Making Sense: February Market Update

Amy: Hello, everyone. I'm Amy Thomas, a strategist here at First Citizens Bank. I'm joined today by our Chief Investment Officer, Brent Ciliano, and Director of Market and Economic Research, Phil Neuhart. Today is February 29th, Leap Year Day, 2024, and I want to welcome you to our Making Sense: Market Update Series.

Each month, Brent and Phil take a deep dive into what's happening in the markets and the economy. And they will also be answering questions that were submitted through FirstCitizens.com/wealth. If your question isn't answered today, please reach out to your First Citizens partner.

As a reminder, 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. And Brent, with that, we're ready to go. So I'll turn it over to you.

Brent: Great. Thanks, Amy. Good afternoon, everyone. Hope you are well. Well, Phil, we are 2 months into 2024, and the equity markets continue to grind higher. Through February 28th, the S&P 500 is up 6.5%—which is just kind of crazy. Link that with the last 2 months of last year, we're up more than 21.5% in only 4 months. That's effectively pulling forward more than 2 years' worth of returns in only 4 months. So just an incredible grind higher.

So a lot to cover today, so we're going to start off with an economic update. We'll give you an update on growth, monetary policy, inflation, labor market, wages and then we're going to bring back in commercial real estate—a risk that you and I have highlighted for quite a while. We'll talk about that and then an update on markets. So Phil, why don't you kick us off?

Phil: Yes, let's jump right into the economic update as we flip ahead, Amy. So looking at global growth, in 2022 the world grew 3.5%. Remember, we were coming out of the pandemic, really rapid growth. Look at Europe, look at the UK.

Brent: Incredible growth.

Phil: And coming into last year, 2023, look at the expectations as of December 2022 were really muted—0.4% in the US. What you saw was a surprise to the upside really across regions, across the world. US ended up growing at 2.5%—multiples higher than expected. So you think about why did risk assets rally like they did last year, even in the fourth quarter? A lot of it was the realization that, hey, maybe we aren't having a hard landing. Maybe this is a soft landing or no landing at all.

As we look at expectations for 2024, world 2.8%—that number has been rising. US 2%, that was sub-2% even a few days ago. So certainly expectations have improved and markets are trying to price this new optimism.

And on that point, as we flip ahead, look at the ISM indices. So as a reminder, these were Alan Greenspan's favorite indices. And these are surveys of businesses. So this is real-world businesses, not governmental data. And above 50 means expansion, below 50 means contraction. And what you'll notice is services, which is the gray line here, has remained in expansion. It's actually improved dramatically of late, a pretty sharp increase last month. Manufacturing, which is the gold line, has been in contraction—still is in contraction, but look at that gold line. It is getting much closer to the 50 break even.

Brent: Fingers crossed, ready to break through.

Phil: So in other words, things are looking better when you ask businesses. And to that point—CEO confidence.

Brent: Yeah, I mean, another measure is to get it right from the horse's mouth. The Conference Board has a measure of CEO confidence—how they're feeling about current conditions, how they're feeling about future conditions on the next slide here, Amy. And what you'll see is certainly when we saw the multi-decade highs that we've talked about a number of times back in 2021. As we got into later 2021 and specifically into 2022, not only did economists, but CEOs thought that a recession was in the cards. And you can see how that confidence fell dramatically as we got through much of 2022. But you can see that bottoming-out process.

And we've seen CEO confidence about the economy rise since sort of the beginning part of 2023 all the way to now. To where now, for the first time in more than 2 years, CEOs are confident—above that 50.0 line—are confident about the forward views on the economy. And again, driving policy, driving growth within their own companies. That's a good thing to see.

Phil: Really, really excellent to see. And it also feeds into—when you think about economists being really bearish going into last year—look where CEO confidence was late 2022. It wasn't just economists. The truth is people that run businesses were pretty bearish as well.

Brent: Exactly. And one of the reasons—and we've talked about this slide, I mean, countless times—is the incredible monetary policy impact that this current cycle has. And for folks that haven't seen this slide before, we've covered this quite often.

We're looking at every hiking cycle post-1982. The gold line here is the current cycle, and you can certainly see, as it relates to magnitude of hikes and basis points and the slope of that line, the most significant cycle that we've seen in more than 40 years. The Fed's been on hold since July of last year, Phil. And what everyone is really focused on, market participants, economists, is "When are we going to shift from a tightening policy to one of easing?"

