on average outperformed the market in the US.

Large growth stocks led the pack domestically, which is a continued trend from the last quarter on a relative basis.

Internationally, large value stocks and large neutral stocks tended to outperform the market with international large value stocks posting the best performance for the quarter among international developed regions.

But no matter the recent trends, it's important to remember that we shouldn't make longer term projections based on short term performance.

Now we take a longer view to see how different investment styles have performed for standard periods ending June 30, 2024.

Looking at annualized returns in the US, we can see that markets have shown resilience, especially over the trailing one year period, when faced with significant headwinds, such as the continued conflicts of war across the globe, uncertainty surrounding the future path of interest rates and inflation paired with what the Fed is projecting, and growing dysfunction on Capitol Hill.

Despite these potential issues, US markets returned 23.1% over the last year and have been nearing or exceeding 10% per year during longer time horizons.

Large growth stocks have the best performance for the trailing one year period, gaining 33.5%, which beat the US market by 10.4%.

We can also see that small and value stocks have generally been out of favor during these time periods.

Consequently, we expect that portfolios that have a small value tilt, such as those that we typically design for clients, will have underperformed portfolios that are market cap weighted or tilted to large growth stocks at these longer investment horizons.

Keep in mind that the very long term evidence demonstrates that on average, small stocks outperform large stocks and value stocks outperform growth stocks, but size and value factors can still go through extended periods of underperformance like those shown above.

Turning to international markets, we see that large cap value stocks have led the pack over the one year period.

At the longer time horizons, we see varying performance among different styles with value stocks, large cap stocks, and growth stocks, each posting leading performance over the trailing three, five, and ten year periods respectively.

Relating to the prior slides, you see that international markets have underperformed the US market by 12.3% during the last twelve months as well as at longer horizons with the three, five, and ten year performance trailing by 6.1%, 7.8%, and 7.9%, respectively.

It's also worth noting that the US total stock market has had an exceptional ten year run with the bulk of it being driven by richening valuations and strong corporate real earnings growth.

And a recent AQR research paper suggests that to expect a repeat of this performance over the next decade, even with an aggressive increase in earnings growth, investors would have to continue to bid out valuations far above where they were at the height of the tech bubble.

Nonetheless, given the the higher US return over longer term horizons, we expect portfolios concentrated in US stocks to have outperformed a globally diversified portfolio.

However, as we'll see in the next slide, these relative performance numbers aren't reason enough to abandon international stocks.

Thus far, we've discussed quarterly performance on a relative and absolute basis.

Now let's take a look at current stock market valuations and how they relate to future expectations of market performance.

The charts on this slide show how expensive stocks are by measure of the price to earnings ratio, a very common metric used to value equities.

The higher the ratio is, the more expensive the s class is overall.

Thought of another way, these values depict how expensive one dollar of earnings is.

For example, as we can see in the chart on the top left, the average dollar of earnings for the total US stock market costs roughly $25.10.

Internationally, as you can see in the chart on the top right, earnings are cheaper at just over $16 per dollar of earnings on average.

The values represented here use historical fund and ETF data to establish the price ratios, and the average PE is reflected by the dotted line on the chart.

These averages start in the first quarter of 2004 for US measures and in the fourth quarter of 2006 for international stocks.

Noting the strong market performance during the last twelve months, we see both broad US and international markets are now trading close to or above their recent historical averages.

We can also see that small value stocks in global developed markets appear cheap relative to their recent historical averages.

All else being equal, we would like to pay less for a dollar of earnings.

These valuation ratios aid in setting expectations about the future.

Low valuations today imply higher future returns and vice versa.

The recent strength of broader US market performance means that it is reasonable to expect lower returns than in the past when valuations were below their long term historical averages.

The opposite is true for international markets and small value stocks globally.

It is reasonable to expect higher returns than in the past when valuations were above their long term historical averages.

I'll emphasize that this long term relationship and that short term outcomes will likely be dominated by unexpected market forces.

Here we have the same analysis, but isolating US equities so we can see how valuations compare across different styles.

Recalling the annualized performance slides, we know that large growth has had an exceptional ten year period.

We can see that the growth in prices has exceeded the growth in earnings as the PE ratio has climbed to 35.8 to close the quarter, which is above its average since 2004.

Small value, on the other hand, has a PE ratio of 12.2 and remains under its average since 2004.

Although many investors may be interested in chasing the returns of large growth companies, we would point to these valuations charts as one reason to stay the course in a diversified portfolio tilted to small, relatively inexpensive companies.

Next, we'll take a look at fixed income performance, the shape of the current yield curve, and how the market is currently pricing inflation.

The charts on the screen show the average performance of different bond maturities in the segments of the fixed income market that we commonly track.

