Making Sense: April Market Update

Amy: Hello, everyone. I'm Amy Thomas, a strategist here at First Citizens Bank. Today is Wednesday, April 24th, 2024. I'm joined today by Phil Neuhart, Director of Market and Economic Research, and also Blake Taylor, our Market and Economic Research Analyst. I want to welcome you to our monthly Making Sense Market Update series. As always, we received a number of questions for Phil and Blake on our FirstCitizens.com/MarketOutlook page. We will answer as many questions as possible during this session. If we're not able to answer your question, please reach out to your First Citizens partner or connect with one at FirstCitizens.com/Wealth.

As always, the information you're about to hear are the views and opinions of only the authors at the time of recording and should be considered for educational purposes only. If you have any questions or concerns about your financial plan, please reach out to your First Citizens partner. And Phil, with that, we're ready to go. So I'll turn it over to you.

Phil: Thank you, Amy. First, I should introduce Blake Taylor, who is filling in for Brent, who is on the road today. Blake joined the team recently. You might have seen him in recent In Brief videos, but he'll become a familiar face for you all. So welcome to the team, Blake.

Blake: Thank you.

Phil: Thank you for joining us today. So what are we talking about today? Well, as usual, we're going to touch on the economy and the market. There's a lot happening on both the economic and market front. The economic front, it's really been all about inflation. We're going to spend a lot of time talking about that today. And that's impacting markets, particularly fixed income, where we've seen interest rates rise sharply even since our last monthly recording.

So let's dig into the economy quickly. One, there is a lot of optimism from a growth perspective. The outlook for the US economy has improved substantially. Here we're showing 2024 GDP growth year over year. This is the median professional forecast. In other words, think Wall Street economists. You can see as of what, summer of last year, that expectations for growth this year were below 1%. Today, they're 2.5%. Really pretty incredible rebound in terms of growth expectations. We're having to confront, and it's a good thing, the concept of maybe a soft landing or no landing in the economy. We'll talk about risks in a moment. There certainly are risks to the outlook, but this is one of the reasons we think about why have the stock market specifically rallied so hard since late 2022 and particularly since last October. A lot of it has to do with improving expectations. And it's becoming a little bit more broad based as we flip ahead.

Here we're showing, as we often do, the ISM indices, both manufacturing and services. As a reminder for you all, above 50 here means expanding activity, below 50 means contracting. So manufacturing, the gold line, has actually been in contraction territory for a couple of years. Now, as you can see, it just ticked above 50. Really what was keeping us out of recession was the services economy, which remained expansionary. If we were purely a manufacturing economy, we would have had a recession. The services economy, though, has continued to perform, and 70% of GDP is personal consumption, people spending money. So that's the most important part of the economy. But seeing that manufacturing tick up recently is another positive. And we are hearing from—we're in the middle of an earnings season—from some important bellwethers point to potential improvement in manufacturing activity as well. That is a good thing to see.

As a reminder, when we look at the Federal Reserve on the next slide, interest rates remain high. We can see here, of course, the most recent Fed hiking path compared to past hiking paths all the way back to 1983. And the outlier here is the current rate increasing environment from the Fed. And they have been on hold now for some time since what middle of last year. What are they going to do going forward? That is the question that markets are asking. That's what's swinging yields around in the Treasury market and other fixed-income markets.

Coming into the year the expectation was one that the Fed would start cutting in March. That obviously did not happen. It's late April. And the expectation was they would cut six or seven times. Well, now that has been pushed back dramatically. Now the first cut is priced for September, but that's only a 65% chance, not exactly a given. And now only one or two cuts this year. We came into the year thinking maybe three cuts, maybe two. We never thought it would be six or seven. Now, look, there's a chance that the Fed does not cut at all. It's going to really depend on what does inflation data look like in coming months. If they do cut, maybe it's very late in the year.

Blake: Yeah, it's been a huge repricing of expectations.

Phil: Massive repricing. And that's really had big implications for Treasury yields, as you all know. So financial conditions is something we talk a lot about. And you'll hear Fed officials speak to this. And financial conditions, you can measure many different ways. But basically, loose financial conditions mean it's an easier financial market environment. And this index we're showing here uses everything from credit spreads to stock market volatility to bond market volatility to stock return. What you see is the conditions have loosened materially. When you're above zero here, that means conditions are loosening. And so they really have since the back half of last year. What's interesting is you look further back in history, you can see that the Fed, when they began to hike, we saw a real tightening in conditions. So there's no question in the stock market sold off in 2022. There was an impact. It's just that now the economy seems to—and companies—seem to be absorbing the higher rate environment certainly better than many expected. So speaking of rates, let's turn to inflation, Blake.