And right now it sits at about three to four cuts in fiscal 2024. That's certainly come back an awful lot when we were coming into the year. Seven, right? And right now the probability of the first cut has continued to move from March to May to now June, sitting at a 60% probability of the first cut happening in the June meeting. Obviously May is still live, and we'll see what happens, but right now three to four cuts in the year, and the year-end expected fed funds rate of about 4.5%.

So again, this is more in line to what you and I have been talking about for more than a year. We are on the shorter end of the side as it relates to the number of cuts in fiscal 2024. But again—we keep, seem to be pushing that out. As we get later into this presentation, we talk about some of the wage data, some of the core PCE data. This might change.

Phil: And speaking of some of that data that has been pushing expectations for the first Fed cut rate hike, let's flip ahead to inflation. Consumer Price Index peaked at 9.1% in 2022, 40-year high. It's marched lower, but we have gotten some surprises recently, right? A surprise to the upside in terms of expectations.

You'll notice that gold line is starting to move kind of to the side and not down to the extent we would like to see. Why is that? It's the last mile, right? It's much easier to get from nine to three than from three to two. And core inflation, which excludes food and energy, is still above headline. So when the Fed says we still have work to do, well, this is why. The truth is inflation's sitting at 3.1%, 3.9% on core, is above that 2% target they have.

So what is driving inflation? Well, a big story is owners' equivalent rent, right? Basically cost of shelter, right? And this is a metric that is somewhat controversial within CPI, how it is measured. But what you'll notice is that one, it's still very high. That's the gold line here. And two, yes, it follows real-world measures like the Zillow rent index, but on a lag. And it's fallen, but nowhere near to the extent of something like the Zillow rent index. If you exclude shelter from CPI, CPI rose just 1.6% year on year. It rose, what, 2.2% during January on the core.

So the truth is—shelter is a lot to do with this. Now, in the real world people are spending more on shelter. Home prices continue to appreciate. So it's not that this isn't impacting people. It is, but it is not as broad-based as you might think without shelter. It really is keeping inflation elevated.

So what do economists expect as we look forward? You can see the gold bars here, expectations for inflation year on year from the consensus. Year end, 2.5%. These numbers have been ticking up a little bit, and that's because inflation has surprised to the upside. Third quarter, 2.6%. So when you say, "Well, how can the Fed start cutting, say, mid-year-ish?" Well, the answer is something called real rates, right? So if you have the Fed at 5.5% and inflation is at 2.5%, well then the real rate's three. Well, the real rate may only need to be, say, 2%.

So that's how you get to the Fed cutting three or four times this year, is that they're looking at the real rate, which is why you want inflation to come down. And that gives the Fed the green light to cut. It does not mean they're cutting aggressively, but it gives them the green light to moderate the rates of interest, which, of course, would be good news for the economy.

Brent: Yeah. And what is incredible is, to that point, is the terminal value for the Fed going to remain at 2%? Historically, if I look post the hyperinflation that we saw in the 80s and I sort of look forward all the way back from 1983 to now, we had inflation averaging about 2.8%. So is the terminal value for inflation going to be two? Is it going to be two-and-a-quarter, two-and-a-half? Unknown as of now, but it's certainly clear, as you can see, all the way out until June of 2025, we don't get back to that 2% level.

Phil: Yeah, and I think it's a real reasonable expectation we don't, outside of something like a recession. And then we'll all miss a little bit of inflation. But certainly, let's say inflation levels out at 2.3%. Is the Fed going to be pedantic about their 2% target? I doubt it. I think that you're close enough to target that they'll be pleased.

Another real boost to the economy is on the next slide—that's been the labor market. You'll notice here these are monthly job gains or losses. You don't see any losses until you go back to the, really, immediately after the pandemic period. And we have seen surprisingly strong numbers—353,000 the most recent report. So the labor market just continues to hum along.

Brent: Defying all odds.

Phil: Defying all odds. If you look into last year, this was really what supported the economy, right? We are a consumer economy. People have jobs. They're going to spend what they make. This has certainly been a surprise to the upside and great to see. We have seen layoff announcements, but the truth is things like initial jobless claims—we just got some fresh data on that—still very low. So right now it is not hitting the economy as a whole. This strong labor market, though, Brent, is starting to support wages.

Brent: Yeah, and certainly a key driver of consumption. And we've talked about this numerous times. We are a consumption-driven economy. So as goes our consumer, as goes our economy. And you can see wage growth, when we look at average hourly earnings—now up to 4.5%. So we had kind of bottomed out around 4.3%, and it kind of started to move higher. I mean, we are 50% above the long-term average on wage growth. So, not only are we seeing wage growth move higher kind of taking it back to what you just said earlier. From a real wage perspective, not only are consumers seeing wage growth, they're seeing real wage growth, which is certainly important.

