Making Sense: March Market Update

Amy: Hello, everyone. I'm Amy Thomas, a strategist here at First Citizens Bank. I'm joined today by Brent Ciliano, our Chief Investment Officer, and Phil Neuhart, Director of Market and Economic Research. Today is Wednesday, March 27, 2024, and I want to welcome you to our monthly Making Sense: Market Update series.

We received a number of questions for Brent and Phil on our Market Outlook page on FirstCitizens.com, and we will answer as many as possible during today's 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 Brent, with that, I'll turn it over to you.

Brent: Great. Well, thank you, Amy, and good afternoon, everyone. Hope all of you are well. Well, Phil, we are a quarter of the way through 2024. S&P 500 is up 9.5%, annualizing at more than 45% year to date. We have three North Carolina teams in the Sweet 16. So my question to you is, do you have higher conviction in your team getting to the Final Four or the S&P continuing to rise?

Phil: Oh, gosh. Well, I wasn't prepared for this. I'll say S&P. I wish I had a little more conviction in my beloved Blue Devils than I do right now. And S&P's got a lot of momentum.

Brent: Excellent. So why don't we jump right in? And we're going to certainly cover that and then some, not basketball, but the S&P 500. So, as we normally do, we're going to give you an economic update. I think this month we're going to be talking about an update on where US growth expectations are. We'll talk about monetary policy. We'll talk about inflation. We can't get away from talking about inflation. We'll talk about the labor market and certainly corporate earnings and profitability, as well as consumers and spending. We'll talk about equity markets, fixed-income markets, and maybe a little bit about the election.

Phil: Great.

Brent: So why don't we jump right in, Amy, and get to the economic update, and let's start with growth. And interestingly enough, Phil, expectations for growth in the United States keep rising—sitting at 2.2% for fiscal 2024. Interestingly enough, a little bit of perspective, 6 months ago, consensus expectations for growth this year was sitting at only 0.9%. Even in January of this year, we were sitting at 1.2%. But economic momentum continues, and consensus is now upwards of 2.2%.

Phil: Yeah, soft landing is starting to really enter the numbers. Maybe no landing.

Brent: Right, right. It's almost becoming consensus.

Phil: That's become the debate.

Brent: Absolutely. So interestingly enough, when you look across the board, the US is doing better than the rest of the world. So you've seen some modest improvement in the Euro area. And specifically in Japan, we've seen a little bit of a come down, by and large, similar in emerging markets with China. But by and large, at least in the United States, the economic momentum is propelling expectations higher. And we'll have to see what that actually looks like.

So the next slide, Amy, let's get under the hood a little bit and let's bifurcate US economic growth between manufacturing and services here. On the gold line, we are looking at ISM manufacturing. Gray line, we're looking at services. And Phil, we've covered this on numerous WebExes. Obviously, economic momentum is, in fact, moderating from the multi-decade highs that we saw back in 2021. But what you can see is—looking at the gold line first and looking at manufacturing—it looks like we've seen, knock on wood, a little bit of a bottom in manufacturing in mid June of 2023. And momentum is maybe starting to shift to that of a recovery. We'll have to see.

We get data prints on both ISM manufacturing and ISM services next week, the week of April 1st. And we'll have to see. On the services side, which is a bigger driver of overall US economic activity, services remains in expansionary territory. Remember, readings above 50.0 is expansionary territory and below 50 is contractionary territory, and services continues to plow along at expansion.

Phil: Yeah, if you look at last year and the economy really outperforming expectations, of course, the labor market is the underlying driver. It was the service economy that saved us from recession last year.

Brent: Absolutely. And interestingly, you know, the thing that's been driving everyone's view on economic activity is certainly monetary policy. And what we're looking at here is all Fed hiking cycles post 1982. The gold line, as we've talked about many times already, is this cycle. So you're looking at the most significant monetary policy actions in more than 40 years. The Fed has been on pause since July of last year, and everyone is wondering, market participants included, when will the Fed start to cut rates.

And we've talked about this before, but right now, fed fund futures are pricing in a 70% probability of the first cut—25 basis point cut—in June at the June meeting on June 12th. Overall for fiscal 2024, we are still looking at that three to four cuts for this year and sort of an ending Fed funds rate of about 4.5%. We've been saying for many, many months that we believe it's probably more in that two to three cuts this year. You and I might have a bet over a coffee as to where that might be. I'm probably more in the one to two. Maybe you're more in the two to three.

Phil: Two to three, yeah. And what's amazing when you think about the moves and yields this year that we'll talk about later is that this expectation of Fed moves has just changed dramatically. Early in the year, it was basically a slam dunk according to futures that the Fed would cut in March. So we had that March meeting, they did not move. And the belief was they could cut seven times, potentially eight times this year. We were always very skeptical that. Futures have really come closer to where we are. And the truth is that the fact that stock market has performed well, even as the number of cuts has come down, the potential of cuts, that's a good sign in the marketplace and really shows just how much momentum the stock market has had.