Blake: Well, when you think of the big picture, it's remarkable the story of good news that's happened in this economy for today compared to just 6 months ago, what people were expecting. But unfortunately, there is still a big thorn in the side of this economy, and that's inflation. It's kind of hard to believe that it's been 2 years since inflation peaked in the summer of 2022 at about 9%. But since then, it has fallen precipitously. And until late last year, a lot of people were believing that it was on a glide path straight back to 2%, which is the Fed's official inflation goal.

And that's where this outlook for six to seven interest rate cuts came from. If inflation was not going to be as hot as it was, then there wasn't need for the Fed to maintain these high, restrictive policy rates. But that's not really the case the first few months of this year. It's looking like inflation has stalled out closer to 3%. And there's been a big change in the inflation narrative, yet again, not for the first time, in the last few years. So it's looking like 3% underlying inflation might be more the case. And that's, of course, much better than the inflation we had a year or two ago. But three is not two, and it's not close enough to two for the Fed to be declaring victory.

Phil: You can see the gold line in this chart has started to kind of move sideways, right? We had this really nice move down. And now, as you mentioned, it has stalled out.

Blake: The big question is where inflation is going from here. And inflation is notoriously difficult to predict. It's tripped up a lot of investors and central banks even in the last couple of years. But something that's caught our eye recently is the relationship between consumer price inflation and small businesses simply telling us that they plan to increase prices.

So what we have here in the gold line is the share of small businesses, as recorded by the National Federation of Independent Businesses in the survey, of how many of them plan to increase prices in the next few months. And as we can see here, that relationship tends to lead consumer price index changes by about 4 or 5 months. And recently, the share of businesses reporting that they're going to be raising their prices has risen by about 10 percentage points from about 20 to 30%.

So does this mean that inflation necessarily has to rise substantially in coming months? No, it definitely does not. But what interests us about this year is that it's just another reason to be a little bit skeptical of this view that inflation is just going to glide back to 2%. It might still be bumpy. It might stay elevated for a little bit longer. And then also, it's an important reminder that despite all the strong economic data that we just went through, small businesses are reporting a very low level of optimism on average. This survey indicates that small businesses are as pessimistic as they were in 2012, which was not a good period for the economy.

Phil: And that's in contrast to S&P 500 companies, the very biggest companies, who seem to be looking ahead to margin expansion and are feeling much better on average than their smaller brethren.

Blake: That same kind of mismatch between the strong economic data and sentiment has very much been present for consumers as well. There's a whole host of factors, of course, that affect consumers' sentiment and confidence. But something that we've noticed is that the prices for staple purchases, things that households can't choose to not go through with or even really change—things like food and housing and utility bills and insurance—those have risen by over 20% since the beginning of 2021 and that's faster than the increase for inflation on average.

And of course, it's also faster than some measures of wages. So these, again, are things that households can't change. You might be able to amend your plans for recreation or what you're doing on the weekend, where you're going to dinner or travel. You can also cut those out of your budget entirely if you have to. And that's what's in this lighter gray line here. That's where we're showing the prices have increased at a slower pace than the staples. And even if, and it's a big if, if a household's income has kept up with inflation, then these staple items have likely outpaced their income.

Phil: And when we're on the road, there's a lot of angst around inflation. I think this is one of the main reasons. Is that, yes, let's say inflation is running at 3, 3.5%. Well, that's in addition to 9% you already experience. It's not that inflation is negative, and your staples have increased far more than your discretionary items. So you really are feeling the pressure. So we definitely sense this among our clients as well.

Blake: Again, the big question is, where is inflation going from here? And we don't pretend to have the exact answer, but something that we've been talking about is how, just like when you're running a race or you're on a diet and the last mile is the hardest in the race, those last few pounds might be the most difficult to shed.

For inflation, it might be the last percentage point or two that's proving the most difficult to vanquish. And there are definitely still plenty of optimistic analysts out there that believe that inflation will get back potentially expeditiously to the 2% goal, maybe by the end of this year. But a lot of forecasters recently have been moving away from that narrative. They've been leaving behind this kind of bits-and-pieces approach to inflation forecasting, where they might say, well, just until car prices get back to normal, just until housing prices and the official index catch up with more real time measures, then we'll be right where we need to be with inflation.