Phil: And they were not when inflation was running at 9%.

Brent: Correct.

Phil: So now this is helping to support consumption.

Brent: Yeah. And when you take that even further and we think about the most important slide to look at from a consumer perspective—we think about consumer expenditures. You know, the gray line here is spending on services. The gold line is spending on goods. We've talked about this before, right? You know, 68% of US real GDP is consumption, another four-ish percent is housing. So again, more than 70-plus-percent of US real GDP is the consumer.

And what you can see, whether it's services spending or goods spending, both running above their long-term averages. And I think it's really interesting when we look at goods, we had hit the low with the two handle, and we've seen a resurgence in year-over-year change in spending on goods. So there seems to be no let up in consumer spending, whether that's services or goods. And as we've talked about before, when I disaggregate total consumer expenditures—more than 70% of total consumer aggregate expenditures is the services side. You can see, you know, while it's trending down, growing at a very significant rate.

Phil: Yeah, a lot of ways we aren't just a consumer economy. We're a services economy.

Brent: That's right. So moving ahead, let's talk about commercial real estate. And you and I have been talking about some of the risks that we see potentially on the horizon in commercial real estate. What we're looking at here is the percentage of commercial real estate loans for banks outside of the top 25. So we just talk about smaller banks.

And you can see the percentage of CRE bank loans, you know, on small banks is an excess of 70%. And when you disaggregate that even further and you look underneath the hood and you think about where we are with rates and the extent to which those CRE bank loans need to be refinanced. You know, more than 2/3 of CRE bank loans—$1.5 trillion of those loans—need to be refinanced by the end of 2025. So the total amount of CRE bank loans held by the small banks continues to rise. And the percentage of those that need to be refinanced against the backdrop of a higher interest rate environment is a really high number.

One of the things that we wanted to show you this month, when you look at the chart on the left, is US major metropolitan areas office vacancy rate. So we're talking about roughly about 79 to 80 major metropolitan areas. And when you look at that number, we're approaching 20% office vacancy rate. And that's, you know, A-rated, B-rated, C-rated in major metro markets, which is one of the highest levels that we've seen in decades.

Phil: Well above even the Great Financial Crisis.

Brent: Yes, which is just incredible to see. So we're seeing that trend in vacancy rates continue to rise, not abate. And when you look at the chart on the right, when you look at year-over-year growth in loan delinquencies on those loans, you can see upwards of almost 80% year-over-year change. There's a little bit of a base effect there to some degree. But by and large, run your eyes, you know, sort of that, you know, right to left. When we see these major spikes, they're either sort of in sniffing distance of a recession or congruent to a recession. So it's something that we are going to continue to keep an eye on and could be one of those things in the broader ecosystem that causes some liquidity issues.

Phil: Yes. Certainly one of the major risks in the marketplace from our view.

So let's turn to markets, Amy. As we flip ahead to the first slide in this section, let's look at just returns by asset class year to date. This is through February 23rd. Much like last year, risk assets are up, but the US is leading, right? Good to see being US investors primarily, but certainly would love to see international start to catch up, whether you're looking at international developed or emerging market. But so far, you are seeing asset classes up in terms of risk assets.

Now you think about fixed income on the right side here. Aggregate fixed income and municipal bonds—both those bars are below the line. Why is that? We'll talk about it in a moment. Rates have risen rapidly—rates go up, price goes down. So after a really good fourth quarter, you are seeing some give up in terms of fixed-income returns. It's still incredibly early in the year, but this is what we're seeing so far.

So let's dig into US equities on the—let's flip back Amy—on the right side, the table here. When you look at US equities uh um it under the hood, essentially. Large-cap growth, much like last year, is the leader—9.8%. But you do see there's positives elsewhere, right? Large blend, mid cap across the board value in both large and mid-up. Small-cap value is down, and that is pulling down the small-cap blend. So yes, large-cap growth is leading, but to say the only thing performing is large-cap growth is really, really just not the case.

Brent: Yeah, and there's some of a give-back, right? If I look at the performance of small-cap value in the last 2 months of 2023—they were up in excess of 20% in 2 months. So again, like we normally see—volatility as we head into a new year.