So as we flip ahead, I mentioned we just had a Fed meeting—the March meeting—we want to talk to, of course, the fed funds rate is the gray line here. You can see, of course, the rapid rise in the fed funds as we talked about last slide. But I also want to talk about the Fed's own forecast. They have something called the Summary of Economic Projections in which Fed officials predict everything from growth to unemployment, inflation, and the fed funds rate.

And what you'll see here is in the March meeting, which is the gold bar versus their last forecast, which was December in the green line here, you'll notice that first of all, their end-of-this-year expectation for the fed funds rate was unchanged. The median of dots moved around, right? It's a close call, but you did have no change there. But you do see that the fed funds rate expectation for both 2025 and 2026 rose. In other words, this feeling in the marketplace, the Fed might be a little bit more hawkish than expected a few months ago, is starting to show in their own forecast. Not a major move. It's why I think the market moved very quickly past the Fed meeting, but a move nonetheless.

So why is the Fed so aggressive, as we flip ahead? It's been all about inflation. We are so tired of showing this chart. And I hope one day it goes to 2%, and we can just never show it again. But as a reminder, this is really what is driving everything. So if you're worried about the Fed, really what you're worried about is inflation. And inflation peaked at 9.1% in 2022. We are now sitting at 3.2%. That is pretty remarkable improvement. Very fast. But as you'll notice, that gold line has started to move kind of sideways. It is difficult to get from three to, say, two. Getting from nine to three, just base effects alone make that easier. And core inflation, which excludes food and headline, exceeds headline inflation. I'm sorry, excludes food and energy, exceeds headline inflation, is at 3.8%.

Brent: Yes.

Phil: That is problematic, right? So that is why we have not thought the Fed would cut really aggressively this year. They have some ability to cut moderately because inflation has come down, but not overly aggressively.

So what are companies saying? That is the economic data. What are companies saying in their own earnings reports? This is S&P 500. We have a transcript analyzer. One of our vendors does. And just searching for the word inflation. So you look at quarterly reports. What are C Suites saying? And you'll notice, you know, post-January-2022, inflation unbelievably a hot topic. I mean, literally thousands of mentions. That has fallen, still elevated compared to the average pre-pandemic. But this is also seen in things like company margins starting to expand.

Companies are adjusting. They're not talking as much about inflation. It does not mean it does not matter for them. It does.

Brent: It does, for sure.

Phil: But much like supply chains, companies in the US—we are amazing in the United States at adjusting. And we'll talk margins in a moment, but clearly companies are moving past inflation being this unbelievable headwind for them. They have adjusted.

So where might inflation go? We're back to economist consensus. So the degree to which you trust economists will sway your view of this chart. But you can see the estimates on the right side. This is just quarterly estimates of year-on-year CPI, Consumer Price Index. You'll notice at the year end of this year, the expectation is 2.5%. So, if you say, "Well, how can the Fed cut?" Well, the fed funds rate top ends 5.5%. If they're at 2.5% sometime third quarter, fourth quarter, or they're moving that direction even sooner, then you have a real rate that's 3%. Do they need a 3% real rate? So it's not that the Fed has to get to that 2% target, it's they need to get to something closer. We've actually got some questions on that. We'll dig into that more in a moment in terms of their target. But moderation is what we need to see. Seeing a two handle on inflation for CPI would be a great thing.

Brent: Yeah, and I think it's very interesting, and I think certainly the Fed is certainly a student of history and certainly they're concerned about the potential for rolling inflation like we saw in the 70s and 80s. And if you go back, and if you think about, you normalize long-term inflation, and I get rid of the craziness that we saw in the late 70s early 80s, and I kind of look at that trough around 1983 all the way through now—inflation's actually averaged 2.9%, right? So just because the last 20 years or so average about 1.9% doesn't necessarily mean that we are going to immediately go back to 2%. That last mile, as you said, very nicely, Phil, could take a long time, and maybe we never actually get back to 2%. Maybe it's 2.25%, maybe 2.5%. We'll have to wait and see.

Phil: 2% flat could be aspirational.

Brent: Absolutely. Absolutely. So let's talk about one pillar of stability and resiliency that we've seen for many, many quarters. And that's certainly the US labor market. Looking at February data, we saw that the US created about 275,000 jobs in February, so another strong month. The consensus expectations were for 200,000, so a beat there. And even though we saw some material revisions, Phil, in the January data, we had that blowout 353,000 jobs.

Phil: Which always looked a little suspicious, honestly.

Brent: Looked suspicious, right? Got revised back down to about 229,000. So again, significant of material revision downward—was still above the 185,000 jobs that was expected. So it was still a beat, just not as momentous as the 353,000.

