Making Sense: May Market Update

Amy: Hello, everyone. I'm Amy Thomas, a strategist here at First Citizens Bank. Today is Thursday, May 23rd, 2024. I'm joined by Phil Neuhart, Director of Market and Economics Research, and Blake Taylor, Market and Economic Research Analyst, who is filling in for Brent Ciliano today. Brent is traveling.

I want to welcome you all to our monthly Making Sense: Market Update series. We've received a number of questions through our FirstCitizens.com/Market-Outlook page. 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. Phil, with that, we are ready to go, so I'll turn it over to you.

Phil: Great. Thank you, Amy. And welcome again, Blake. So what are we going to cover today? Let's jump right in as we flip ahead. One, the economic update. There is a lot happening in the economy, whether it's fresh inflation data, labor market data, speculation around the Fed. And then market update. We've had quite a rally north of 5% as of this moment in May equities after a sell down in April. So really, we have a stock market hitting fresh all-time highs, quite a move in stocks, not to mention moves in interest rates.

So let's jump right into the economy. So as we covered recently, we are increasingly in what looks like either a soft landing or maybe even a no landing scenario. That does not mean max growth. It just means that the recession that many expected coming into last year does not seem to be coming to fruition at least this year. Here we're showing 2024 GDP growth estimates, the median professional economists forecast rather. So that is surveying economists. What do they think in terms of GDP growth in the US this year? You can see as of late last summer, GDP growth was well below 1% expected this year. Now you're around 2.5%, so expectations have improved dramatically, and that's finding its way into things like the stock markets—one of the reasons stocks have performed so well. So we'll dig in to those specifics in a moment here.

As we flip ahead, though, not all is perfect. If you look at ISM indices, these are surveys of people who run businesses both within the manufacturing and services sector. If you're above 50 in this chart, that is expansionary. If you're below 50, it's contractionary. So, one, what you notice in recent years is that if we were purely a manufacturing economy, we would have been in a contractionary environment. But 70% of US GDP is consumption. And you can see services has remained expansionary. What's interesting, the most recent data point for both services and manufacturing, they're both just below that 50 line, right? One month does not make a trend, but it does point to the idea that, yes, the economy is growing maybe better than expected, but not necessarily gangbusters, right? We have moved past that post-pandemic period of rapid growth and are seeing a bit slower growth now in both manufacturing and services.

So all eyes remain on the Fed as we flip ahead, and this is a chart we've shown before, but just as a reminder, the gold line here is the current hiking cycle. Over 500 basis points of hikes north of 5% in the recent cycle. Past cycles all the way back to 1983 are the dotted lines. And what you'll notice is the outlier is the current period. So for most people in their working lives, this is the exception. I think it is one of the reasons that markets are having issues pricing the implications of higher rates, and we'll talk more about that in a moment.

So what is the Fed going to do? So a little bit of historical context. Coming into this year, expectations were that the Fed would cut maybe six or seven times, quarter-point cuts. We were always skeptical of that view. We did not understand how the Fed would cut that rapidly unless we were in some sort of recession, which we clearly are not. That has moved dramatically. Inflation has been stubborn, particularly in the first quarter of this year. Now expectations are maybe one or two cuts this year. Right now, futures are pricing the first cut in September, but only a 65% chance. That's not a slam dunk. That can change dramatically depending on inflation data and wage data, for example. So we are in a situation where there's a chance the Fed doesn't cut at all this year, but one or two cuts are now being priced versus six or seven earlier in the year.

Blake: On this chart, initially what was striking was the speed at which the Fed hiked rates by over 500 basis points. So you can see that in the steepness of that gold line in the first 18 months. But what's equally interesting to me now is how long that gold line has been flat. And that's how long rates have been on hold. And as you can see, historically, rates typically haven't stayed flat for very long, which is what we show on the next slide.

It's been 10 months that the Fed has been on hold. And already that's longer than the average amount of time that elapses from the last Fed rate hike to the first time they cut. That's a typical interest rate hiking cycle, but it's important to note that it's definitely not without precedent. In the 1990s, for example, we went 18 months before the Fed cut interest rates. So with policymakers telling us that they intend to keep rates higher for longer, then this is something that needs to really be taken seriously.