We typically prefer investing in bonds that are shorter maturity and higher quality compared to the broader market.

In the chart on the left side, we see that bonds of longer term maturity ranges had negative performance, but markets favored shorter maturities relative to intermediate to longer maturities with the ten year ten to twenty year segment posting the largest loss because of their increased sensitivity to rising rates.

The chart on the right shows the performance of different intermediate maturity credit quality bonds.

We see that there was mostly positive performance across the different credit qualities listed with the exception of municipals being slightly negative for the quarter with investors favoring corporate and inflation protected debt relative to other credit segments.

Next, we'll look at the treasury yield curve and what it means for returns going forward.

Here we plot the yield curve to show the current yields for treasury bond investments at different maturities.

The light blue line represents current rates. The dark blue line represents rates from the end of the prior quarter, and the gold line represents rates from one year ago.

With the exception of the ultra short term portion of the curve, rates increased for all maturities during the quarter. As stated previously, this detracted longer dated maturity debt.

Looking forward, expected returns for fixed income remain elevated relative to the pre pandemic era due to the Fed's rate hike program.

For long term fixed income investors, this is likely to be a net positive as new money and maturing bonds are reinvested into higher yielding bonds.

The yield curve remains inverted as it was at the end of the last quarter, although less so than earlier in the year.

When this happens, particularly between the two year and ten year points on the curve, it is widely regarded as one of the precursors, but not as a guarantee, to an impending recession.

Finally, we plot the market's forecast of inflation by taking the difference in yields between US Treasury bonds and TIPS at different maturity levels.

Like the last chart, the bright blue line represents current inflation expectations.

The dark blue line represents inflation expectations from the end of last quarter, and the gold line represents inflation expectations from one year ago.

Current market estimates for future inflation have been little changed compared to the prior quarter and this time last year.

Even though inflation readings have continued to moderate, the Federal Reserve has been persistent in stance that it's too early to declare victory over inflation because its 2% inflation objective has yet to be met and will need to show evidence that inflation is able to stay at that target in a sustainable manner.

To that end, future rate hikes have not been completely ruled out as of their their June meeting.

The Fed will be watching growth in the economy's service sector, which is less sensitive to interest rates, as well as the housing sector, which has been showing signs of picking back up as mortgage rate mortgage rates fell from recent highs.

As these expectations continue to change, it is important to remember that these levels of inflation are baked into prices today.

The markets are pricing an average inflation rate of approximately 2.2% per year for the next five years, and the market collectively expects inflation to similarly outpace the Fed's 2% target over the next 30 years.

Not only are these expectations baked into bond prices, but they're also baked into equity prices.

Making a bet on higher inflation would mean that we expect inflation to exceed the current forecast.

Next, let's take a look at how some major asset classes contributed to a 60/40 index mix this quarter and how that index mix behaved during recent history.

On this slide, we look at the absolute impact of different asset class returns on the quarterly return of a sample 60% stock, 40% bond index mix, With stock markets moving upward this quarter and bond markets stagnant, we can see that equity asset classes contributed to the overall increase of the index mix.

US large cap stocks were the largest contributor for the quarter while US small value had the smallest contribution to overall return.

Diversifying stocks across geographies and investment styles, as well as allocating to bonds, helped avoid undue portfolio concentration risk while allowing for ample growth this quarter.

This resulted in the 60/40 index mix achieving a return of 1.5% versus the US total market return of 3.2%.

The portfolio was able to achieve a smoother outcome with less overall risk given its diversification across the different asset classes.

Here we see a collection of major asset class calendar year returns displayed on a Quilt chart.

Looking at year to date returns in the right most column, we see that all asset classes, with the exception of US small value stocks and real estate, posted positive performance with the S&P 500 a popular headline index primarily tracking U. S. Large growth company performance, gaining the most value at 15.3%.

We can also see that the performance of each individual asset class tile shows no predictable return or relative ranking from one year to the next.

A diversified index mix, such as the 60% stock 40% bond index mix, shown in the white tile, tends to stay away from the extreme returns, both positive and negative, on a yearly basis and over time while also dampening the volatility of returns.

This is an example of the potential benefits of a well diversified portfolio.

It also helps us as investors to stay in our seats through any given quarter of market turbulence and not take away our ability to prosper from the many quarters to come.

And with that, we've reached the conclusion of today's presentation.

Thank you for joining us, and we'll see you next quarter.

Beacon Hill Private Wealth is an independent, fee-only, fiduciary investment advisor providing evidence-based wealth planning solutions that simplify our clients' financial lives. Founder Tom Geoghegan, CFP®, CIMA®, CPWA®, RMA® is also a member of the National Association of Personal Financial Advisors (NAPFA).      

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