Broad momentum in the labor market still remains strong. You can see 6-month moving average—231,000 jobs. And yes, U3 unemployment has ticked up to 3.9% from the low that we saw at 3.4% back in April of last year. But, by and large, the labor market is resilient. And when you look at jobless claims and continuing claims, we're relatively sanguine. We're not seeing this upward momentum in job losses. So, by and large, the labor market is still fundamentally resilient.

Phil: And participation among prime age workers continues to remain solid compared to even pre-pandemic levels. There's a lot of evidence that the labor market remains quite tight.

Brent: Absolutely. One of the byproducts of obviously a strong labor market on the next slide, Amy, is wages. And certainly, you know, wage growth has kind of been between 4 to 5% for quite a long time. Right now, average hourly earnings tracking at about 4.3% year over year, materially above the long-term average of 3%.

Phil: And this is really a good thing for the consumer because it means wage inflation is above CPI, above price inflation, but it is a challenge for the Fed because the Fed knows that wage inflation finds its way into prices.

Brent: I was just going to say that. And when you look at something like the New York Fed trend wage tracker, which is sort of a new measure that they have, trend wage growth is about 5%. So it's certainly in the back of their mind that the inflationary pressures as it relates to wages, which is obviously a significant component of corporate expenditures, remains high. Good for the consumers, maybe difficult for companies, also basically difficult for inflation.

So bringing this home as it relates to the consumer and spending, obviously we've said many, many times when I disaggregate US Real GDP—more than 68% of US Real GDP is consumption, another 4% is housing. So roughly about 72% of our economy is the consumer. So as goes the consumer, as goes our economy. What we're looking at here is spending on goods. Gray line is spending on services. And what you can see is we had a soft retail sales data in January, just an okay holiday season. And you can see spending on goods has come down materially. This used to have a two and a three handle. I think last month it was almost a three handle. And that's come down to about a 1%, which is materially above the 20-year average.

The good news is that spending on services continues to have that six handle year over year—6.33% materially above the 20-year average. And again, when I disaggregate total consumption, more than 75% of all consumption is spending on services. So again, a driver of both growth and inflation is spending on services, and it's remarkably resilient.

Phil: Right, that's right. So that's the economy. Let's turn to markets for a moment and what we're seeing. So as we flip ahead, total returns by asset class year to date on the left side, US equities have really been the leader in the clubhouse. You see a lot of positives on the equity side, whether it's developed or emerging, US equities have outperformed. That is a continuation of a trend we have seen by and large—with exceptions, of course—but by and large since the financial crisis. Not necessarily something you see if you look further back, but that has been the trend over the last cycle and a half.

Aggregate fixed income on the right side, down and municipal bonds down in total return terms. Just to be clear, if you hold the bond to maturity, it's just a marked market, but why would that be? It's because we have seen interest rates rise rapidly.

Brent: That's right.

Phil: And we'll talk about that more in a moment. Rates go up, price goes down. It does not mean that fixed income is not still attractive from a yield perspective. So let's dig into US equities on the right side. What is performing? What is not? Well, large-cap growth—and we'll talk more about market breadth in a moment—large-cap growth is absolutely the leader, right? You think about, well, just select stocks within the Magnificent Seven, not all of them, and some others within the growth space.

But other parts of the market are participating. Look at large value, look at mid-cap. Small-cap's up. Really small-cap value is the only thing that's down, and it's basically flat on the year. So to say that there's only a few stocks that are performing, that's inaccurate. There's a few stocks that might be pulling us higher. But the truth is we are seeing some pretty wide-ranging gains in the stock market.

So let's talk a little bit more about the US stock market on the next slide. One, a reminder, since October of 2022, we have rallied 46%—and counting, by the way. Since last October, roughly Halloween, that low we had last year, up 27%. So we have come a long ways. Think about this. We're updating our price target this month. Keep this in mind in a few slides when we talk about price target.

So let's talk about market breadth on the right side. Market breadth is a fancy word. People like us like to use a fancy phrase, which basically just means—are there other stocks performing outside the big boys, right? So if you look year to date, and you look at the S&P 500 as a cap-weight index, that means the largest companies have more of an impact than the smaller companies in the S&P 500. That index through March 22nd up 10.1% in total return terms, that includes dividends. Equal weight, which means all 500 companies have the exact same impact, right? In other words, a small company impacts just as much as a big company, up 6.1—up, but trailing, trailing by about 4%.

What's interesting is a lot of that spread happened very early in the year. If you look at this same analysis, but from February 2nd through March 22nd, they're on top of each other in the lower right. S&P at 5.82%, S&P equal weighted, technically outperforming, 5.83—0.01% outperformance. So the breadth, it's not every day, right? But if you look on trend, breadth has improved in the market. This is really good news and something we talked about a lot last year, if this were to continue.

Brent: Yeah. And we'll talk about this when we get to corporate earnings, but it's going to be very interesting. Historically, the S&P 500 has bottomed 6 to 9 months before earnings bottom. And it's interesting that the bottom that we saw in October 12th of 2022 just so happens to coincide to that 6 to 9 months to where we had that earnings recession. So it's very interesting that at least historically, the market is moving very, very much in lockstep to what we've seen historically as it relates to past.

