2024 Capital Markets Mid-Year Recap

2024 Capital Markets Mid-Year Recap

Written by: The Investment Committee

Executive Summary

The first half of 2024 was strong, albeit a much more concentrated rally versus the preceding Q4 of ‘23. Fundamentals drove nearly all the performance of the Mega Cap 7 stocks. Particularly for the market’s new AI darling, NVDA. Outside the “Magnificent 7”, sectors such as industrials, energy, utilities, and asset classes like Foreign/EM Value, also benefitted. Substantial government subsidies in US infrastructure, green tech, and manufacturing, combined with an explosion in data centers, were the primary drivers. Fixed Income/interest rate volatility picked back up in Q1 from continued economic resilience and inflation. In the face of higher rates, good stock performance required good or improving fundamental profits, both top-line and bottom-line, as such quality stocks outperformed low quality by the largest margin in recent history.

By June, long-term rates dropped substantially, over 0.5% on the 10yr after a few weaker prints of inflation, and normalizing GDP growth from slowing consumer spend. More specifically the lower-income consumer within non-discretionary categories, like groceries, and other staples within broad-line retail. Additionally, weakening labor market data came in for May, with unemployment now at 4.1%, an increase of over 0.6% from ‘23. Proof of such material cooling, we feel, likely supports the Fed cutting rates 2 – 3 times before year-end.

Despite some of these pockets of weakness, the investment committee still has a favorable outlook for the economy and markets in aggregate. We feel strongly that both the Wealthy and Baby Boomer Consumer, combined with government spending and corporate capex should be offsetting much of this weakness. Datacenter buildouts, expansion of domestic manufacturing facilities, improvement of travel infrastructure, and upgrading the US energy grid are all firmly still in place. All must be done irrespective of a slowdown in consumer spending within one income demographic. As such, SAF portfolios will likely remain fully invested through the rest of the year.

As you will soon find out in the attached piece, our portfolio models have been concentrated in the sectors and asset classes benefiting from these mega-trends in AI and Infrastructure. We also managed to exclude the weakening categories most exposed to the low-income consumer, such as consumer staples and broad-line retail. Although we have much confidence in our current allocation, as is always the case for markets, the environment is continually subject to change. Therefore, we have assigned confidence levels to a few different outcomes for the economy over the next 6-12months. Details of these risks/outcomes are found near the end of the attached piece.

Thankfully, the silver lining for a higher rate environment is always a broader opportunity set of investments offering real, inflation-adjusted returns. As we have mentioned ad nauseam over the last 18months+, fixed income and cash yields offer substantial protection to any stock allocation without completely squandering market-like returns. It is no mystery that a well-balanced, diversified allocation of stocks/bonds is likely prudent to ensure a successful retirement funding plan, no matter what might occur moving forward.

Stagflation, slowing growth + re-accelerating/high inflation. Proceeded by a bear steepening of the Yield Curve (long-term rates rise substantially). (negative for stocks and bonds)
Taiwan Blockade or Invasion by China or escalation and broadening of conflict in the Middle East. (negative for high-yield bonds and equities)
Fed Policy Mistake, and or recession driven by the labor market and high unemployment. (negative for mostly equities, but some lower quality bonds too)
**Soft-Landing/No-Landing. (no-recession, eventual economic re-acceleration, or mid-cycle expansion)**(positive for most all financial assets)

Intro

Markets closed out 2023 strong, riding on the coattails of lower rates married with a healthy dose of disinflation. Mix in the continued artificial intelligence (AI) excitement and the infrastructure needed to support it, AKA “data-centers”, and the Government subsidizing a US manufacturing renaissance and it appears that 2024 is shaping up to be a stellar year. We must admit, after Q4’s rally in bonds and the progress made on inflation for many CPI’s components, we were a bit caught off-guard by the continued volatility in intermediate and long-term interest rates. Given the economic resilience, higher for longer has been the prevailing narrative for most of the year. Bonds only recently began clawing back some of their earlier drawdowns as evidence of cracks presented in the durable and non-durable goods sector with weakening consumer spending numbers and dwindling savings, specifically for those of lower incomes.

