We’ve finally reached the official start of Pacific Northwest summer- the 5th of July. It’s time to put away the raincoat and sweatshirt and buy a new pair of sunglasses you’ll use for three months and promptly lose. The official start of NW Summer is also the halfway point of 2024. So far, the equity markets have been cooperative assuming you, at least partially, ignore the conventional wisdom of asset diversification.
The S&P 500 is up a touch over 16.50% (year to date as of the 5th of July) driven by the same handful of large AI tech names that led the market higher in ’23. The Magnificent Seven may have left Tesla in a ditch, but the remaining six mega caps are still very much responsible for driving the market higher. This is at least somewhat justifiable since these names account for nearly all the earnings growth in the index for the past five quarters. On an equal weighted basis, where each company’s equity performance has the same impact on the overall index, the S&P is up just 4.77% in 2024. There are a few research reports that show the market’s return without all the AI related tech names is zero. While there is some subjectivity involved in that drastic conclusion, there is no doubt that AI is the main focus of the market at the moment.
While leadership has remained stagnant and focused on just one element of the equity market, the economic data has been evolving. Two areas of interest for us now are the health of the US consumer and the implications of the election.
US Consumer and the labor market
There’s mounting evidence that US consumers are finally pulling back on spending. The most recent retail sales numbers disappointed analyst expectations and wholesale inventories have remained elevated for the past few months. The ISM services index, a key measure of economic health and an important market indicator, fell dramatically in June. Households are thinking twice before making purchases and retailers have been caught off guard by the abrupt slowdown in demand.
According to San Francisco Federal Reserve research, Americans have finally run out of their pandemic excess savings. Savings rates are currently about half of the long-run average and wage growth is minimal; about 1% after adjusting for inflation. Average household incomes are yet to catch up to pre-pandemic trend growth after adjusting for inflation. Even with price growth moderating, it’s not getting any easier for consumers to maintain their standard of living.
The consumer’s willingness to spend is largely a function of the health of the labor market. COVID made analyzing the labor market a big challenge. At this point, most of the Pandemic distortions on the US workforce have been resolved. This suggests that one of the best places to gauge the health of the labor market is continuing jobless claims, which consist of people who have filed for unemployment insurance and are actively seeking work. Businesses tend to stop hiring before they make layoffs in response to economic weakness, which causes continuing claims to move higher before the unemployment rate signals danger. On this front the news isn’t great, but it certainly is not at distressed levels. The last reading for continuing claims was 1.859 million against a pre-pandemic average of 1.700 million. These figures square with the Job Openings and Labor Turnover Survey, known as JOLTS. The number of job openings has fallen from as high as 12 million in March of ’22, to 8 million in May of this year. The unemployment rate ticked up to 4.1% this morning. The labor market is clearly cooling, as evidenced from the mosaic of data available.
One of the biggest contributors to high levels of economic growth since the pandemic was the strength of the US consumer and their spending on services. Strong wage growth, pandemic savings and a wide-open job market fueled high levels of confidence. These factors are now normalizing or have been exhausted. If the trend continues, interest rate cuts from the Federal Reserve this Fall become a very likely outcome.
The Third Rail (Politics)
Politics globally has been a polarizing (to say the least) topic in 2024. Already, investors have navigated surprising results that have moved equity and currency markets in Mexico, India, France and South Africa. Of course, the biggest question is how Americans will vote this fall and what the ramifications will be on capital markets.
It’s very popular now to use historical market returns to predict what the market will do if Republicans or Democrats win or lose the White House. The bottom line is there aren’t enough presidential election results to show anything that resembles statistical reliability. Additionally, there have been several elections that are huge outliers, such as the 2000 Tech Crash, the 2008 Financial Crisis and COVID in 2020. These are stark reminders that capital markets are primarily driven by external factors and macroeconomics. The occupant of the White House has little influence and zero control over the “invisible hand” of the markets. You can cook market data around elections to show anything you want when you have a small sample size, so take any “study” on the market response to election results with a large grain of salt. If we’ve learned anything since COVID it’s that the old rules don’t apply like they used to. It doesn’t seem as though that will change before November. However, that’s not to say there aren’t items to plan for.
There is one issue that the next administration will need to address that has large implications for capital markets and individuals. The Tax Cuts and Jobs Act of 2017 sunsets at the end of 2025. One way or the other, there will be significant changes to the tax code for both individuals and corporations.
On the personal finance level, the Tax Cuts and Jobs Act of 2017 changed individual tax rates, standard deduction amounts, the deductibility limits of State and Local Taxes (SALT), capital gains rates, estate taxes and gifting limits (among others). It’s too early to speculate about what will replace the 2017 tax cuts- the candidates have wildly different views- but it is safe to say 2025 will be a busy year for financial planning. Stay tuned.
In terms of the equity market, the 2017 tax cuts brought the corporate tax rate down to a flat 21%, which certainly helped improve corporate profitability and supported higher equity valuations. Previously, corporate tax rates ranged from 15%-39%. Falling corporate tax rates have been a major driver of long-term equity performance. It’s impossible to know how all the inevitable horse-trading will impact the final tax code between now and the end of 2025.
What is clear is that the US is running ~2 trillion-dollar deficits annually. The current trajectory of government spending and tax collection is not sustainable. The next administration will need to try to bring spending and tax collection in line without harming the economy. Doing so will be a tough needle to thread. Err too much for fiscal responsibility and the equity market will suffer at the expense of the bond market. Fail to win approval of the bond market and higher interest rates will harm the equity and fixed income market. The solution to this problem is going to be the most impactful near-term outcome of the election, at least as far as capital markets are concerned.
On the equity side of capital markets, there is one theme that appears likely to persist regardless of the outcome of the election. US industrial policy is set to continue to favor domestic production of key components of our modern economy. For several reasons, both candidates prefer policies that encourage US firms to move the production of certain key technologies to our shores. This policy shift has been evident since the supply chain disruptions of COVID and creates new opportunities for US firms to build and invest domestically, hopefully driving profits higher.
The halfway point of the year really feels like an inflection point. US consumers, the all-important driver of the global economy, have been squeezed by inflation and now face a slower labor market. Equities have enjoyed a great start to the year, but the gains are concentrated among just six names investing heavily in exciting, but thus far unproven, new AI technologies. The rest of the equity market is lifeless. This fall’s election is either exciting or unsettling depending on your political viewpoint. Our stance thus far, when it comes to all our portfolios, is to underweight long-term fixed income in response to the uncertainty of fiscal policy in the near future. We’ve also been using the push for US firms to build and invest in the US as a theme for our Schwab portfolios and will likely continue for the foreseeable future.
We cannot predict what will happen in the market in the next year or two. Nor can we decide who will live at 1600 Pennsylvania Avenue come January 21st. What we can do is our job, as fiduciaries, which is to serve you, our clients, to the absolute best of our abilities. And we will continue to do just that.