Phil: That's right. It's been fairly forward-looking the last few years. 2021 sold down, looking ahead to muted earnings 2022. Last year up, looking ahead to what looks like it's going to be a good earnings year in 2024.

So let's flip ahead. You might have heard it's an election year. We are required every month this year to talk the election. A few things. This is a new slide showing some stuff we've shown in the past, but just in a different way.

One, this is the S&P 500 total returns in election years with an incumbent president. We have an incumbent president. What you'll see is going back to 1944, every year it's been up. There is variability. The average is 15.8%, but you're ranging from 5.5% to 32.4%. And of course, so far this year, we are up. What is the belief behind this? If you listen to sort of policy analysts, the thinking is, well, an incumbent is going to do what they can to boost the economy for reelection, whereas a second term president is not nearly as concerned. They're thinking about their presidential library, right? So that's the thinking.

The caveat we always give, though, just remember there's other things happening in the world in election years. A couple examples—the year 2000 was the beginning of the tech bubble—that was election year. 2008 was an election year—that was the Great Financial Crisis. 2020—we had a pandemic. So there's other things that happen in the world. The market's going to turn to fundamentals pretty quickly. It's not that elections aren't important. It's that markets don't necessarily care about our feelings, right? Whether we like the president or not, they're going to return to fundamentals fairly quickly. So it matters. Just don't—there's a reason you don't see hedge funds that their one strategy is elections. Because it's not the only thing that matters.

Brent: That's right. So let's continue on that theme of fundamentals, and let's talk about corporate earnings and profitability. 2023, Phil, was a very flat year for corporate earnings—basically growth of about 0.9%. We had an earnings recession in the first half of 2023. Where are we right now?

Well, consensus expectations, bottom-up, right? Analysts looking at each individual company, putting in their forecast, looking at about almost 11% growth for this year—$244 a share. That's been highly variable. We probably believe that maybe analysts will continue to sharpen their pencil as we get into this year. Earnings season is going to start. Sorry, first quarter earnings are going to be coming in not too distant future in the next couple of weeks. By and large, we think that that number might be coming down.

But again, 11% earnings growth in a year compared to the long-term average of about 7.5%—robust. Looking at 2025, very interesting. $276 a share of almost 13.3% growth. Again, so, maybe some of the pull forward that we saw in the S&P 500 in November and December of last year was looking ahead. As we always say, equity markets are an expectational pricing mechanism. They bid themselves up and down in anticipation of what's to come, not what's actually transpiring, whether that's what's going on in the markets or in the economy. And by and large, you can see that the corporate earnings picture for this year and next year is quite robust.

On the right-hand side, you can look at the next 12 months S&P 500 operating margins—sitting at almost 17%. If you normalize and get rid of that little hump coming out of the COVID pandemic, we're at the highest level for next 12-month operating margins going all the way back to 2008. So again, robust operating margins, expectations for corporate earnings and profitability remains robust. So at least there's some fundamental legs underneath what's going on in this equity market momentum.

Phil: Yeah, but there's one thing that—you think about the degree which the market has outperformed really all expectations over the last year and a quarter or so—that margin photo, I think, or graph is really important, right? We knew that margins when money was very easy, fiscal stimulus, monetary stimulus, that those margins were a little artificial coming out of the pandemic. We knew they had to come down. They did. Seeing that swing up really is important.

Brent: It really is. It really is. So let's talk about something. And we put in a new slide, and we want to talk about valuations. And you had mentioned the Magnificent Seven and what they've actually done. What we're looking at here is the forward P/E ratio, next 12-months P/E ratio. And what that means in English, Phil, is what an investor is willing to pay for a dollar of earnings over the next 12 months.

And what we're looking at here is that while certainly the Magnificent Seven in price has gone up significantly—the P/E ratio over the next 12 months is just about average. And then we're going back almost a decade, and you can see the P/E ratio is roughly about 28 times for the Magnificent Seven. Again, high relative to the S&P 500, but relative to this group, certainly have seen much higher forward earnings ratios for this Magnificent Seven.

Phil: Yeah, when we pulled this data, I honestly was surprised just how muted it is compared to sort of the 2021-, 2022-type timeframe. It just shows that there are companies in the Magnificent Seven, they're making a lot of money, right? So the denominator of price to earnings is high and growing.

Brent: Yeah, and very, very different than the technology, media and telecom bubble that we had in 2000, 2002 where you didn't have the same degree of earnings, revenues and profitability.

Phil: Balance sheets.

Brent: Yeah, balance sheets. Much, much different tech stack today than we had back in 2000.

Phil: Especially on the biggest names.

