The Horizon

The second quarter of the year was defined by a resilient U.S. economy with strong consumer spending, a solid labor market, better-than-expected earnings reports, the likelihood the Federal Reserve (Fed) will cut interest rates this year, and the continuation of the 2023 Equity market rally.

In this edition of The Horizon, we highlight the impact these changing macroeconomic forces have on the tailwinds and headwinds facing consumers, the important role dividend-oriented stocks may play, and the financial credit space.       

It’s hard to overstate the importance of the consumer, who has acted as a continuous bright spot against a sea of macroeconomic uncertainty over the last few years. Specifically, this quarter saw a resilient economy alongside a relatively stable consumer. In “Consumer Check-In: Tailwinds Overpower Headwinds,”¹ a piece from our weekly Capital Market Outlook, we emphasize the positive and more challenging forces impacting the consumer.

In terms of tailwinds, the labor market remained resilient as jobs growth data came in stronger than expected, continuing to defy expectations, and layoffs remained fairly steady. The Atlanta Fed’s Wage Growth Tracker shows median wages rising by 4.7% in the year through March.² Additionally, real wage growth flipped positive in 2023, which may signal that increases in inflation are no longer outpacing increases in employment income. Furthermore, consumer balance sheets have been buoyed by higher prices for homes and financial assets. Household wealth in the U.S. increased by $11.6 trillion in 2023, to reach a record $156.2 trillion.³ The value of Equities held directly and indirectly rose by $7.8 trillion last year, and the value of Real Estate climbed by about $2.0 trillion.⁴ The uptrend in consumers’ portfolios has likely continued in 2024, as risk assets have powered on, with the S&P 500 Index climbing 14.5% in the first half of the year, adding to 2023’s robust 24.2% gain.

On the other hand, headwinds remain for the consumer going into the second half of the year. Prices continue to be elevated, which is the number-one challenge for consumers. The CPI report for June came in at 3.0% YoY, which, while high, shows that the rate at which prices were increasing fell. Additionally, excess savings that accumulated during the pandemic have largely dried up. The U.S. personal savings rate, defined as personal savings as a percent of personal disposable income, hit an all-time high of 32% in April 2020. As of June, the savings rate had declined to 3.4%.⁵ If inflationary headwinds remain, excess cash balances may continue to dwindle.

While headwinds remain a concern, the tailwinds seem influential enough to support consumer spending, which accounts for more than two thirds of U.S. economic activity. Ultimately, a relatively stable consumer should continue to support the economy.

As we continue to navigate through periods of volatility within the summer months, we highlight the importance of dividend growers in an investor’s Equity allocation. In our May Equity Spotlight report, “The Case for Dividends,”⁶ we conclude that stocks that have sustained or grown dividends over time signal several positives for long-term investors.

To start, these stocks reflect financial health, including free cash flow generation, profitability, compliance with debt covenants, and a commitment to returning capital to shareholders. Five of the market-leading Magnificent 7 stocks now offer common dividends, although income-oriented investors often underprioritize them in comparison to other assets. Dividends indicate that a company values profitable growth and is committed to returning capital to shareholders. They are responsible for almost half of the stock market’s total return historically and should continue to be a necessary component of investors’ asset allocation plans.

Additionally, given that interest rates have probably peaked this cycle and the Fed’s next rate adjustment will likely be lower, there may be opportunities for investors to favor dividend-paying stocks. In past easing cycles, dividend-paying stocks outperformed the S&P 500, on average, by 3.2%, 7.3%, 8.0%, and 12.0% after the first Fed rate cut on a 6-, 12-, 24-, and 36-month basis, respectively.⁷ The performance of Value-oriented dividend stocks post a Fed cut is understandable: A lower interest rate should increase the present value of profits and dividends (future cash flows). It is a reason we favor a disciplined approach to Value and Growth for long-term investors. Even if a scenario of higher-for-longer interest rates were to play out, companies that have continued to pay and grow dividends in such a difficult climate will likely merit long-term investor interest. Regardless of the Fed’s future movements, dividend payers and growers should be considered as a part of investors’ asset allocation plans.

While the banking sector experienced significant headwinds last year that caused investor confidence to fall, there are some signals that point to a potential inflection, from a Fixed Income perspective. In our Fixed Income Spotlight piece, “Update on Financial Credit: Parsing Through the Headwinds,”⁸ we highlight several fundamental pressures that continue to affect the sector and the signs that some cyclical headwinds are beginning to ease.

First, while we anticipate continuing increases in loan losses, particularly in Commercial Real Estate (CRE), loan loss performance continues to be relatively benign this year. We believe most larger banks are well-reserved for CRE losses. Despite high borrowing yields, most issuers have been proactive with their reserving. We believe the slow CRE workout process will eventually encourage earnings generation to handle losses over time.

Credit markets have factored in this positive, with the Bloomberg U.S. Aggregate Financial Index outperforming non-Financials, recouping underperformance seen in 2023. We continue to believe that higher-quality banks are positioned well to navigate the current environment given healthy capital and liquidity. However, the possibility of ongoing macro and interest rate uncertainty could make the path to full spread normalization bumpy. Regulatory uncertainty also remains a concern, although change should lead to higher capital and liquidity across the sector, a likely a credit positive.

Moreover, we think that net interest margins may bottom this year, stabilizing above the levels seen at the beginning of the Fed rate-hiking cycle. Another positive for the sector, unrealized losses on longer-duration Fixed Income securities that banks acquired during quantitative easing, should slowly fade.

Macro trends, interest rates, and Fed policy still influence outcomes for the sector. Important considerations, however, are that credit spreads have fully retraced widening from the impact of the 2023 turmoil and sentiment has improved.

Ultimately, as we progress through the remainder of 2024, we believe long-term investors should remain fully invested with an emphasis on time in the market, rather than timing the market. We continue to advocate for a diversified and well-balanced portfolio, with exposure to both Equities and Fixed Income (and Alternative Investments where appropriate).