A lot of people have started to move away from that, and they're instead saying, let's just look at the big picture. This economy is hot. Financial conditions are easy. Consumers are spending very strongly, and the labor market although it's not in complete disarray like it was 2 or 3 years ago, a lot of businesses are still reporting—and you hear on the road small businesses saying—it's hard, it's still hard to get labor, and it's hard to maintain staffing levels. So a lot of people that we're listening to and reading are now saying maybe in looking at the big picture, maybe that's just a pattern that's more consistent with 3% than 2% inflation, at least for the next little while.

Phil: It's possible. If you look at the fourth quarter of this year, for example, 2.9% is the consensus estimate right now. Last month, even just a few weeks ago, that was 2.5%. So there is a realization that, yes, inflation is not nine or six or seven, but that maybe three is the new two. And by the way, the stock market is up this year, right? It doesn't necessarily mean markets don't perform. But just like we ran below the Fed's 2% target for an extended period, maybe we're going to be above it for quite some time, and consensus is starting to show that—it's still north of 2.0 through the middle of next year.

Blake: And this isn't the last time that the narrative around inflation is going to change, probably not even this year. But it's just another reminder why maybe it's the right thing to keep a little bit of humility around your inflation forecast and maybe pay attention to these bigger picture themes.

Phil: That's right. And speaking of that bigger picture, the labor market has been incredibly important for the US economy. One of the reasons we stayed out of recession last year, one of the reasons the economy continues to be in decent shape is job gains. We had another surprisingly strong jobs report just a few weeks ago. That has become a pattern. The last 6 months, on average, we have gained 244,000 net-new jobs, that is a net number. You can see those gains have been pretty consistent. As you mentioned, maybe not to the same extent, but we still often hear from business owners that they feel understaffed, that they have problems keeping labor or finding labor. So as long as that's the case, job gains you would expect.

Also, as long as you have that tight labor market on the next slide, you'd expect wages to persist, wage growth. So much like inflation, it's come down from the highs, right, of 6.7%, but you do still have wage inflation in the fours. Depending on the measure, 4 to 5%, that is well-above the average. And the average, of course, is pulled higher by recent periods. This is a slightly different measure. Blake, would you want to kind of outline what we're showing here compared to what we've shown in the past?

Blake: Just like there's a bunch of different ways to measure inflation. There's tons of ways to estimate wages. This is a big country with lots of different workers, countless different types of jobs and different paying arrangements. And this tool here from the Federal Reserve Bank of Atlanta tries its best to track wages across the same types of workers over time. So you're not going to get these unusual compositional effects. It's not a perfect measure. There's not one out there, but we think this one is one of the best, and it tells largely the same story as the inflation charts that we were just looking at, which is there's been movement down, but this measure is still probably running a little bit too hot.

Phil: That's correct. If you're the Fed, I think in the dream scenario, which is not the scenario we're in and we may not be, but is 2.0% inflation, a wage inflation in the threes, right? And then you have positive wage gains. But you don't have wage gains to the point that they might feed back into consumer prices in some way, which, of course, is always a risk.

So people are still seeing wage gains as we flip ahead. They continue to spend. Here we are showing personal consumption or consumer spending on both goods and services. We show this most months. And the reason is, it's the key to our economy. 70% of US GDP, as I mentioned previously is consumer spending. We're still spending more on services. Services are above that 20-year average. Goods are below, as you can see. People are still spending on experiences. During the pandemic, they were spending on goods. Now people are, you know, they bought that new couch in 2020 or 2021. Now they're taking their kids to Disney World, right?

And that is really remained remarkably steady if you look at services spending. As a reminder, the majority of consumer spending is services spending. So if you're cheering for services or goods from an economic perspective, you're cheering for services. So that's some good news. Why don't you dig into one of the risks we have been speaking to over the last year and a half or so?

Blake: Yeah, this economy is far from perfect, but there's been good headline after good headline measure of the economy coming out for several months. And good things don't have to come to a premature close, but it is good to keep an eye on some risks. One of the big known unknowns out there is the commercial real estate market. In the last few years with some post-pandemic effects and higher interest rates the vacancy rate in commercial real estate office buildings the major metro areas has risen to almost 20%, and that's a substantial increase over the last few years. It's even above the rate after the financial crisis 15 years ago.

So what's that causing? The delinquency rate on commercial real estate loans has been growing. And that poses, as we can see on the next slide, that poses substantial risks for banks outside of the top 25, the smaller banks in this country. Over the last decade, the share of commercial real estate loans that are held by these smaller banks has risen to almost 70%. So do we know where all the pieces are going to fall if something substantially negative happens with commercial real estate? No, but one place that's worth keeping an eye on are these smaller banks that hold a lot of the loans.