Brent: Absolutely. So let's talk about forward valuations on the next slide—thank you, Amy—for the S&P 500 in aggregate. Again, we're looking at the next 12-months P/E ratio—what market participants are willing to pay for a dollar of next 12-months earnings—for the entire basket of the S&P 500. You can see the average is about 15.8 times forward earnings. And you can see right now we're trading at about 21.4 times forward earnings. So we're a little bit more than one standard deviation expensive. So in aggregate terms, the S&P 500 from a forward valuation perspective is a bit expensive.

But again, you've seen periods of time where we've had melt-ups to where we've been, you know, 22, 23, 24 times forward earnings before earnings started to contract. So folks fearing that maybe the momentum might slow—there's a possibility for that, but we've seen higher forward valuations in previous run ups.

Phil: And it's a reminder that we need earnings to come through. You need earnings to justify this multiple. The coming earnings season is really an important one as analysts sharpen their pencils. So fingers crossed that companies continue to beat expectations as they have for many quarters.

So what does earnings mean for forward return, as we flip ahead? If you take that forward 12-month P/E ratio, and you tranche it out on the horizontal axis here, you know, very cheap market sub-10 times all the way to an expensive market north of 20 times. Not surprisingly the lowest number in terms of forward expected return for the S&P is north of 20 times. That is not surprising—about 4%. Not surprising. So expecting lower returns looking forward when the market's expensive makes sense. What is interesting, though, and something that can be lost, is that all of these numbers are positive.

Brent: That's right.

Phil: So saying that the market's expensive traditionally has not actually meant the market's going to sell down in the next 12 months.

Brent: That's right.

Phil: It can. Of course it can, right? The end of the tech bubble, for example. 2022, for example. That does not mean it is assured, but does it mean returns have been pulled forward? Yes, it does. It means lower returns going forward are absolutely positive. Doesn't mean they are not positive, just say, lower going forward.

So speaking of that let's look at our price target. We update this quarterly. We updated in December and had an expectation that was up quite a lot in December, and the market proceeded to blow right through that expectation. What we said when we launched that in December, our price targets, we said our bull case was really Goldilocks. So why is it called Goldilocks? Not too hot, not too cold, but the economy.

And right now it does appear the Fed is successfully walking a tightrope, and the economy is still doing pretty well. Earnings are growing. So if Goldilocks is playing out, that means our bull case is becoming our base case. So our base case is 5,500 on the S&P. That's up about 5.7% from where we were trading at the close of March 26th. Just to outline for you the bear case at 4,000. This is downward earnings revisions, subpar earnings the following year and some serious multiple contraction. That's down 23%.

The base case is modest earnings revisions downward over the next 12 months. Then basically average earnings growth and some multiple contractions. In this number, we still expect the multiple, or the P/E ratio, to put it another way, to contract. In the bull case, we think earnings revisions or expectations are too low. We have positive earnings revisions. Then we have in the next year something like average earnings growth, and we have slight multiple expansion.

A couple things I'll point out. One, there's asymmetry here. There is more downside to our bear case than upside to our bull case. Why is that? The market's pulled forward some returns. We are not naive to that. So clearly we have some asymmetry there in our view. But look, I think our optimism on the markets, which we've really had since the sell down 2022, persists. How rapidly does the market get to these numbers? We shall see. Additionally, we should mention markets do not move in a straight line.

Brent: That's right.

Phil: We do think we will have drawdowns this year. We do not think the market—what do you say is annualized for 45%?

Brent: Yeah, 45.5%.

Phil: We do not think the market's going to do 45.5% return this year. So a lot of the optimism so far in the first quarter. Yes, there are going to be drawdowns. We are looking out 12 months, though. We're looking out till end of March of next year. And we do think the market can be higher.

Brent: Yeah, and I think there's two other important points to call out. Number one is that we hit a low on October 12th of 2022 at 3,577, right? So our bear case is still above the lows in the market that we saw back in that October timeframe. And by and large, when you think about what you were just talking about with intra-year drawdowns, the average intra-year drawdown since 1980 has been about negative 15%. We certainly haven't seen that year to date. So again, expecting somewhat of a drawdown, even a double-digit drawdown, is not, "Oh my gosh, I should worry and jump out of stocks." It is normal. If we don't see a drawdown this year, then we really start to get a little bit concerned.

Phil: That's the exception to the rule.

Brent: Absolutely.

Phil: So let's talk fixed income for a bit. That was a lot on equities. I mentioned when we talked about the return of aggregate fixed-income index, the main index we all follow, that rates had moved higher this year. So what we're showing here is the yield curve. The vertical axis is US Treasury yields. The horizontal is the maturity date, one month all the way out to 30 years. And you'll notice is the gray line. This is where we were end of last year, and then where we were on last Friday. We have seen a major shift up in the yield curve, particularly when you look sort of what we call the belly of the curves or 2-Year out. Why is that? This is Fed cuts rather coming out of market expectations. So if you believe the Fed's going to cut less this year, which the market had to come to terms with that, then you think that, for example, the 2-Year Treasury should be higher. So should the 10-Year. So a lot of everything is going back to the Fed. There is a reason that there's so much focus on the Fed right now because it is moving, not just equity markets, it is moving fixed-income markets.