Nonetheless, the good has continued to outweigh the bad in an economy driven by fiscal spending and a group of 7 companies (the Mega Cap 7) spending their seemingly limitless cash hoard on what is likely to be the most revolutionary technology since the dot com era. Only time will tell on the importance of AI, but for now, it’s build, build, build, assuming there’s substantial demand for labor replication in our very services-based economy. Given some of these dynamics, we felt it appropriate to predict a far broader equity rally, instead, major benchmarks outside the Nasdaq or S&P500, have continued to see lackluster performance. Unfortunately, the broader rally we saw from small/mid-cap companies in Q4 ran out of gas when the bottom-up fundamentals and higher-for-longer rates got in the way of any further price appreciation. Thankfully, all was not lost if you were just a tad selective, focusing on infrastructure or data center adjacent sectors and industry groups like Industrials, Energy, and Utilities. Within Consumer Discretionary, you were rewarded for being focused on luxury, specialty retail, or travel and leisure, all areas still experiencing resilient demand from the baby boomer cohort and wealthy consumer. Traveling abroad, the higher-for-longer narrative drove much dollar strength, but on a currency-adjusted basis, many foreign stocks in luxury, pharma, energy, and insurance/financial services also performed well. But many wouldn’t know it. We were fortunate to participate in many of these broader themes and luckily, they were additional drivers of favorable performance YTD. More on this later, for now, let’s provide a bit of an update on the economy outlook since the beginning of 2024, as our title so accurately describes, it is much of the same.

2024 Economic Outlook Update

GDP/Overall

We are witnessing corporate capital expenditure on AI software, data centers, and domestic manufacturing/infrastructure, driving much of the favorable earnings growth on the S&P500. However, it is not enough to keep the overall US economy’s real GDP growth rate continually humming along at above trend growth like 2021 and mid/late 2023. Recall that the consumer drives over 60% of GDP. With nearly 3 years since the American Rescue Plan and over 3.5 years since any Trump Era COVID stimulus, the consumer–particularly the lower income consumer–has been steadily drawing down their savings. We are just now seeing it flow through to base levels of consumer spending, specifically now in non-discretionary categories like name-brand staples and groceries. As a result, GDP growth is continuing to normalize to longer-term trends of 2%, with Q1 dipping slightly below the trend at 1.4% and Q2 estimates targeting mid-2s according to the GDP Nowcast from the Atlanta Fed As many of our readers already know, we have discussed at length the limitations of GDP, however, it is one of the best aggregates we have of the overall economy outlook in 2024. Its signaling strength might be questionable when used as a sole indicator, but it provides a decent indication of the direction of growth and is most useful when one disaggregates the components, providing context to the contributors or detractors of economic growth.

As you can see below, Q1 and Q2 are showing much lower growth attribution from consumer spending. This has been discussed ad nauseam internally and in our previous articles, but the consumer clearly bought all the TVs, furniture, and outdoor power equipment they need for the next decade. The primary difference now is you are seeing material weakness in non-durable goods/staples reported from broad-line retail, specifically on name brands, consumers are now opting for store brands and private labels. The data on earnings calls from the likes of General Mills is staggeringly bad, with many consumer staples or broad-line retailers being some of the worst performing industry groups YTD. These firms were huge beneficiaries of price inflation, and with both demand and inflation moderating, or in a lot of cases, outright deflation, margins are compressing, and revenues are stagnating/dropping. Despite all of this, we still see much of the normalization in this category as just that, normalization.

On balance and in aggregate, the offsetting impact Corporate Capex, Fiscal Subsidies in domestic manufacturing/infrastructure improvement must be made irrespective of some of the material weakness seen from some industries The safety trade for SAF has been underweighting the categories most exposed to the middle/low- income consumer, overweighting infrastructure, insurance/financial services, and technology companies, insulated from much of this marginal weakness. Again, assuming full employment is maintained, we should not see such a material weakness from the consumer in the aggregate to offset the positives for the economy represented below. More on this shortly.

Consumer/Labor Market

It’s key to note that just because we are seeing a normalization of the economic growth rate by one wage demographic of consumers, this does not equate to recession. No amount of AI or energy transition subsidies can keep an economy out of recession if consumers don’t have paychecks to consume. Admittedly, non-residential construction and subsidizing domestic manufacturing/energy infrastructure is more icing on the cake, with the real story being the labor market with wage growth not seen in over 3 decades. The majority of which come from the lowest-income households. Again, if people are employed, and sustaining wage growth is at or slightly higher than the rate of inflation, consumers will likely continue to spend enough to keep the economy afloat For some, this might be an indication of corporate profit stress or contributing to sustained inflation, for us, it just means the consumer is still capturing real wage growth, a welcomed data point given the tremendous price levels vs the pre-covid era.