Phil: As we flip ahead, Amy, on the left side, just a reminder of how far we've come. S&P up 42% from the October 2022 low, up 24% from the October of 2023 low. So to say that some returns might have been pulled forward is a bit of an understatement. And talking to that point of narrowness versus a broad rally—still somewhat narrow on the right side.

S&P 500 year to date up 6.9%. If you equal weight the S&P 500—remember the S&P is cap weighted, so big companies have more of an impact on it. If you equal weight those 500 companies so every company has the same impact—up 2.7% through Friday the 23rd.

So there is a spread there. But again, the point being that things outside of just the largest companies are rallying. They might be trailing, but they are rallying. In fact, if you look at 100 industries in the S&P 500 since October 2022—what, half of them were up more than 20%?

Brent: Right.

Phil: So they might be lagging, but they certainly are up. And just a thing to remember that lagging is not negative.

Brent: Yes, exactly.

Phil: You are seeing positive returns outside of just those largest companies. Of course, we want to see it broaden out more. But we have made some progress.

Brent: Yeah. And keeping with that theme of staying under the hood a little bit and taking a look at sort of the what's led stocks. We've talked about the Magnificent Seven. We've talked about the weight of the top 10 stocks in the S&P 500, which is now more than 31%.

What we're looking at here is when we break down the top 500 stocks in the US and I just simply split them into two categories—either growth or mostly growth, or value or mostly value, right. So kind of, you know, there's no such thing as a core. It's exactly fifty-fifty, right? There's always a little bit of a slant. So the gold line here is growth or mostly growth. And the gray line is value or mostly value.

And what you can see is that the component or the cap distribution of growth stocks or mostly growth stocks hitting almost 80% breakdown and only about twenty-ish-percent in value. And you sort of look at those circles, Phil, the last time we were really here is back where we saw in the late 90s, early 2000s, that TMT—that technology media telecom—bubble, where we had the predominance of growth companies dominating the cap distribution of the top 500 companies. So something that we're certainly watching.

We're not saying that this time around that those companies are exactly like they were back in, you know, 2000 or 1999. But again, the quality of those companies are a little bit different than what we have before, but it's something that we're certainly watching.

So let's talk about and look at the contribution of those top 10 stocks in the top 500 companies. And we're looking here at positive years. And you can see year to date, the contribution of the top 10 stocks in the 500 stocks in the United States—almost two thirds of return contribution coming from those. So a significant contribution. You can see even in 2023—that bar was high. You kind of go back through time and you look at those high bars, you know, 2007, 1998, 1999. So again, eerily similar to periods of time before we had a major downturn as it relates to the contribution of those top 10 stocks and the 500.

Phil: And, you know, something that strikes me, Brent, is absolutely we're at a peaky level now, but when you look through history it is amazing how often the top 10 stocks are, you know, 30% of return, 40% of return. So the idea that 10 stocks are pulling us one way or the other is not that unique—but certainly we are—this is exceptional where we are today.

Brent: So let's talk about corporate earnings and, again, taking the fundamental side of everything that's going on here. We've talked about for a while how 2023 was really a flat year—only seeing growth of about one-percent-ish year-over-year or $220 a share.

The good news is that we saw a bottoming in corporate earnings, you know, in sort of the first two quarters of last year, kind of a reacceleration. Expectations for this year, you can see—10.6% earnings growth for the year, about $243 a share. That's come down a little bit. It was about 11.6% kind of at the end of last year, coming into this year. So analysts are sharpening their pencil a little bit as it relates to corporate earnings, and we're seeing that come down. But 10.6% still above the long-term average of about 7.6%.

And you and I expect that to continue to come down a little bit, but we don't see something like a year like 2023. We do see continued corporate earnings growth and resurgence. When you look at the chart on the right, which is very interesting, Phil, the percentage of stocks that are forecasted to see corporate margin expansion—which is really good, so we're forecasted to see that margin expansion—sitting at almost three quarters of stocks. It is amazing. So, again, this rally that we've seen in equity markets seems to be a pull forward of what we're starting to see in the fundamental data as it relates to corporate earnings, corporate margin growth, et cetera.

Phil: And you look at that chart on the right and you think to yourself, "Well, no wonder CEO confidence is rising." I mean, three quarters of companies are expecting margin expansion, which there's a lot of argument that it's not earnings growth that matters. It's margin expansion that matters more for the market. This is good news and certainly feeding into that Goldilocks scenario.

Brent: Exactly.