The second part of this bar that we show here for 2024 is the market pricing. So 4 more months on top of the current 10 that rates have been held flat. That takes us to September. As you mentioned, current market pricing, as we showed, was about 65% chance of that first rate hike coming. But if we go through the rest of the year or even longer, then this green bar here could start to match that of the 1990s.

Phil: And as we'll discuss in the market section, this has implications for the rates markets, for yields. The idea that the Fed is going to hold higher for longer, which was not the expectations—at least of many market participants coming to the year—has to have an implication. And unfortunately, the implication is higher interest rates.

Blake: And what's the Fed doing here by keeping rates higher? The channel through which the Fed believes that they have an impact on the real economy is through what we call financial conditions. And in a nutshell, financial conditions are how easy or difficult it is for the private sector to obtain financing. So in this financial conditions index that we show here, some of the components are credit spreads. How wide are they? When credit spreads are wider, it's more expensive, more difficult for companies to obtain financing compared to treasuries.

How high is volatility? When volatility is high, same thing. It's more difficult to obtain financing, stable financing. And equity prices. When the Fed tightens monetary policy, typically equity prices tend to fall. What we've seen over the last several months, though, is that financial conditions have loosened substantially, and this remains one of the biggest questions out there in the current Fed hiking cycle—is if interest rates are elevated and being kept high for longer in an attempt to cool what policymakers judge to be an overheated economy, then why are conditions loose like this?

Phil: It doesn't appear to be working. It would appear that the economy is less interest-rate sensitive than maybe it was in past cycles.

Blake: And this is no secret. This was mentioned in the recent minutes of the May 1st FOMC meeting that were just released. Some policymakers did note that, why are financial conditions so loose if we're trying to cool this economy? So it's a little bit of a question of just how tight is monetary policy at the moment, even though the funds rate is quite high.

And why are we talking about all this? Of course, it's because inflation remains elevated and we've now gotten 4 months of data for this year. And the story on inflation has just really been quite disappointing this year, especially in the context of where we were at the end of 2023, expecting market pricing and policymakers believing that inflation was going to glide back down to 2%. Look at this graph. Instead, what headline inflation—the gold bar—has done is really just move sideways. And core inflation, which some believe to be a better metric of underlying inflation, has been very slow to decline. And this has largely been driven by services, not by goods.

Goods inflation has been almost close to zero and in some categories has actually been falling. Prices have been falling, but it's the services sector that's keeping inflation too high. And what does this mean for the Fed? They've told us that it's been a very disappointing few months. One of the Fed governors a few days ago said that we're not necessarily failing on the inflation data like we were a couple years ago with inflation rates north of 6 or 7%, but—

Phil: —C plus.

Blake: —Yeah, it's maybe a passing grade but not something that you would go home and hang on the refrigerator.

Phil: That's right.

Blake: So there's still a lot more work to be done here, and policy makers have made clear that they're going to need to see several more months of improvement, maybe even without hiccups, before they begin to cut interest rates.

Phil: We need to see a resumption of that downward trend we saw from 9% all the way down to the threes. A sideways move is a real problem for the Fed.

Blake: Right, right. But where we have seen maybe a little bit more normalizing over the last few months has been in the labor market. And a metric that we use to judge that is this gray line here, which is called the quits rate. That's the share of workers in the economy at any given month who voluntarily left their job for a better opportunity or they don't want to work in their job anymore for whatever reason. And, as you can see, that series was at its peak when the labor market was most distorted in 2022, when there were huge imbalances between labor supply and demand. And around that same time, wage growth was also at its peak. And we like strong wage growth. We like strong household income. But when it's as high as it was a couple of years ago, that's just not consistent with stable inflation.

Phil: Yeah. So during that period, if you quit your job, it was likely because you had several, you may even have multiple job offers at higher wages. So it was this huge incentive. So what does it mean when we see that quits rate move back towards average and even below?