Phil: Yeah, it's something we speak to quite often because it's a known risk, right? But how does it play out? We don't know. And it's going to take time. This is not a liquid asset. We'll know a lot more in a couple years than we do today, but certainly something we're keeping an eye on.

So let's turn to markets. Based on the economic data, we are having quite interesting moves in markets. So as you can see here, US equities, even given the recent drawdown, are leading both international and emerging. Emerging markets are now down year to date. This is through Friday, April 19th. But you see a drawdown, but certainly US equities are the best performing asset class.

On the right side, fixed income. Fixed income is having a difficult year so far. Why is that? When rates go up, price goes down. Now, reminder, these are total return indices. If you hold individual fixed income and you hold to maturity, of course, you're made whole at maturity. But from a total return perspective, rates moving so sharply higher has had an impact. We'll talk about that more in a moment.

If you look within the US stock market on the right side, some interesting things have changed since the last time we met. Large-cap growth and value are basically in line with each other. That is very different. Growth had substantially outperformed year to date for most of the year. What has happened over the last month with volatility in the equity market? Value has outperformed growth pretty dramatically. And now they're basically flat on the year. That is quite a change. You also now see small cap is down. That was up. Why is that? These are riskier companies. And when there's dislocations, generally small cap's going to feel it more. Also, you could argue for many reasons they are more rate sensitive. So when interest rate goes up, small caps feel that a bit more.

So let's talk a little bit more on the US equity market. First, just a couple of reminders. Even with that drawdown you see there, look at the incredible rise we've had since October 2022, up almost 40%. Just since last October, essentially Halloween, we're up over 21% after the drawdown. So as Brent and I have been speaking in recent months, that straight line move up in the market, that was not going to last forever. To see some rationality, a little bit of consolidation here is not all that shocking and is okay from our perspective.

Another thing that's good from our perspective is there has been a broadening in the market. So on the upper right, this is year to date through Friday the 19th. We have the cap-weighted index, the S&P 500. So that's an index where a big company has a much bigger weight than a small company, right? So we talk about the Magnificent Seven, for example, have a bigger weight. That has outperformed year to date 4.6%. Equal weight where all of the companies are equally weighted, right? So a big company has the same weight as a smaller company, 1.2%. So it's trailing—3.4% difference.

What's interesting, though, is a lot of that is due to very early in the year. Since February 2nd, the S&P 500 cap-weighted has trailed the equal weight. So the equal weight has outperformed by 1% since early February. So you hear a lot of worry last year. Magnificent Seven were leaving the market. The truth is we have seen a broadening. And by the way, that broadening, we were seeing that a month ago when the market was up. It's not just because we've had a selldown. It's an up and down market. You see this with sector performance as well year to date. We have seen some broadening. If the market's going to continue to rise, that's important, right? Eventually, you cannot just depend on a few companies. So speaking of the recent volatility, what about some historical context, Blake?

Blake: Well, you said something in there that I've heard you say several times since I joined here, which is that equities rarely move in a straight line and also volatility is the norm and not the exception.

Phil: I am repetitive, so I apologize for that.

Blake: But that's something that's important to remember here in this next chart is that even in years where there are substantial equity market returns, there tend to also be pretty considerable drawdowns within the year. So even as we can see here when years with returns in the 20s or even 30% there might be there might be within that year drawdowns of 5, 10 even 15% or more. So last week when the equity market was down 5% we got a lot of headlines about worst week for the S&P 500 in over a year or something like that. And when you look at it in this context, 5% is actually not even typical. What is typical is closer to 10%.

So as we've said, and we'll continue to go on saying, we believe that there are a lot of strong fundamental factors driving this equity market, and a 5% drawdown last week or even further throughout this year is not something that's going to shake us too badly.

Phil: Yeah, I mean, on average 15% drawdown, that's what we should come into a year expecting is something like—I mean last year we had a great year in the market, we had a 10% drawdown entry year. So volatility is the name of the game. It's about investors having the correct buckets, right? Having your safe bucket of assets, but for risk assets, equities, you have to be ready for some volatility.

Turning to that point as we flip ahead. So if you think about fourth quarter of last year and first quarter of this year too, really, we mentioned that straight line rally up, right? Again, I'm repetitive, aren't I? We had 10% gain in each of those quarters, consecutive quarters, over 10, over 10. That's pretty rare. As you look historically here, we're showing past periods where we've seen that all the way back to the 1920s.

So you might say, and what we're showing the chart is, well, what about the following quarter? After two quarters in which each quarter is up over 10%, meaning a pretty incredible run, what happens? Well, if you had asked me this without showing me the data, I might have said, well, I'd expect a decent number of givebacks. The next quarter is down. What's interesting is typically, more often than not, the next quarter is actually up. So it's a reminder that price momentum is a very powerful factor in equity investing. Now, so far this quarter, we're down. We have well over 2 months left in this quarter. So we shall see. But just a reminder that good news does not always mean bad news the next day.