Phil: As we flip ahead to the price-to-earnings ratio for the S&P 500—this is next 12 months. As a reminder, this is estimated earnings, right? So it's what are you willing to pay for a dollar of earnings? So when this is high, the market's viewed as expensive. When it is low, the market is viewed as cheap. Now, that does not mean it tells you where the market's going tomorrow.

Brent: That's right.

Phil: But what it does show, and you can see here north of 20 times in terms of the multiple, more than one standard deviation above—it's not a cheap market.

Brent: That's right.

Phil: That is not something you can argue. Now, what we need is earnings to actually grow.

Brent: That's right.

Phil: And maybe even outperform. And that'll make the market seem more affordable. But just something to think about. And as you turn to the next slide—that north of 20 times starts to matter.

Brent: That's right.

Phil: So this is average for 12-month return by PE ratio, essentially, from 1950. And what you'll notice is a few things. One, all these bars are positive. So this is not fear mongering. The truth is the market goes up more than it goes down. But you'll notice that the lowest bar is north of 20 times in terms of forward 12-month return.

When the market's expensive, on average, you should expect less returns. Now, if you look at how much we've rallied since last October—

Brent: Yes.

Phil: Well, the truth is a lot of the good news might be in.

Brent: That's right.

Phil: So expecting this rocket ship to continue, I hope, but may not be the base case. So speaking to that point, let's talk to our price target. Our base case is 4,850. We set this in December. When we set this, that was up, what, mid-single digits from where the market was trading. And here we are, double-digit percentage points higher, and it's actually down from where we are. That does not mean we are bears. We tend to update our price target quarterly. We'll be looking at this in next month's video.

The truth might be that there's a reason we have a bull case at 5,500. The truth might be that the answer is somewhere between that base case and bull case. This is why we have a bear, base and bull when we outline it. When we outlined this, our view was that the bull case was Goldilocks. And if Goldilocks is playing out, then closer to that starts to make more sense. The base case was more of a landing of some sort. It might have been a soft-ish landing. But the truth is, if fundamentals have improved over the last few months, we have to face that. And that is where we stand today.

Brent: Yeah. And it's going to really matter where corporate earnings come in, right? So expectations, as we just covered, are double digit, which is a lofty expectation relative to history, relative to where we were last year, the same time the year before. So again, we'll have to see what it actually looks like. But again, when we will look at the slide that you had on multiples, if we get another 3.9% over the next 12 months geometrically linked to where we've been—I think consumers and investors will be pretty happy with those returns.

Phil: Yeah. So let's talk about what's on everybody's mind, the election. Here we are showing the presidential cycle average S&P 500 return all the way back to 1937 by year. So the first year of a term, second, third, and fourth year. For new presidents—we're in a new presidential, President Biden is a first-term president. Fourth-year return, which is what we're in, tends to be pretty positive.

And the thinking there, if you listen to experts is—well, that president's going to do everything they can to support the economy and thereby support markets. Reelected president, in other words, second term, the return is basically flat, negative 0.1. And the idea being, well, that president is about to go on vacation and may not be as concerned. The facts are the facts. You can see them here. We have some skepticism of data like this because it's pretty small sample size. Also, I would point out that in that reelected, that 0% return, that equals 2008, which is the Great Financial Crisis, and 2000, which was the beginning of the end of the tech bubble. Neither of those really have much to do with the presidential cycle. So that swings data around. But when you hear about presidential election years tend to be pretty good for markets, the truth is it's actually first term, which is what we're in. And so far, the market is up, which is always good to see.

Brent: And I think like look back at that year one, so as we fast forward and everyone's sort of already moving past this year, which is sort of ironic. We're only 2 months in and everyone's already thinking about what's going to happen post the election. If you look at that year one, whether I look at reelected or new, I think any of us would take 4.3% or 7% in 2025.

Phil: Given the rally we've already had. It doesn't mean the election doesn't matter. It does. There's a lot of policies that are going to have sector-specific impacts. But to say that there's an easy playbook is probably a little naive.

Brent: Yeah. So let's shift gears, Phil, and let's talk about fixed income. To say that we've had fixed-income volatility and rates volatility is certainly an understatement. What we're looking at here is the Treasury yield curve. And you can see the gray line here is as of the end of last year. The gold line here is at roughly the end of this month, February 28th. And what you can see is—specifically within, sort of, that belly of the curve—as expectations in November and December of last year for that first Fed cut and expectations that yields were going to fall, right? Sorry, yeah, yields will fall. Basically, we kind of had, you know, prices pull forward and the returns that we saw in taxable bonds and municipal bonds were, you know, 8-9% in November and December. And what we've seen is really that yield curve just sort of popped back to, sort of, that September, October yield level. So obviously within sort of that 3 years to 10 years, we've seen yields rise back up to a level that was more congruent back then. So again, a lot of volatility as it relates to expectations for the number of cuts and the timing of cuts. And we don't think that this is going to stop anytime soon. It's going to be present most of this year.