Blake: Yeah, as you can see in these dotted lines here, those are the 2018-19 averages before the pandemic in a healthy but somewhat tight labor market. And we now have fewer people voluntarily quitting their job than before that. And so workers might be starting to feel like they're willing to take less risk in the labor market. They're going to hold onto a job for maybe longer than they would have otherwise. And this is a sign that the labor market is potentially just coming into better balance. And we've seen some softening in labor market data in recent months. The unemployment rate has ticked up to 3.9%. The underlying pace of job growth has fallen below 200,000. Wage growth has started to come down a little bit, but this is really much more of just a labor market that's normalizing rather than one that's really weakening.

Phil: Yeah, we've had this incredibly tight labor market, something that when we're on the road, we hear that complaint often, right? "I can't find skilled labor. I can't find unskilled labor." So there's some sign of normalizing, not necessarily healthy yet, but normalizing.

So when we do still see wage inflation, which we do as we flip ahead, Americans are going to continue to spend. And really what they're spending more on is services than goods. You can see services spending, which is the majority of US American spending, is on services and it's well above the 20-year average, as you can see here. Goods spending has risen of late, but still muted. A lot of goods spending was pulled forward during the pandemic. A lot of us outfitted our homes, et cetera. That is not necessarily something you're going to do every 3 years. So a lot of goods spending was pulled forward. Now it is a services story. But the truth is, as I mentioned before, 70% of US GDP is personal consumption. If the consumer is employed, seeing wage inflation, they're going to spend, and that's going to help support the economy.

So let's talk about excess savings. This is something we hear a lot of questions on on the road. Here, we're showing cumulative excess savings. So what is excess savings? This is the difference between the actual savings rate and the pre-pandemic trend. So before all that fiscal stimulus, monetary stimulus, money slushing into people's checking accounts.

So you'll notice, first of all, we had an incredible amount of excess savings. Well, that has diminished now is basically back to flat. This is not all that surprising. It is a great American tradition that we are generally going to spend our excesses. That's not necessarily true outside the US. It is true in the US. This, by the way, has found its way into the economy. So when you think about the US economy doing well, it's hard to ignore the fact that a lot of this has come in. Now, you might say, "Well, does this mean we're going to have a recession tomorrow?" It does not, and the reason is the labor market, right? A lot of these excess savings were early on at least, when unemployment was still very high, right? People weren't working. People were working fewer hours maybe. Well now that's not the case. The truth is we are seeing participation rate among prime age workers at a pretty healthy level compared to pre-pandemic, and we are seeing wage gains. So it does not mean recession but it might mean that that excess dollar of spending is not there and might hurt personal consumption growth, might diminish the growth of personal consumption.

Blake: It's just another way that the economy is getting back to normal after years of being fairly distorted.

Phil: That's right. And that's feeding into data. You hear things like credit card delinquencies are on the rise. The truth is they're returning to the pre-pandemic level, right? Because, why is that? A lot of the excess savings that were keeping those delinquencies from happening are now gone.

Blake: Well, something that we've been noticing in a lot of surveys and talking to a lot of people is that a lot of individuals are not happy with the current state of the economy. Sentiment is at pretty low levels, especially compared to where a lot of the economic fundamentals are. And the picture that we've just laid out for the US economy compared to even recent history is pretty robust. And this metric that we're showing here is called the misery index. And this was drawn up in the 1970s when both inflation and unemployment were at very high levels. And the metric has stuck. And over time, we can just add those two variables together—the CPI inflation rate and the unemployment rate together—to get a little snapshot on "How good are things at the moment?"

Phil: Yeah, I mean, look at the level of the misery index in the 70s and early 80s when you had high unemployment and high inflation. I mean, really pretty, pretty shocking result.

Blake: And since then it has normalized over the last 40 years. And that's that average line that we're drawing there. And in 2022, 2023, when inflation was very high, we were well above that average, and it made sense that American households were very displeased with the economy. But recently, as inflation has fallen from its very high levels, we're below that average. And of course, things are not perfect in this economy, but as we just mentioned, unemployment rate is almost at generational lows. CPI inflation is about a percentage point—maybe a little bit higher—above the Fed's 2% target. But something to notice here is that in the years before 2020, unemployment and inflation were both very low compared to historical averages.