Blake: Good things can continue.

Phil: Good things can continue. And we've seen that historically in the equity market. We spoke a little bit about broadening as we flip ahead. Something that we hear a lot about is, well, the market's very top heavy. And in some ways, as you look on the left side, the top 10 weights—the S&P 500 or the largest 500 stocks—it's just true, right? There's no question that the biggest companies have become very big. These are massive companies, make a lot of money, have massive balance sheets and they are a big part of the S&P. What's interesting in the bullet points on the right is that if you look over the last 6 months, you know, through the first quarter there has been broad-based gains across size and sector. In fact, if you look at the 25 industry groups within the S&P—22 of them had positive total return in fourth quarter of last year and first quarter of this year.

So it's not that only the biggest companies are returning. In fact, the vast, vast, vast majority of industry groups are seeing positive returns. And again, I mentioned broadening. We are seeing year-to-date movement outside of just those largest companies. So there is under the hood, I think, some better news than some might be acknowledging.

So let's talk about valuation. Valuation is a fancy way of saying how expensive is the market. Here we're showing next 12 months price-to-earnings ratio. This is how much you're willing to pay for a dollar of future earnings. The market's expensive. There's no way to back away from that. It's a little cheaper now than it was before the selldown, but still historically expensive.

A couple of things we'll point out. One, we always like to remind people, one, the market rarely trades at that average. So you will hear in financial media, the market's expensive or cheap versus history. That tells you very little about how the market's going to perform in the near term. The market stayed cheap throughout much of the 1980s. It was expensive through much of the 90s. It was cheap for years after the Great Financial Crisis and performing well. So that is not a great indicator. It does mean, of course, forward returns are potentially lower as you look through the long term, but doesn't mean they're negative.

The other thing we want to talk about, and this is something we haven't shown before, is what about breaking the market into two parts as we flip ahead, Amy? And we're looking at just the price-to-forward earnings, that same measure, but we're looking at the largest 10 companies versus numbers 11 through 500. And what's interesting here is, yes, the 10 are expensive. Looks a lot like that chart I showed you in the previous slide. They are expensive versus their history. They're expensive to the pre-pandemic level.

Look at the others, though. Not very expensive compared to either the top 10 or their own history. In fact, basically in line with where they were pre-pandemic. So it's a reason to remember that when we say the market's expensive, well, a lot that has to do with the biggest companies are expensive. And by the way, some of them justifiably so. There's a reason that some of these have really expensive valuations. But it is not all companies. We don't want to paint with that broad of a brush.

While we're on this topic as we flip ahead. Something we wanted to show for you all is that Magnificent Seven, right? These are the bars on the right side. What is their sector weight versus their income weight? In other words, how much of a portion of the S&P 500 are they versus how much do they earn? And basically, because some of them have great franchises, their sector weight is much bigger than their income weight, right? As we see a broadening, look at energy, for example, look at financials, the income weight is above the sector weight. So you could argue that those bars should get closer to each other.

In other words, your sector weight starts to carry the same weight as the income you generate. There's no coincidence that if you look at year-to-date sector performance two of the best performing sectors are energy and financials, right? I think that we got a little carried away with just Magnificent Seven thinking last year and now there's a little bit of a return to normality. So if you're thinking about why can other sectors perform, that is one of the reasons.

You might have all heard it's an election year. So we're contractually obligated to speak election in every monthly webinar. We've shown this chart before, but for those who have not seen it, I'll remind you what we're showing. So we're going back to 1937, year one, two, three, and four of a term. And you're looking at a re-elected president, so think that's a second-term president, or a new president. And what does market performance look like? New president, of course, being first-term.

So we are in the gray bars, right? We have a first-term president. Generally, first-term presidents a year for the election year where we are tend to be really good performance. What's interesting for second-term presidents, the performance is basically flat to down. So the thinking is, of course, that an existing president is going to do things they can to juice the economy, which hopefully will help the stock market and help in terms of their re-election campaign.

And the second-term president is more worried about their presidential library than maybe the market. I would only remind everyone, as I always do, not to be a Debbie Downer, is that all of this is small sample size. There are things that happen in the real world. So we talk about that second-term president. 2008 was an election year. That was the Great Financial Crisis. I don't think that was because it was an election year that the market sold off the way it did. 2000 was an election year, second-term president. We had the beginning of the end of the tech bubble. Same thing, not because it was an election year. The truth is that had been many years in the making. So there are small sample sizes and there are big outliers that can drive things. So eventually the market is going to turn to fundamentals and look through the election cycle, even if it's difficult for all of us to do so.