Phil: It's all about the Fed, right? If you think the Fed's going to cut later and fewer times, if you look at the 3-year, well, then your 3-year average rate of those 3 years should be higher. And that's why we're seeing that move.

Brent: But let's put this into perspective on the next slide. We've covered this slide a number of times in our WebExes. And if you look at sort of that 12/31 of 2021 column when yields across the board, across all fixed-income areas were quite sanguine, pretty low. We've certainly seen yields rise. And when you think and you kind of go down that list and you look at, let's say, the US Aggregate Bond Index sitting at almost a 5% yield-to-worst.

You know, you've got a high yield, almost 8%. Municipal is 3.4%. You tax adjust that. You're in the high- to mid-fives, almost 6%, depending on your tax bracket. So the purchase yield or yield-to-worst, which is a pretty good prognosticator of what your returns will be over that duration horizon, are still very, very attractive, especially when you combine that with what we discussed on the last WebEx, which is sort of that forward expectation for equities being a little bit more muted, decent, but around 7%.

If my starting point or yield-to-worst for fixed income is around that four-and-a-half to five, you have a much tighter range in expectations between both fixed income and equities. So again, more balanced portfolio approach over the next decade might be better than where we were—where the decade that ended 12/31 of 2021 saw a huge spread between stocks and bonds.

On the next slide, if we break it down and look at just credit across the board, the gold line here is high yield spreads over Treasuries. The gray line here is investment grade spreads over Treasuries. Again, incredibly tight. And I would argue when you look at investment grade spreads, sitting at about 128 basis points over Treasuries. Roughly kind of average spread when I go back and look at average spreads going back to 2011. High yields sitting at about 366 basis points over Treasuries. Again, roughly average, a little bit below average to the spreads that we've seen on average since 2011. So we haven't seen any type of real issues underneath the hood in both investment grade and some investment grade credit.

Phil: And certainly fixed income people will certainly tell you this, but there's a belief that fixed income sees the issues before the equity market, maybe. And at least to this point, spreads should be higher if there's trouble coming. So either the market's not looking forward very well or certainly a better scenario is playing out.

So as we flip ahead, one of the top questions we get, I get when we're on the road, is government finances. As you can see on the left side, federal debt as a percentage of GDP. We're back at 100% and moving higher. That's back to World War II levels. Pretty incredible. And you can see it's been something that has accelerated in recent years, but been a problem for some time.

And on the right side—this couldn't have come at a worse time for the government as a borrower. Rates have risen, as we just spoke, in recent years. What does that do? Well, that pushes up your net interest cost. Net interest cost is percentage of tax revenues in gold here. And it pushes up your weighted average cost of maturities. As bonds mature at a very low rate than that you issued them at and now you have to reissue—well, it's becoming more expensive.

So we have an issue that is not really sustainable. Chairman Powell recently has pointed that out. Something has to give. There's no easy answers because it's either revenue or expenses or both. But the truth is—government finances are certainly becoming something more in focus in terms of our clients. It's something we're watching. I think I actually see we have a question on that. So a little bit more on that in a moment as well.

From a geopolitical standpoint, this is another question we get essentially every time we speak—China and Taiwan, Ukraine and Russia, Israel and Hamas. There's so much facing us. Why would I invest any assets? As recent months have reminded us, the market is more resilient than we give it credit in terms of geopolitical events.

Here we're showing geopolitical events all the way back to World War II. And what you'll notice is in this third column here, the time to the bottom on average is only 16 days. That's 3 weeks, right? The time to recover that bottom is 16 days. That's 3 weeks. And this includes things like major wars—big issues, oil embargoes, you name it. So the truth is the market's very quickly going to move to fundamentals, right? And just as it is today, geopolitical events are terrible. They pull at the heartstrings. But pretty quickly, the market's going to turn to company earnings and things like corporate margins and the multiple you're willing to pay for those margins. So with that, I'll pause, Amy, and let you discuss some of our content.

