Weekly Investment Update (07/12/2024)

Amid continued noise surrounding both U.S. and international election cycles, financial markets remain focused on incoming economic data. June inflation data (discussed in more detail below) were notably cooler than consensus expected. Earlier this week, Federal Reserve Chairman Jerome Powell stated, “[M]ore good data would strengthen our confidence that inflation is moving sustainably toward 2 percent.” With the 3-month annualized core Consumer Price Index reaching 2.1%, our view is that the Fed now has sufficient data to start cutting rates. Most likely, it will use the July meeting to clearly signal a September rate cut, though we would advocate for a July cut. For context, the market is now pricing in three rate cuts by the end of January 2025. The 10-year Treasury rate started the week around 4.30% and fell to 4.18% after the CPI report. Peaking interest rates should support our slightly longer-duration fixed income positioning. Lower rates should also encourage a broadening of equity market participation, particularly as earnings growth is expected to be more evenly distributed in the coming quarters. After the inflation report, we saw a dramatic reversal in market leadership at the expense of large cap technology stocks. Although this pressured the S&P 500 index, we saw broad equity market gains across the equal weighted S&P 500, as well as in mid and small cap asset classes.

Inflation and Labor Market Data Support Interest-Rate Cuts

What is happening: Recent U.S. macroeconomic data support Fed policy rate cuts. June CPI rose 3.0% while core CPI was up 3.3%; both measures eased from May and came in below consensus estimates. Core CPI reached its lowest level since April 2021, driven by meaningful price declines in airline fares and used autos, which were down 5% and 1.5% month over month, respectively. Although shelter prices are up 5.2% on an annual basis, rent and owners’ equivalent rent had their smallest monthly increase since April 2021. The softer inflation print is welcomed as it further supports inflation trending toward the Fed’s 2% target as we projected at the start of the year.

On the employment front, the U.S. labor market continues to rebalance while remaining healthy. The supply of jobs continues to expand, albeit at a modestly slower rate. June nonfarm payrolls added 206,000 new jobs, exceeding consensus expectations by 17,000, while payrolls for the prior two months were revised downward by 111,000, cumulatively. The U.S. unemployment rate ticked up slightly to 4.1% from 4.0%, and U.S. job openings per unemployed person have reached the pre-pandemic level of 1.2, down from 2022’s peak of 2.0. Additionally, average wage growth has steadily declined to 4%, below the 12-month average of 4.6%.

This week, Chairman Powell acknowledged to Congress that despite a bumpy start this year, inflation data are improving, and U.S. labor market tightness continues to ease. Powell emphasized that the risks to the Fed’s dual mandate are “much more in balance.”

Why it matters: The Fed’s decision to begin cutting its policy rate hinges on inflation staying subdued and moving toward 2% alongside the labor market rebalancing. June’s easing in Core CPI provides additional confirmation that inflation remains under control and continues to trend toward the Fed’s target.

This recent inflation and labor market data support the Fed’s lowering its policy rate. We also view this as supportive of our asset allocation decisions to overweight equities relative to bonds and maintain a longer duration in fixed income portfolios. Policy rate cuts in a non-recessionary environment have historically boded well for financial markets, with equity markets leading bond markets. Interest-rate cuts could support more rate-sensitive areas of the equity market, leading to an increase in market breadth. Furthermore, our slightly longer duration in bonds should benefit from price appreciation and mitigate reinvestment risk as rates adjust downward.

Gap Between S&P 500 Market Capitalization and Equal Weight Indexes Remains Wide

What is happening: Over the past 12 months, the S&P 500 index (the “market cap” index) has outperformed the S&P 500 Equal Weight index (the “equal weight” index) by more than 13%. Since the inception of the equal weight index in 1990, there have been only two other periods (the dot-com bubble in 1999 and COVID pandemic in 2020) when it has underperformed the market cap index by an equal or greater magnitude. Much of the difference has been driven by the largest stocks in the index. The “Magnificent 7” have contributed 63% of this year’s S&P 500 index returns through the end of June, compared to 62% of 2023 returns. Outside of the S&P 500, the return disparity between large and small cap stocks also remains historically large, with the Russell 1000 large cap index outperforming the Russell 2000 small cap index by 11% year to date.

Why it matters: There are some fundamental reasons that would support the continued outperformance of the biggest stocks. For example, the percentage of unprofitable Russell 2000 stocks is currently near an all-time high while the percentage of unprofitable Russell 1000 stocks is close to long-term averages.

At the same time, we believe it’s important to hold some exposure to small cap stocks for diversification purposes. There are compelling stocks within the space due to valuation or growth potential that Bessemer portfolio managers select and actively manage, largely avoiding the non-earners. Alpha can be more plentiful in the small and mid-cap space given the proliferation of names and higher volatility.

Historically, large gaps between market cap and equal weight index performance eventually normalize and reverse. Long term data also show that the biggest stocks don’t always drive the most returns. Since 1990, the S&P 500 Equal Weight index has outperformed its market-cap-weight counterpart, with an annualized return of 11.05% compared to 10.50%. Moreover, despite the dominance of large cap stocks over the past few years, large cap and small cap stocks have had similar cumulative returns over the past 20 years. Small cap stocks, in particular, outperformed by a wide margin between 2010 and 2018.

While Bessemer’s equity portfolios have substantial positions in the largest companies, we have been thoughtful about our exposures and have maintained our emphasis on high quality companies. We have both overweight and underweight positions across the Magnificent 7 stocks, and we also have broad market cap and geographic diversification within our portfolios. For instance, the 10 largest stocks in the S&P 500 index constitute 38% of index weight while our 10 largest holdings make up 25% of our All-Equity portfolio.