So speaking of those fundamentals, why don't we talk earnings for a moment?

Blake: Yeah, regardless of the political outcome, people will return to the things that have always and always will matter for the equity market. And we see two of those fundamental factors looking quite good right now. First is estimated forward earnings, which look very positive, almost 11% earnings growth for this year and almost 14% growth penciled in for next year. Those are well above above long-term averages. Remember, these are bottom-up analyst estimates for every stock in the S&P 500. And the equity market is all about expectations. So the fact that these expectations, even if they get revised down a little bit, because these can tend to be—

Phil: —a bit optimistic.

Blake: Yeah, sure. But the picture here is one of a very solid view for expectations. And that's what drives equity market returns. And the second fundamental factor that looks quite good is on the righthand side of the slide is the operating margin, which we talked about a little bit earlier. But operating margins got kind of crushed in 2022 when inflation was making its way through the economy. But we started to see a rebound in margins and expectations for the rest of this year and into next so that they'll continue even further. And that's another very solid piece of fundamental news and another reason why we remain fairly constructive on the equity market.

Phil: Correct. And it is worth mentioning we're in the middle of an earnings season. It's still fairly early, but so far, north of 80% of companies have beaten their estimates. Companies tend to beat, right? Analysts lower the bar, and they beat a lowered bar, but still north of 80% is pretty high. Still a long ways to go. We'll know a lot more in about 2 weeks in terms of earnings results. But some of the bellwethers have certainly said things that we like to hear on the optimistic side.

So speaking of our price target, as we flip ahead, we updated this last month. I won't dig into it deeply, but our base case is 5,500. In that case, we have a modest downward revision to some of those earnings estimates is sort of an average earnings growth year. The following year and a little bit of multiple contraction gets you to 5,500. That's about 8.5% from where we are today. That 8.5% upside is higher than we said in March because the market has come down, but we still feel optimistic on the market in 12 months.

Is there going to be volatility this year? Yes. We do not view price targets as something you move to in a pretty straight line. What we think is that there's going to be bumps along the road, geopolitical risk, elections, et cetera. These can cause volatility, but on trend, we think fundamentals remain in place. So that's equities. What about fixed income, Blake?

Blake: Over in fixed income, the story is that yields are higher. The Treasury yield curve, which we show here with yields on the vertical axis and then the term of Treasury debt on the x-axis, the whole thing has moved up substantially. And this is a very large move up relative to what we typically see in a 3 or 4 month period.

Phil: Less than 4 months. It's incredible.

Blake: Less than 4 months. 70 to 90 basis points across almost the entire curve except for the shortest end, of course, and why is this? So there's plenty of reasons why that affect the supply and demand for treasuries, but at least two big pieces of this story are one—Fed rate cuts. As we've said they've been pushed further out and they've been marked down—fewer cuts, later date, higher yields.

Phil: That has to find its way to further out on the curve. Because if you think of the two-year Treasury as the overnight rate each day for 2 years, and the overnight rate, the federal fund rate is going to be higher for longer, then the 2-year has to go up, right? And that carries on throughout the yield curve.

Blake: And maybe even more importantly, as we've made very clear earlier on, is the strength of this economy and the resilience of the economy is leading a lot of investors to expect higher yields longer into the future.

The other thing that's interesting about the Treasury yield curve here is that it's inverted. In other words, the shorter end is yielding more than the longer end. That's unusual. Typically, we expect longer-dated Treasury debt to yield more. In the past, this inverted relationship has typically been a sign of impending recession. And a lot of analysts and forecasters saw that inverted yield curve almost 2 years ago, and they foresaw a recession coming. I remember there was one model that predicted it with 100% certainty that it was going to happen. But so far, it hasn't proved problematic. And if the Fed remains on hold for the next while, and at the short end, Treasuries continue to yield about 5% and towards the longer end, they don't rise above that, then this atypical relationship might persist for some time into the future.

Phil: Look, this cycle is unique in many ways. The nature of the 2020 recession due to the pandemic. Maybe this will also not be a predictor as it normally is, but certainly the economy's outperformed what consensus expected coming into 2022, certainly.