Phil: That's our most recent experience, yeah.

Blake: That recency bias is potentially what's playing in here. So are things perfect in this economy? No. How are they compared to the average of the last two or three decades? Roughly in line, if not a little bit better.

Phil: That's right. I think as a reminder just how rare the period after the financial crisis, before the pandemic in which we had such low unemployment, such low inflation, how unique that was—especially with a lot of monetary stimulus and even fiscal stimulus. The fact that that was the outlier. And unfortunately, we're returning to a more normal environment where rates are higher, and I think that's tough for consumers. Additionally, inflation is cumulative. We talked about that last month that, yes, let's say inflation is around three now. Well, that's on top of 6% and 9%. It's cumulative. It's not negative. I think that really is impacting folks in terms of their view of the economy. But it is a reminder just how far we are from, say, the 70s or early 80s.

Blake: And it's an interesting reminder that people's feelings and experience of the economy is not necessarily the same as what the hard data show for whatever reason.

Phil: Most workers, most supporting young families right now, they were not working in the 70s, right? Their experience is pretty low inflation and unemployment. So what about the housing market, Blake?

Blake: Well, as interest rates have risen to very high levels, so have mortgage rates. And one of the main effects that's had is to keep inventory at very low levels. And of course, that's normalized a little bit over the last few months. But as we can see in the right panel of these charts here, the volume of home sales has just collapsed over the last couple of years.

However, looking at the left panel, the number of new housing starts hasn't fallen as substantially. It is off its trend. And if you can imagine that line continuing to move up into the right at roughly the pre-2020 pace, then we might be building about 1.9 or 2 million new homes per year. But we're under-building, potentially, by about half a million a year right now. But as I've heard you say before, you can't sell a home that's not listed. And one of the main effects of higher mortgage rates is people are just not listing their homes for sale. A lot of families and individuals are needing to move, of course, things are much more normalized. But a stat that caught our attention a few days ago was, I think it was 57% of mortgages by volume have an interest rate of below 4%.

Phil: Yeah, below 4%. So we're talking pushing 60% below 4%—that's restrained supply. People are going to move because they have to move, not necessarily because they want to, because they don't want to refinance to that higher mortgage rate. This is something that I think we're going to be stuck with for some time. And you mentioned the housing shortage. Look, coming out of the financial crisis and just the huge disaster for a lot of homebuilders and homeowners that was the housing crisis, we didn't build as many homes, right? So we came into the pandemic with a shortage of homes, and that has persisted. And that's geographically specific, right? It's different in every metro area, but broadly that is a real issue. And by the way, that's supporting price appreciation. If you look at that home sales chart, that is not a chart that you would expect to still see 5 or 6% national home price appreciation. That looks like a chart where you're seeing no price appreciation, right, if not depreciation. It's a very unique housing market that is affecting many Americans.

So let's switch from the economy to the market. So first, let's talk a little bit about the path of things of late. The data here is through May 20th. As you might remember, the stock market sold off in April and has now rebounded sharply. As I mentioned, global stocks up north of 5% so far in May. Big rebound. You have the S&P 500 hitting new highs, all-time highs in May. So what are we seeing? Year to date, US equities on the left side here have outperformed international and emerging, but both international and emerging are doing pretty well in total return as well.

Now, the different side, the other side of that coin, is fixed income. On the right side, aggregate fixed income down in value, municipal bonds down. Why is that? We'll talk about this more in detail in a moment. When yields go up, price goes down. This has moderated, right? Because one, you're clipping coupons, and two, rates are not at their peak. But you are seeing two sides to that coin. But it is great to see fixed—equities rather—doing so well after really what was a remarkable 2023. I mean it is quite a run in stocks. We'll speak about that more in a moment.

When we look in US underneath the hood on the right side, we're splitting the world into large, mid and small companies, and then value, blend and growth. The leader is large-cap growth, right? We've talked a lot last year about the Magnificent Seven. Maybe it's the Magnificent Five now, but these big growth companies are pulling us higher. But if you look at the other squares, the truth is there is a lot of participation and that participation has broadened so far this year. Value up 9.2%, mid-cap up 7.6%, small-cap up 4.2%. So it is not just one game in town. They are the leaders, but other parts of the market are participating.