Brent: And we're still steeply inverted, right? So that hasn't changed, right? So it's just going to be a matter of time. And it just makes sense to what you're saying. When you're pricing in six to seven cuts or seven to eight cuts, and then you migrate towards those three to four, you would expect the yield curve.

Phil: It has to show in yields.

Brent: So when we take it a little bit deeper and we break it down into various fixed-income asset classes, again, going back to where we were at the start of 2022, where we had no yield to speak of. Whether we were looking at treasuries or the US Aggregate Bond Index or municipals or investment grade corporate bonds or high yield, you had almost no yield to speak of. Now, when you look at where we are from a yield-to-worst perspective, which is nothing more than yield to maturity adjusted for the optionality of those bonds, you're looking at aggregate bond, almost a 5% yield. Municipal bonds, 3.4%. You tax adjust that for the highest tax bracket, and you're 5.5% to 6% when you add in the Medicare surcharge.

So again, the starting value for fixed income, even though we've seen a lot of variability, but when we're thinking about more intermediate-to-longer term, a great starting point as it relates to portfolio diversification. And by and large, we think that the forward expected return for fixed income because of the starting point is quite attractive relative to recent history.

So if we take that further and we look at corporate bond spreads—and what we're talking about is, in essence, just the yield of either investment grade bonds or high yield bonds over the commensurate Treasury yield, right? That sort of default risk-free asset. The gray line is investment grade spreads. The gold line is high yield spreads, and you can see that both high yield and investment grade spreads have tightened materially.

For investment grade, we're sitting at about 119-basis-points spread over Treasuries. High yields about 344 basis points over Treasuries. By and large, corporate bond spreads continue to tighten, right? Prices continue to look attractive. What I think is very, very interesting—we've had a change in the Bloomberg Barclays Investment Grade Index. For a long time, Phil, the largest component of that index from a credit stack was triple-B bonds. We've now migrated to where the highest weighting in that index is now single-A.

Phil: Which is higher quality.

Brent: Which is higher quality, right? So A is higher than triple-B. So overall, not only have spreads contracted, we've also seen the underlying quality of investment grade corporate bonds rise, which is a great thing to see. It lends itself to what we talked about as it relates to earnings and operating margins. So broadly, the corporate picture continues to become more robust.

Phil: And look, we show this because if these numbers were to rise, in other words, there's more risk in the fixed-income corporate bond space. That is an indicator that there's some trouble under the hood. The fact they continue to tighten is a great sign.

So we talk a lot about yield-to-worst. Well, what does it mean? Do you capture as an investor the total return of your yield-to-worst? So, for example, you buy the aggregate bond at that moment, it's yielding 5% over 6 years. Do you capture that 5% over those 6 years annualized?

So we did an analysis going all the way back to 1989 and said, "What is the percent capture of yield-to-worst of the aggregate bond index?" Percent capture means if you capture that 5%, it's 100%. If you capture only 4.5%, it's sub-100. If you capture 5.5%, it's north of 100. What you find is, on average since 1980, on average, you capture 111% of the yield-to-worst. So in other words, over those 6 years in that example, you captured that 5% yield.

Now, what is the exception on this chart? Your eye moves to the right—it's recent years. Why is that? We had a historic move from record low rates to normalized rates in an incredibly short period of time. When rates go up, price goes down. But when you look historically, generally, when you buy a fixed-income index, you can expect, with exceptions, something like capturing that yield-to-worst in your total return.

Brent: Yeah, and you have to ask yourself as an investor, where are we in this cycle? We just spent all this time talking about where fed fund futures are pricing. I don't see anything in fed fund futures that are pricing that we're going to hike. So at the end of the day, it's either we're going to stay on hold for a continued period of time, or the cycle will go to one to where we are cutting rates, right?

So again, that bodes well into this picture. And remember, when I think about what Phil was quoting as it relates to those 6 years, the duration of the Bloomberg Barclays Aggregate Bond Index is 6.28 years. That's been extending, but if I go back to 1984 the duration was about 3.8 years. So we've seen not only quality improved we've seen duration extension, right? So again being able to lock in—

Phil: Which has helped quality.

Brent: Yes, absolutely.

Phil: Companies extended their debt stack and were able to help the quality. So to that point you mentioned a cut. Here's another analysis we want to show, a new chart for you all. This is Treasury returns around Fed rate cuts. So here we're using Treasuries, right? You could, of course, use a broader set, but if you just owe the 10-year Treasury, what does the total return look like over the next 12 months based on when you buy that relative to Fed cuts?

