Three Key Thoughts:

1.     Technology Stocks Dominate
2.     Labor Market Slowly Weakening
3.     Geopolitics: Elections Matter

Technology Stocks Dominate
Investors’ fascination with everything “AI” continued throughout the second quarter. Large cap technology companies with involvement in this space curried investor enthusiasm while most other stocks struggled to tread water. The “Magnificent Seven” dragged the S&P 500 higher during the quarter, reaching many more new all-time highs, bringing the year-to-date increase to 15.29%. Meanwhile, the equally-weighted S&P 500 trailed by more than 10 percentage points, returning just 5.08%. And, this is after the equally-weighted index trailed the cap-weighted index by more than 13 percentage points in calendar 2023!

The obsession with AI replaced the optimism for imminent interest rate cuts. There is no doubt that AI holds great promise for advances in many areas of the economy. In this “first wave,” we are seeing companies involved in building the AI infrastructure (e.g., data centers, microchips, large language models) dramatically accelerate their revenue and earnings. In a second wave, we will likely see adoption broaden across many, many businesses. And finally, we should see that adoption give rise to productivity improvements that benefit company earnings and economic growth for some time to come. All of this will play out over several years. In the last several months, we have experienced the initial euphoria for the first wave. As some point soon, we will need other drivers to push the stock market forward. Rate cuts could provide that boost.

Hopes about impending rate cuts has been dashed several times over the past couple of years, with the stock market pulling back sharply each time. More recently, corporate earnings and economic growth held up better than expected, allowing the market to absorb the rate cut disappointment without pause. Rate cuts now do seem closer at hand as recent inflation reports have been more benign and the job market is gradually but consistently softening.

Labor Market Slowly Weakening
Since the end of the pandemic, the labor market has been exceptionally strong. The number of job openings rose to record levels as did the ratio of job openings to unemployed people (i.e., number of openings per job seeker). Coincidentally, the “quits rate” also rose to a record level as those with jobs could readily find a new and better position. For the last eighteen months, though, these statistics have slowly but surely returned to pre-pandemic levels. This isn’t necessarily bad – it just means the extreme tightness of the labor market is now largely gone.

There are a few broader implications. First, we can expect wage pressures to moderate – and they are doing so in recent reports. That helps keep inflation at bay. Second, consumers, the lifeblood of the US economy, may be a little less willing to spend than they have been for the last couple of years. Third, with less consumer spending, we should expect to see the economy grow somewhat more slowly. All of these factors make it easier for the Federal Reserve to think about reducing interest rates sooner rather than later. Unfortunately, these changes also reduce the margin of safety from recession.

As we have previously reported, the enormous amount of deficit spending (more than $1.5 Trillion per year) now taking place also provides a further cushion against recession risks. And we have seen in the monthly employment reports that government hiring is still very strong. There is no appetite in Washington DC, on either side of the aisle, to address this spending issue, which is only destined to grow. However, the nature of this spending can shift significantly from one administration to the next so elections can have a big impact.

Geopolitics: Elections Matter
Elections were held in the UK, France, India, Iran and Russia recently. In the UK, the Labor Party won in a rout over the incumbent Conservative Party. Change is promised but where it will lead is unclear. Speaking of change, a reformist candidate won the presidency in Iran – it will be fascinating to see if any reform is actually possible there. In India, Modi didn’t receive the mandate he expected so he is now having to cooperate with other factions to continue his aggressive economic agenda. The Russian outcome was of course pre-ordained as Putin continues to expand his iron-clad grip on the country.

We bring these elections up to point out that the US election this fall is not the only one with potentially far-reaching implications. The rest of the world is indeed watching our election and wondering, like us, why we can’t do better than the two presumptive candidates. A lot can and will happen between now and November – we should be prepared for the unexpected.

Investment Implications
For now, we expect the economy to keep growing, albeit more slowly, and inflation to gradually decline. This should allow stocks and bonds to fare reasonably well. That said, the risks to both the economic and geopolitical environment can’t be ignored. We believe that well-diversified portfolios with substantial amounts of liquidity are best for this environment.