So I mentioned that stocks have rallied sharply. Just for some context, we'd love to show this chart just to remind people. Since October of 2022, the low from the 2022 sell down, the stock market in the US large-cap is up 48%. Since just last late October, essentially Halloween, we're up 29%. So when you think about things like our price target, a lot of good news has certainly been pulled forward. But also just a reminder of how hard it is to time markets. I did not know many people last October that were saying the market would be up 29%.

Blake: I didn't know anybody.

Phil: Exactly. In what—6, 7 months? So let's talk a little bit about that market breadth point I mentioned. So last year, Magnificent Seven, a small number of stocks really pulled the market higher. What are we seeing so far this year? So the upper right, this is S&P 500 year to date through May 20th. We're looking at the S&P 500 cap weighted. That's the top index. That is an index in which a big company has more weight than a small company. And then we're also looking at S&P 500 equal weighted. This is where all 500 companies have the equal weight. And what you'll notice is both are up, up quite a lot, but there is a pretty big spread, 5% spread year to date. What's interesting is a lot of that was really the beginning of the year. If you look at these same indices from February 2nd of this year through May 20th, that spread is only 90 basis points, 0.9%. And at points in recent weeks, equal weighted has been outperforming cap weighted. So the truth is we have seen a broadening. It does not mean the big names are not pulling us higher. They are. But we are seeing some broadening. And I think if you are a market watcher, that is a reason for positivity.

So continuing on that point on the next chart, and I'll take a moment to explain this, we're showing the largest contribution of the 10 largest stocks to total S&P 500 return by year. So you can see there's years in the 90s here, all the way up to 2007 as well. What you notice is the most concentrated year was 2007, and the dot there is the performance of the S&P that year, right, which is shown on the right axis—pretty low performance. The last 2 years rank as two of the most concentrated years in an up year, 2023 and 2024. And what's different is 2023 we had an incredibly good return as you can see here. At 2024, the status through April, if you're doing this through May 20th—pretty good return as well. So is the market broadening? Yes. Is it very concentrated and really dependent on those top 10 stocks? It is. We do want to see some of this broadening we've seen continue so that we are not dependent on just 10 names as we have been the last couple years.

What about valuation, Blake, of the market as a whole?

Blake: Yeah, looking at the market as a whole, the market is fairly expensive compared to historical averages. However, it's important to note that if you look at this chart here, over the last 40 years, the market rarely trades at—or even all that close to—that average. So are stocks expensive now? Yes. Are they the most expensive they've ever been? Absolutely not. So there's, we do recognize the, potentially some of the richness here.

Phil: Yeah. And to your point, with the market rarely trading at that average is it does not tell you much about near-term return, right? The market can be cheap for years on end. It can be expensive for years on end. Long term, it might tell you something. But short term, it doesn't tell you much. By the way, we would have said the market was expensive, fairly expensive beginning of this year, and look at what the stock market has done. But if you look underneath the hood, Blake, what are we seeing from the largest stocks to other stocks on this next slide?

Blake: A lot of that, the height and that valuation, is concentrated in those top 10, as you were mentioning. Stocks number 11 through 500 in the S&P 500 are trading quite a bit lower—their PE ratios are trading quite a bit lower. So that suggests maybe there is some opportunity here for more broadening out of the market if those stocks outside the top 10 start to trade somewhat higher.

Phil: Yeah it's a unique period. There's an argument when you hear the market is expensive. That is absolutely true—income weighted, cap weighted—but that does not mean all the companies in the S&P 500 are expensive. In fact, many are not versus their own history. That could be good news and yield a potential broadening in the market.