So down on the horizontal axis, 3 months before the cut, 1 month, 0 months before the cut, right? Add the cut. One month after the Fed cut, three months after. What's the highest bar here? It's actually 3 months before the first cut in the Fed cycle. So what this is saying is generally buying fixed income—or 10-year treasuries in this case—before the Fed cuts is advantageous because eventually it's going to start to get in the price, right? The market starts to expect the Fed to cut and starts to move ahead of that cut.

Brent: Yeah, and I think what's interesting is that the average yield on that 10-year bond over that period of time from 1984 is about 5%. So the good news is that any one of these bars is a higher total return than where your average starting yield-to-worst was. And again, you know, 3 months before, which again, you know—maybe knock on wood that we are 3 months before the Fed cutting in June, if in fact they were to do that.—you're talking almost a doubling of the yield-to-worst, looking at a 10-year Treasury's 12-month forward performance.

So we've had a lot of questions come in, Amy. So why don't we get to Q&A?

Amy: Yeah, thank you, Brent. Thank you, Phil. You guys are making markets in the economy almost as exciting as March Madness, but we will get into our questions here. Before we start on our Q&A, just a reminder to those interested in staying informed throughout the month. We have several publications coming out to our subscribers, including weekly market outlooks from Phil in our In Brief series that's delivered at the start of each and every week. We also follow updates around the Federal Reserve and inflation reports and any other noteworthy items in the markets or in the economy. You can hit the QR code and get signed up or visit FirstCitizens.com/Wealth.

Okay, jumping into our questions. Phil, this one, Phil, Brent, you may both want to tag in on this one. It's really interesting. There's talk of the Fed not cutting rates at all this year. What is the likelihood that there will be a shift from an inflation target of 2% to a target range of 2-3%?

Phil: So, yeah, let me take the second part, which is really the question. It's very low likelihood in our view they shift away from the 2% target. Now, remember, the 2% target is still fairly young, just over a decade, I believe, if I have my math right. So it's not as if there's been a 2% target throughout the history of the Fed. The Fed, in a way, has kind of backed themselves into a corner with that target because we will inevitably get questions like this. Let's say inflation is at 2.5%. Well it's not the Fed target.

The truth is—my belief is, just my opinion—is that the Fed would not be too upset with inflation say 2.4-2.5%, but backing away from their target to a range can actually drive inflation because that will be reported widely. That would be on the evening news. And that can come into consumer inflation expectations. So I don't believe they can back away for the 2% target. Does that mean it has to be 2.0% for the Fed to be happy? Of course not. They had a 2% target and inflation was at 1.8%, right? It can be at 2.2%. It can be 2.5%. And honestly, what we want is contained inflation. And I think that that's what they are trying to communicate.

Brent: Yeah. And I think it's asymmetric, right? Because the Fed, even though that they were significantly late to the game and had used the T-word and said that inflation was going to be transitory when obviously in hindsight, it certainly wasn't. We talked about earlier on, we saw the most significant monetary policy actions in more than 40 years, and in the second half of 2023, the US economy grow in real terms more than 3%. The long and variable lags that are sort of washing in on the economy kind of peaked in October of 2022. And we've actually seen a loosening of financial conditions, higher equity markets and the like, easing of conditions.

Phil: Tight corporate bond spreads.

Brent: Exactly right. So by and large, the Fed is going to wait and see. So to answer the first part of the question of like, "Is there the possibility that the Fed doesn't cut at all?" I'd say, again, Jay Powell went on 60 Minutes and basically told us that he was going to cut at least once this year. So I'm going to take him at his word that he was messaging ahead of time. And I believe that the FOMC will likely do at least one cut.

But again, the velocity of inflationary data, whether that's wages, whether that's, you know, super core consumer prices, absolutely, to where we are not out of the woods as it relates to the velocity of inflation. And the worst thing that could happen is if we have a spike up in inflation and the Fed is too aggressive too early. And then, God forbid, has to start hiking rates. That's what they absolutely don't want. So they're going to wait to see that inflation is fully on the right trajectory before they actually make more material cuts to ease into that 3% real rate that you were talking about.

Phil: I think the markets had to come to terms with the idea that the Fed can cut once and pause.

Brent: That's right.

Phil: And then maybe cut again a few months later. There's no rule saying they cut and they just cut every meeting. And that's what the markets had to come to terms with.

Brent: Yeah. And I think certainly the financial markets, in my opinion, have it wrong. I don't think you're going to see three to four cuts. Is it going to be two to three? Maybe it's only going to be one, probably more leaning that way than you would see three to four. But time will certainly tell.

Amy: Phil, why are Treasury yields still rising, even though the Fed is expected to cut rates? Does the market know something that we don't?

Phil: In our classic form, we accidentally answered this question a little bit before. But the reason is—it's around expectations for Fed cuts. So think. If the market early this year is in late last year's starting to think the Fed is going to cut six or seven times. That has to find its way into yield. So what we saw, yields fell dramatically late last year. It actually helped the aggregate fixed-income bond index have a positive year.