So that's the risks of higher rates. What about some of the positives from an investment perspective? And we show this each month very intentionally because there is opportunity for investors of fixed income. The 2-year Treasury at the beginning of 2022, end of 2021 was yielding 73 basis points, 0.7%. Now it's yielding close to five. The 10-year Treasury, 1.5%, 4.6%. Aggregate bond, 1.75 to 5.3. These numbers matter. If you think about what's changed the most in the investing landscape over the last 2, 3 years, it is the reset in yields and potential return in fixed income.

Stocks have been volatile. They've been down in 2022, up in 2023. That's what stocks do, right? That is normal. Fixed income going from, in certain parts of the curve, sub-one-percent, near zero at points in 2020 to more normalized yields. That's a big deal and not something you see that often historically so certainly an opportunity there.

One more chart we want to discuss. We've shown this before, but want to emphasize it is we often get the question of like, "I have cash on the sidelines, when should I invest? Should I wait?" And the truth is—have the correct buckets, but for your long-term equity bucket of assets. The answer is to try not to time markets.

And there's many ways to show this. We had one of our quantitative analysts cook this up, I believe, late last year and said from 1980 through 2023, you have $12,000 to invest, right? And you are investing that each year for those four-plus decades in four different scenarios. So to walk through the scenarios in the perfect timing scenario, this is somehow you're omnipotent. This is not possible, but somehow each year you invest your $12,000 at the yearly low for that year, right? One year that might be October, another year that might be mid-January. But every year, you know that. You invest it. Well, first of all, that $12,000 annually becomes $10.5 million, which, by the way, just unbelievable compounded return is really something else. Remember, this includes the tech bubble. This includes the lost decade of 1999 through 2009, S&P being down. This includes the Great Financial Crisis. It's not as if—1980, this includes the pandemic—it's not as if this includes just great, all great times. It does not.

Okay, second scenario, worst timing. This is also not possible or statistically minuscule, but somehow you're the worst timer in the world. Every year you invest at the yearly high. Your $12,000, the high was in March. That's when you invested, the market sold off. You still capture 76% of that $10.5 million.

Now, two more real world scenarios. First day of the year, this is something—there's people that do this, right? January 2nd of each year, they put their $12,000 in. You capture 92% of that 10.5 million dollars. Another real world is kind of the 401(k)-type scenario. Monthly dollar-cost average, each month you put $1,000 in, $12,000 for the whole year, 87% capture of that $10.5 million.

So the short answer is just invest, right? If you kept that in cash, or if you're using using 3-month T-bills here as a proxy, kept that in cash for those four decades, you captured 5% of the $10.5 million. So invest, try not to worry when there's volatility in the markets, just invest for the long term.

Amy: Blake, Phil, thank you so much for that in-depth analysis. Just a reminder to everyone who may be interested, we do have several publications available to our subscribers, including a weekly economic outlook in our In Brief series that's delivered at the start of each and every week. And then we keep you informed on what the Fed's doing and other important reports throughout the month. So if you're interested in getting signed up, you can visit FirstCitizens.com/MarketOutlook.

Let's jump into questions. Phil, we've got several. You may be a little repetitive, but so are some of our questions. There's definitely a theme around Fed rates and what's going to happen coming into the rest of this year.

Phil: Yeah, it's the number one question we're hearing on the road as well. Look, if you believe fed funds futures, which probably you shouldn't, they've been very wrong, it's pricing one to two cuts this year, as we discussed earlier. I think the Fed has made it pretty clear through statements beginning late last year, and correct me if you disagree, but they would like to cut for a number of reasons related to their dual mandate. And honestly, probably some outside of their dual mandates, think commercial real estate, for example.

But they need the data to cooperate. Inflation does not need to get to 2.0 for them to cut because they're focused on the real rate. How high is the fed funds rate above inflation? But the problem is they do probably need to see that data continue to cooperate. Importantly, we do receive the PCE deflator this Friday. That is the Fed's preferred inflation measure. We talk CPI because that's what people like to talk. But PCE deflator has actually been in the twos. It's just still a ways from 2.0%. So we'll get that on Friday. Look, I have been in the camp of the Fed cuts two or three times. And Brent has thought maybe they don't cut it all. I think it's a real possibility they don't cut it all.

Blake: They've told us they want to for several months.

Phil: Yes.

Blake: But they always caged it with if the data cooperates.

Phil: Correct.

Blake: And that's what we heard from the Fed chair last week was that the data hasn't cooperated. And they seemed to believe that the policy rate was restrictive, maybe too restrictive. But they've told us in order to lower it, they need to see progress on inflation. And Chair Powell said there hasn't been progress on inflation this year. That's not a good sign for the expectations.