Blake: We've been hearing a lot from our clients about the upcoming election in just under 6 months now. And something that we put together here that we noticed being talked about is it's important to remain invested in the market regardless of how an investor might feel about which political party is in power. If, for example, you only invested in the equity market when a Republican was president, then the growth of $10,000 over the last 70 years would only be about $83,000. Similar story if you were only to invest in the market when the Democratic president was in the White House, about $215,000. And the reason is that you're not letting compound interest do its job. So there's, it's obviously, you know, a very, a lot of attention is on the election this year. And we think it's important to disassociate one's, you know, political views and leanings from the way that we invest.

Phil: Yeah, look at the return if you're invested all year is $1.8 million. Why is that? The market returns to fundamentals, and you're getting that compounded return. Instead of coming in and out of the market, which forget even tax implications of that, the truth is the market returns to fundamentals and sometimes performs far better than one might think under various executive branch regimes.

So let's talk about those fundamentals as we flip ahead. Corporate earnings, we finished an earnings season that outperformed, which has been a trend, but even I'd argue better than many thought. And we've seen upward revisions to the annual number. So 2024, right now earnings are expected to grow 11%, just north of 11 to be exact. That is well above the long-term average of 7.6% and a bit eye popping. Even if that's a little bit optimistic, it is important. Remember, earnings didn't really grow in 2023. So 2023 was about valuation expansion, PE multiple expansion. Now it is about fundamentals. We need this to justify this market. But it is certainly good news to see. And 2025 earnings growth expectation of 14%. Take that with a grain of salt. Usually analysts are a little optimistic on the out year. They start sharpening their numbers in the back half of this year on next year. Would not be surprised to see those numbers come down, but still optimism.

Maybe more important than earnings growth, though, is the right side, which is operating margin. This is expected margin. You can see the peak margins we had post-pandemic when we had lots of fiscal stimulus, lots of monetary stimulus, money slushing around. That's going to boost margins. That came down. That was not surprising because it was so above trend, came down. You had companies adjusting to elevated inflation, wage inflation, et cetera. Well, now it's coming back up. We have a dynamic economy. Companies are better at adjusting than we give them credit to things like inflation and other disruptions in the marketplace. So the fundamentals from a market perspective, if you believe bottom-up analysts, looks pretty good, and one of the reasons we remain fairly optimistic.

As we flip ahead to our price target, let's talk about our views. Our base case of the S&P 500 is 5,500. That's up 3.6% from May 20th. Last time we met, that was north of 8%. It's just a reminder that the market has rallied pretty hard. We remain optimistic. And when we set this price target, it was up something like mid-single digits. Our bull case is 6,000. Our bear is 4,000. Bull case is true Goldilocks playing out, right? The Fed is able to cut because inflation comes down, and really a great scenario. Bear is where we have more of an economic downturn, rates do start to bite. That would be our bear case. But right now, base case 5,500. We remain optimistic on the market.

So we mentioned interest rates rising this year. We are showing the yield curve here. The horizontal axis is 1-month all the way up to 30-year treasuries, and the vertical axis is Treasury yield, right, all the way up to the top of that axis is 5.8%. You can see here that the end of last year is the gray line where rates were—they fell dramatically in the fourth quarter. We have given a lot of that back. So we mentioned the idea of six or seven Fed cuts came out of the marketplace. That has to find itself into Treasury yields, right? If the Fed's not cutting as much, yields should go up. And what we've seen is Treasury yields go up dramatically across the yield curve, you know, all the way from the belly to the long end of the curve. This is not too surprising—we have seen, given the Fed funds path is what I mean by that—now we have seen rates come off of their extreme highs of earlier in the year, but certainly elevated interest rates.

This has implications for the economy, but as we show on the next slide, it does also provide opportunity for investors. Suddenly, there is yield in the fixed-income market. You can see where yields were at the beginning of 2022 compared to May 20th of this year. Multiples higher in many cases. The aggregate bond, for example, 1.75 to north of 5. Suddenly for diversified investors, fixed income is a more viable asset class. It's something that we talk a lot about, and we have seen a lot more interest from investors simply because there is opportunity in fixed income—not something we could really say to the same extent, at least in prior years.