Amy: Yeah, Brent, Phil, thank you so much for taking that deep dive into bonds and equity markets. As you said, Phil, we have a ton of market- and economic-related material available. You can visit FirstCitizens.com/wealth and get subscribed. You can also go there to submit questions if you'd like for us to be sure and cover something on a future publication. And you can use the QR code on the screen or visit FirstCitizens.com/wealth.

So, as you alluded to, Phil, we do have a number of questions and the first one—let's go ahead and hit the one you mentioned. Considering the deficit, at what point do higher interest rates on government debt become a headwind for markets?

Phil: Yeah. Yeah, it's a great question. And the question—if I could turn the question just a little bit—is do deficits have impacts on markets? And look, the economic answer is that excess government debt crowds out private investments and it hurts potential growth of the economy, right? That's a very textbook answer for you, but it makes some sense. If it hurts potential growth, well, that feeds into earnings and it's going to impact markets.

The truth is things like government deficits, I've done this for about 20 years, I've been asked about it for 20 years—and 20 years ago, by the way, in hindsight things look pretty great—but the truth is people were worried then as well because we consistently ran deficits. The short answer is most of this is not very tradable, right? How do you make a short-term, 1-year, even 3- or 5- year trade on something like this?

But the longer term answer is that, yes, it has an impact. You could argue that some of the higher rates in the Treasury market have to do with the fact that government finances are just worse now. Right? The biggest answer, of course, is inflation, wage inflation, but maybe part of it is in there. So higher rates, of course, lead to lower growth, which should impact the equity market. But if you were worried about deficits in the 80s—can you imagine if you did not buy the stock market in the 80s, right, because you were worried about deficits? So it's one of those things. It's a longer term structural concern that the government has to address. How does it impact markets in the short term? Fairly minimally. Markets look right through it.

Brent: Yeah, and I might add that, you know, certainly the US dollar has been the reserve currency of the world. And certainly US Treasuries have at least historically been, sort of, that safety play store of value. And I would say a reflection of the underlying credit quality of our sovereign nation is reflected in the Treasury yield curve that I just covered. And it's certainly something to monitor. And to your point, maybe we stick with higher yields for a longer period of time because somewhat implicit or embedded in there is the underlying credit quality or debt situation. But, so time will tell. While yields have historically fallen in significant degree post that first Fed rate cut—maybe this time around they don't fall as much. But, you know, time will certainly tell.

Amy: Brent, can you discuss duration and investing in bonds now versus after the perceived first rate cut from the Fed and what that might look like from a price-to-rate perspective?

Brent: Yeah. And this is something that I think we put together in one of our write-ups. We looked at the starting yield for fixed income. We'll call that yield-to-worst, which is nothing more than yield-to-maturity adjusted for the optionality of bonds that get called, et cetera. But that's sort of your starting yield, right? When you think about that over the duration horizon of either a bond—or let's say an index of bonds, right?

So first of all, I would say in aggregate, if I take something simple like the US Aggregate Bond Index, the duration of that index has extended materially over the last number of years, over the last number of decades, almost doubling. Right now, we're sitting at a duration for taxable US bonds. The Bloomberg Barclays US Aggregate Bond Index has a duration of roughly about 6.3 years and a current yield-to-worst right below 5%. And when we did that research, we said, "Okay, when I look at that starting yield-to-worst over its duration horizon, on average, what has the total return capture been of that starting yield?" And on average, it's been about 110% of that starting yield-to-worst.

So an investor could potentially expect that starting yield-to-worst of about 4.92%. over the duration horizon of about 6.27 years, I think that's where we are right now, you would, again, historically have captured about 110% of that starting value. So again.

Phil: But it takes 6 years, right?

Brent: Right, that's not next year, it's not next quarter.

Brent: But again, once the Fed starts cutting rates, and it was very interesting, if I go back to the press conference at the last meeting, one of the things that was asked—and one of the things that Jay Powell responded on—was that the Fed is very, very conscious of that first rate cut because of the impact on financial markets. And Jay Powell and the FOMC know very specifically that, at least historically, after they make that first cut, the probability or the chances of them hiking rates again is a low probability, right?

So markets will likely, potentially pull forward that information. And you'll see that reflected in lower yields after that first rate cut and potentially higher bond prices. But again, the magnitude of that is variable. But by and large, usually that first rate cut would signal a change in cycle and see prices move up in fixed income potentially and yields go forward. So again, depending on where you are as it relates to your investments, whether that's cash or where you are on the yield curve can matter greatly. And it's something certainly that our strategists and our advisors are talking to clients about. Very important.