Now, if you see those rates cuts go from six, seven, eight to three or four, two or three, maybe one, that has to find its way into yields. So yields are rising this year in a bit of a reversal of some of what we saw late last year. It's all about the Fed. Just because the Fed's cutting, that's fine. It's how many times are they cutting? By the way, an inverted yield curve points to the idea that the Fed is cutting into the future, right? Otherwise, the yield curve would be upward sloping. So the expectation is still in given the shape of the yield curve, but the number of cuts has come out. That pushes yields higher.

Amy: Brent, we talked about this in the presentation, but the first quarter has been really, really great for the S&P 500. Does the market just keep going up? On the one hand, it's great for 401(k)s, but on the other hand, a lot of folks are worried about a correction.

Brent: Yeah, I probably would quote two famous people, one Albert Einstein, the other Charlie Munger, who said that the eighth wonder of the world is compound interest and compound returns. You don't have accretion of wealth if you're timing markets. Certainly markets, as we've talked about, can continue to run. Valuations are certainly stretched, but that doesn't mean that they can't keep going. But by and large, I think it gets incredibly dangerous to try and time markets. It is virtually impossible to time when to get out and conversely back in. And that is usually a surefire way of not hitting or achieving your financial goals.

Let's put this into perspective, Amy. Over the last hundred years, the US equity market has annualized at about 9.6%. If you go back through history and you look at the amount of times in a fiscal year that the US equity market actually returned between 9 and 10%, the answer is virtually zero. You have high highs and low lows that geometrically compound to that 9.6% annualized return. So as long as you are engaging in thoughtful financial planning, understanding your goals and objectives, making sure that you're saving more than you're spending and you have the right plan, the right portfolio diversification, we think staying invested in the markets is exactly what you need to do. We do, obviously, with the price target that we updated, see on the next 12-month basis about 5-ish, 5.7% return from here, or about 5,500 on US equity markets. Time will tell, but by and large, we would say to that person, stay invested, be diversified and have a plan.

Phil: As Brent mentioned, you should come into each year expecting a drawdown of some sort. That's what happens on average. Just because we see the market may be up 5.7% next year does not mean there's not bumps along the road. That's the norm. The exception is a year in which the market just marches higher with very few drawdowns. That's the exception to the rule. That's why your buckets, your financial plan matter. Equities are long-term, higher-risk investments. That's the bucket they should be in.

Amy: Brent, kind of dovetailing into that, I received a number of questions around portfolio allocations tying back into US equity doing so well. What's the benefit in holding international stocks in a portfolio?

Brent: Yeah, well, let's just talk agnostically, Amy. Let's just think about what the world is today. From a pure market-cap perspective, and Phil, as you talked about, when I take a look at price, time, shares outstanding in a market-cap perspective, US equity markets are a little bit more than 60% of the global market capitalization. But about 40-ish%, a little bit less, 37%, 38% are developed and emerging international stocks.

So just on the surface, agnostically, the world doesn't look like 95-5 or 90-10. It is significantly diversified between US stocks and international stocks. When I look at just number of companies, the S&P 500 represents only 6% of the world's stocks. So if you're only invested in the S&P 500, you're saying to yourself agnostically, I'm only willing to own 6% of the world's companies, not market-cap. We're not talking about market-cap, number of companies, pure number of companies.

I would probably say on the surface, you probably would want to be more diversified than only owning 6% of the world's companies. You probably want to own more. And again, markets tend to move in cycles. We've had US exceptionalism for quite some time driven by a very small handful of the world's companies. Now, will that continue? Time will tell. But if I go back and look decades, right, and you look at decades across the board, going all the way back to the 60s and 70s, there's many, many long periods of time where international stocks have outperformed US stocks.

So just say, "Hey, I have a recency bias, and I only want to invest in what's worked over the last decade or so" is probably not the most thoughtful way in building a diversified portfolio. And we think owning both US and international stocks is the right way to go. And the last thing that I'll say is when I go back over the last 75 years for a US Dollar denominated investor that has dollar denominated assets and liabilities, the best risk-adjusted return portfolio is 70% US stocks, 30% international stocks. It's not 100-0. It's not 90-10. It's roughly 70% US, 30% international. And that's actually the underlying baseline that we use to build diversified portfolios for clients.

Phil: And relative to that baseline, what are the biases right now in your team, US versus international?

Brent: Yeah, right now we are still overweight US to international. We believe that there's still some valuation adjustments that need to occur. And we still believe that US over the next 3 years will do a little bit better than international stocks. But again, we're not 100-0. We are just underweight that a little bit and still have roughly in a 100% return generating portfolio—we still have 20-plus-percent in international stocks, not zero.

Amy: Well, Brent, Phil, thank you so much for that in-depth analysis of the bond and equity markets, as well as the overall economy. Lots to consider as we end the first quarter. And I just want to thank everyone for being on today. And we will be back again next month, and we will hope to see you all here.

Making Sense Outro Slide

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