Blake: Getting into the Treasury market a little bit further, it's unfortunate but important to note that the US fiscal position really has deteriorated materially in the last several years, and this was even happening before 2020. What we're showing here in the left panel is the US federal budget deficit, and it was rising between 2010 and 2020 in a time when the economy was strengthening. And the last 5 years of an expansion. Unemployment was at historic lows. The labor market was doing very well.

Phil: Usually you see at the late stages of an expansion the deficits shrink not rise, and it was rising.

Blake: And here we are again post-pandemic, the economy is basically at full employment, and we're running very high budget deficits. And the result has been—unlike in the decade before the pandemic when interest rates were very low—as interest rates have risen, the cost of running those big budget deficits is really starting to bite. And that's what we're showing in the right panel here is net interest costs. And that has risen sharply to a substantial fraction of GDP in a way that we haven't seen really in decades.

So two ways for this problem to be dealt with is either for rates to come down—which policymakers are telling us for now not to expect, substantially at least—or for something to happen to get some of the fiscal house in order. So this was something that we were able to run really without much major consequence in the decade before the pandemic. And now a little bit of reality is starting to set in, and it's a bit of a quandary.

Phil: When we're on the road, we rarely give a presentation where this topic does not come up. This is very much on investors' minds and honestly, citizens' minds. Is it something you can trade tomorrow? Not really. I mean, we've talked about deficits in this country for decades. And the truth is owning US assets has been a very good idea. But is it finding itself into the rates market? It probably is to some extent. So there are implications. How you quantify those in the markets is very difficult, but it does matter. It certainly matters.

Blake: It's a big issue that got a lot of attention for a long time, and it was quiet for a while, and it's back.

Phil: It's back.

Blake: And these deficits need to be financed, which is what we're showing on the next slide. And Treasury issuance has, over the last year, 18 months, has really started to rise pretty substantially. And this could, to some extent, put a floor under Treasury yields as the Treasury issues more and more needs to be soaked up by the private sector. And that has real effects for yields.

And lastly, there has been a lot that's gone on in the world over the last several months, as we all know, and investors at some point may start to think about "How does this affect my portfolio and my investment decision-making?" And something that we point out here, we've shown this slide before for some who may remember, but the takeaway here is that there often are major geopolitical events and concerns going on. And sometimes there are market sell-offs as a response or at least following. And the trend typically has been that these do tend to course correct because the market does tend to just revert to its fundamentals, returns to economic growth. And that's already what we've seen with some of the crises that have emerged in the globe over the last several months.

Phil: Yeah, the market is eventually a fairly rational beast and is going to return to fundamentals. While terrible things happening in the world pull at our heartstrings, as we've seen with the market hitting all-time highs just this month, the market is going to eventually say, what are corporate earnings, and what are the multiple we are willing to pay for those corporate earnings? So to the extent that a geopolitical event could impact earnings, that is real. To the extent that it does not, the market's going to eventually look through it. There is always a wall of worry. It is about having your financial plan and sticking to that and remembering this is not the first time that we've had a lot of geopolitical risk in the world. In fact, that is often the norm.

Amy: Well, Blake, Phil, thank you both so much for all of that information and taking the time to go through markets and the economy. Just a reminder to everyone who may be interested in staying informed throughout the month, we do have several publications that come out for our subscribers, including a weekly economic outlook from Phil, or Blake in some instances, in our In Brief series delivered at the start of each week, and it gives you an update on what's happening for the week ahead. We also keep you up to date on what's happening with the Federal Reserve and inflation reports and more throughout the month. If you're not already subscribed and interested in doing so, you can hit the QR code to get those updates right to your inbox. You can also visit FirstCitizens.com/Market-Outlook. While you're there, you can take a look at some past recordings and submit any questions you'd like for us to answer in future publications.

Brent, I'm sorry, Blake, Phil, with that, let's jump into questions. I knew I was going to do that today. First one here, why is the US story on growth looking so departed from what other developed nations are experiencing throughout the world?