Amy: Phil, one thing that's pretty consistently in the news these days is the commercial real estate situation. And no surprise, we got a couple of questions on it. Still hearing a lot about the impact of commercial real estate in the US. Why is CRE garnering so much attention? Is it some sort of linchpin or keystone indicator for the overall economy?

Phil: Yeah, it's a great question. So one, in markets and for investors like ourselves, there's two types of risks—known and unknown, right. The unknown are the ones that sneak up on you. It could be geopolitical, for example. This is a known risk. This has been widely covered in the press and certainly by research institutions. But it's a risk nonetheless.

I won't hammer home the point, but obviously the smaller banks are exposed, and you're seeing vacancy rates and things like office rise and delinquency year-on-year rise. Additionally, it's not just office. If you look at losses in terms of value, Green Street price index, for example, apartment values are down from the peak. The truth is when rates go up, commercial property is just worth less because it costs more to finance it, not to mention the issues with vacancy and office, et cetera.

Is it a keystone? Look, you can look back in history and see crises that started in the real estate sector. The Great Financial Crisis was residential. You had the SNL crisis. Does it always start in commercial? Not necessarily. It might be residential as well. Residential property is very healthy, but it is a risk because it can impact the financial sector. And in a capitalistic society, the financial sector—lending is so important that if it tightens up lending, it can drive you towards an economic slowdown.

So I do think it's important. It's the reason we basically talk about it every month. I don't give a presentation which I don't mention commercial real estate because it's something that we cannot take our eye off the ball. $1.5 trillion of loans are coming due by the end of 2025. So it is something we think is important. Is it the only thing that matters? Of course not. Of course not. There's a lot of positives that we've talked about today, but it is a real risk out there.

Brent: Yeah. And I think one point that I think is worth mentioning is that when I look at banks outside the top 25—they tend to be the largest lenders to small- and medium-sized businesses in America. So if you were to see any type of liquidity issues or lack of ability or willingness to lend because of what's going on on CRE and the extent to which they have and potential price impairment. That could affect the ability for small- to medium-sized businesses in this country to get the lending that they need. So it's sort of a, could be a cascading effect that goes through small-, medium-sized businesses. That could be a risk as well.

Amy: Brent, the S&P 500 seemed to be driven by just a handful of stocks in 2023. And from what this person can tell, it seems like that rally is even more narrow this year. Is there more to this rally than meets the eye? Or is this upswing really just beholden to a few companies?

Brent: Yeah. So I think the first thing to just pause on and reflect on is—feel good. When Phil covered the slide, we're up 42% from the October 12th low, right? And you think about where we are—as I kind of covered in the opening—over the last 4 months, basically from Halloween of last year to last night, February 28th, the S&P 500 is up 21.5%. The Russell 3000, which is a broader gauge of US stocks, is up almost exactly 22%, right? The long-term return for US stocks is 9.6%. So we've effectively pulled forward more than 2 years of returns in a 4 month period of time.

And this is why when we talk about returns, when we talk about financial planning, and we talk about, hey, the average return is 9.6%—you rarely ever get that return in a given year. High highs and low lows work out to an average, and we're seeing that play out. But the concept of few stocks driving returns for US equities is absolutely and unequivocally not a new thing.

If you go back and look at the disaggregation of what's driven returns in stocks over the last hundred years, you know, we've had a handful of stocks that are responsible for the returns of US equities over the last hundred years. So while you talked about, you know, broadening out and we certainly are not seeing no returns in the other 490 stocks in the S&P 500, we just have a handful of stocks that have been dominating returns. Time will tell whether or not that will continue. By and large, usually we see cyclically those top 10 stocks when they have outsized returns start to wane a little bit and give back. It's a very ebb and flow. But this concept of, well, the top 10 stocks driving returns or a narrow set of stocks driving returns in equity markets is a new thing. It's unequivocally not true.

Phil: And it is a reminder of the importance of diversification because those stocks that pulled us higher through the last hundred years have changed through time dramatically. We can all go back in mind and think of names that were pulling us higher in the 80s or 90s or even before. So it's an argument for diversification that you want to own a broad set of stocks because those stocks can change through time.

Brent: Absolutely.

Amy: Well, Brent, Phil, thank you both so very much for answering questions. And to our audience, on behalf of all of us here at First Citizens, thank you so much for trusting us to bring you this information. That trust is something that we never take for granted. We will be back again next month to share a similar market update with some new data points to share with you. In the meantime, please submit your questions at FirstCitizens.com, and we will see you back here next month. Thanks, everyone.

Making Sense Outro Slide

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