Phil: And the truth is, is some proof we talked about financial conditions that the economy is absorbing higher rates better than the Fed thought and better than than, I think, almost any practitioner thought. The playbook is usually rates move that quickly, and you have something like a recession. The truth is, is the fundamental data looking pretty good. Think about retail sales recently. Think about payrolls recently. Is some proof that the economy is absorbing these higher rates, so we think about the Fed a lot. Maybe the market's looking through it when you think about the stock market. The rates market has to pay attention, but maybe the stock market's looking through it to some extent, given how well the economy has absorbed these rate cuts certainly better than we expected and others.

Amy: Yeah, Phil, that takes us right into our next question with this person's asking, "When will rates hit the company bottom lines and market prices? It seems like the market isn't too worried about anything that's happening right now."

Phil: Yeah, it's interesting. I mean, the market, if you remember, we had a material sell off in 2022, and the market certainly was focused on rates going up. That was really all about the Fed hiking. If we flip to slide 27, really, we even saw and there was expectation that margins would come down and they did. The truth is we have a dynamic economy and companies have absorbed these higher rates and have pivoted. One when rates were low they extended their debt stack, right? So interest income is going to hit, but also remember a lot of the very biggest companies have enormous cash hoards, so I'm talking about S&P 500. I'm not talking about small businesses, we're talking about S&P 500 right now. So margins are actually expanding. If you have an enormous cash flow you're actually earning interest, right, and you may not need debt.

So, the truth is, I think the market, you know, the question was, the market doesn't seem to worry about anything. Well, it certainly was when it sold off precipitously in 2022. We only just reached previous all-time highs. It's just that the market's looking forward to better times, and if you look at 2023, the economy outperformed and so far is doing okay in 2024.

Do not take that as we think everything is rosy. Small businesses are struggling. A portion of consumers are struggling. We're seeing credit card debt go up. We're seeing sub-prime auto delinquencies rise. But the market, especially when we're talking about stocks, is going to be pulled by those largest companies. Think the S&P 500. They look very different. The smallest company in the S&P 500 looks very different than a small business in our hometown. These are massive corporations.

So the truth is I think it did price it, and it has moved past, and you're seeing margins expand. If that margin chart on the right was still marching lower, the stock market would not be up this year, right, and it probably would not have rallied as much as it did last year.

Blake: Right. High rates are kind of like a dose of medicine, and there's a lot of elements of this economy that have been able to absorb it. But there are some that are feeling the pain, and on average things seem to be going very well. But absolutely for some pieces and people and companies, that's not always been the case.

Phil: They're feeling it, and it's one of the reasons that small-caps have lagged large-caps, because they are more dependent on debt and they have smaller cash hoards. But our largest companies, which pull the overall market, are handling it fairly well after some issues in 2022.

Amy: So, Phil, it sounds like rates are going to stay higher for longer, at least for the foreseeable future. What kind of investment opportunities might result from that?

Phil: So, yeah, it's something we just touched on it on slide 31. There are real investment opportunities. Generally, if you look, we did a study we've shown, we went back decades looking at the yield to worst of the Aggregate Bond Index, which is just broad bonds. How much of that yield to worst, right? Think of that as yield to maturity adjusted for options. How much of that yield is capturing the return? Right? If you look over the duration period of the index.

So let's say the index is yielding 5%. The duration's 6 years. Over 6 years, do you return 5%, right? On average, you actually capture 111%, right? Now the exception was the last few years when rates skyrocketed in unprecedented territory. You saw the aggregate bond total return come down. That's happened year to date. But for those entering the market, particularly those who own individual bonds that can hold to maturity, there is now yield in the fixed-income market. This has changed the investment landscape.

Think about a pension that had a certain required rate of return. Maybe they had a little more equities than they wanted, but they did it because they weren't getting a yield from fixed income. Well, now fixed income is more viable asset class. Think about an individual entering retirement. So it is a major shift that now, compared to just a couple of years ago, you are getting pretty substantial yield, 5.3% on the aggregate bond.

Amy: Well, Blake, Phil, thank you so much again for that in-depth analysis and for answering questions. Lots to consider as we move into the spring and summer months. We hope everyone listening found this information helpful. As always, thank you for trusting us to bring you this information. That's something that we never take for granted. We will be back again next month, and we hope to see you then.

Making Sense In Brief Outro Slide

Brent Ciliano

CFA | SVP, Chief Investment Officer

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Brent.Ciliano@FirstCitizens.com | 919-716-2650

Phillip Neuhart SVP, Director of Market and Economic Research

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Phillip.Neuhart@FirstCitizens.com | 919-716-2403

Blake Taylor | Market & Economic Research Analyst

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Blake.Taylor@FirstCitizens.com

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