Phil: It's a great question. And it's true. We're seeing much more rapid growth. If you just look at estimates for this year in the US versus, say, developed Europe, Japan, et cetera, there's a lot of reasons for this. One, we were outgrowing most developed nations coming into the pandemic, right? We recovered more rapidly from the financial crisis than the rest of the world. And there's a lot of reasons for that. Depending on the nation, it could be demographic, productivity in the US, innovation in the US has really driven growth. Two, coming out of the pandemic, many nations had fiscal monetary stimulus. We had a lot, right? And I think that that has certainly helped our growth as well. But look, the US structurally looks on stronger footing than much of the rest of the world. You've heard the statement, the best house on a bad block. I don't think that that is unfair. But I think there's structural reasons in addition to cyclical to think that the US on trend its growth is more rapid than the rest of the developed world.

Amy: Blake, let's jump to you for this next one. There's a lot of talk of increasing tariffs now and in the future. How does that filter down into corporate margins?

Blake: Well, I think first it's important to note that trade policy and tariff policy enacted by the government is first and foremost an international affairs and national security issue. There's plenty of debate on there on the merits and one way or the other. That's not for us to weigh in on. But the downstream effects, of course, do tend to make their way eventually into corporate earnings through margins. A tariff is paid by the entity importing a good, and that makes its way into supply costs. The question is, to what extent can a corporation pass those prices on? And what we saw in 2018 and 2019 when the average effective tariff rate in the United States ticked up as the United States imposed some pretty substantial tariffs on imports from China, a lot of corporations were able to pass on those prices.

So if in the next few years the government institutes another substantial round of tariffs, potentially on consumer products, the question will come down to are they able to pass through those prices? And one other thing that we saw in the years up to 2020 was that companies were able to distribute those price increases over a wide range of their products. Just because one item got a 25% tariff doesn't mean that that one had to go up 25%. A company was able to spread those price increases out in a way that it didn't affect their margin as greatly.

Phil: Right. And, you know, when we say a company is able to pass those prices along, whether it's across products or a single product, that's another way of saying the word inflation. It finds its way into the economy, right? Any disruption, anything disrupting the free flow of capital finds its way in. It might be through margins. It might be through inflation. And it could be something that puts a floor on the inflation rate going forward.

Amy: No surprise to anyone. The number one question and most frequent question we got this month again is around when is the Fed going to cut rates? Are they going to do it at all this year? What do you think?

Phil: Look, it's becoming increasingly possible that they don't cut at all this year. Fed funds futures are pricing one or two cuts, maybe starting in September. But there's a lot of potential that they don't at all. The Fed is very clear in recent speeches and in minutes, you name it. They are clear that they need to see several months of improvement in inflation.

Blake: Something that's worrying me is—of those several, do you need to make every single one of them? Say several means four. Do you need to make four free throws in a row? What happens if you miss on the second or third one after you've had some good progress? Is that enough to throw everything off?

Phil: The bar is just becoming higher. Now, we're sitting here in late May. If June, July and August CPI and PCE deflator data, or at least the data released those months, looks better—yeah, the tone is going to change. But right now, I think there is a material chance they don't cut at all this year. We never thought they were cutting more, you know, two or three times was sort of our thinking. Maybe it's one or two, maybe it's zero or one. And I think we have to come to terms with that. I think the market is coming to terms with that. You're seeing it in interest rate moves. You're seeing that in corporate discussions. The good news is the economy appears to be far less interest-rate sensitive than past cycles—both individuals and corporations—but it has to have an impact eventually. And I think that that is something that we're just gonna have to wait and see as we move to 2025 what that impact is.

Blake: We'll be watching those inflation reports the minute they come out.

Phil: That's right, absolutely.

Amy: Well, Phil, Blake, thank you so much again for your in-depth analysis of the bond and equity markets, as well as a review of the overall economy. And thank you for answering questions today. Lots to consider as we move into the holiday weekend here. We hope you found this information helpful. As always, we thank you for trusting us to bring you this information. And that's something that we never take for granted. So we will see you again next month, and we hope to see you here. Thanks.

Making Sense Market Update Outro Slide

Brent Ciliano

CFA | SVP, Chief Investment Officer

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

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

Phillip Neuhart SVP, Director of Market and Economic Research

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

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

Blake Taylor | Market & Economic Research Analyst

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Blake.Taylor@FirstCitizens.com

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