For the consumer, it’s clear to us that like most things, it’s both nuanced and a bit bifurcated. On one hand, you have wealthy consumers and retirees with significant interest-bearing financial assets and low fixed-rate mortgages. On the other, you have highly levered consumers with lowering savings rates struggling to make ends meet, some of whom are shut out of the current housing market. The median value home mortgage payment has gone up over 70%, and property/casualty insurance has gone up over 50% since 2019. Yet as we’ve alluded to, if you entered 2021 as a retired homeowner, you’ve insulated yourself quite a bit to rising costs of living. Couple this with your social security COLA adjustments of 20%+ over 3 years, and 5% on your cash savings, many wealthy retirees/consumers are sitting pretty, making up nearly 40% of the US population The big question for us as investors is whether the weakening savings rate or balance sheet stress of the low to middle-income wage earner is enough to send the US into recession. Overall, the answer seems to be no when taking into consideration the entire population The beautiful balance that regulators at the Fed are hoping for seems to be materializing, specifically, to slow down inflation and bring interest rates back down to a more normal level relative to recent history.

Inflation

Speaking of inflation, how about that pesky subject? Forever, it seemed like that was the only driver of financial assets month-to-month. Now it seems a bit of a side note or afterthought, with some areas stubbornly elevated, like the

“lagged” shelter components, or auto-insurance, and other areas detracting, like durable and non-durable goods. As with many economic indicators, there are many ways one can slice and dice the data, excluding the components that some might say are “one-offs” or problematic due to their measurement methods and CPI or PCE are no exception. We have been arguing, along with many others, that once you extract the shelter component, replacing it with a better and more up-to-date measure from say, Apartments.com or Zillow/Red-Fin, you come up with a number that is actually at or below the fed’s target of 2%. The trouble is, regardless of how you might spin it, inflation is inflation, and consumers do not have the luxury of excluding these items from their spending. Furthermore, at any time in history that we’ve had well above average inflation, frankly, the individual components have always had an incredibly wide distribution. Just look at the 70’s, it was all crude oil and gasoline. That all being the case, it is important to point out that much of the remaining inflation seen in CPI is driven by auto-insurance and shelter, areas that in and of themselves have less second- order effects vs energy. However, one of the strongest indications for us, Fed officials, and PhD economists alike, is inflation expectations, which have been firmly anchored at a hair over 2% for over 12 months now. Consumers are clearly not pulling forward any of their spending for fear of even higher prices. That is when things become entrenched and you have a serious issue, this being the largest difference between now and the ’70s This, and a myriad of other points, have meant that we have re-focused a bit more on areas presenting far greater risks to markets moving forward. CPI has turned into a bit of a nothing burger as of late, at least when it comes to financial markets. “Knocking on wood.”

Fed Policy

Given our relatively benign outlook on inflation, we feel the current estimates of 2 cuts by December seen in the Fed funds futures market are appropriate. We feel there is sufficient evidence to believe that inflation has been tamed and that the risk of inflation’s re-acceleration is relatively low, particularly now given the continued slowdown in consumer spending and a cooling labor market. There is some truth to the fact that rates could have had the opposite effect on slowing down price inflation, at least when it came to housing. Exacerbated by an already undersupplied and underbuilt market, higher rates are making it far worse by locking the existing housing market into place and constraining financing for builders to shore up supply. Unfortunately, new housing supply is not something that can suddenly meet equilibrium with demand by a few rate cuts, but the existing housing stock could most certainly become more available to new buyers if people sought to move out of their current home with more digestible new mortgage rates, say at 4.5%.

Furthermore, if higher rates had little impact on the way up the overall economy outlook in 2024, and a decade of lower rates already proved to not stoke inflation, then we tend to believe in cutting sooner and more gradually, rather than risking a serious over-correction on the back end, makes quite a bit of sense for Powell.

Any hawkish rhetoric or verbiage recently, in our belief, is just there to quell the impact on financial assets if they do happen to cut. Unfortunately, the Fed has never been good at this, but it appears they are accomplishing the goals

they’ve set… there is always a first time for everything. We won’t spend too much time speculating; we pay far more attention to the fundamental drivers moving financial assets and the robust themes in play, regardless of what the Fed might do with monetary policy. Except for fixed income of course, which is positioned in the shorter and intermediate part of the yield curve (more on this later). In summary, we doubt that consumers/companies alike are letting higher or lower rates drive most of their spending decisions and feel that the Fed generally agrees. Again, given the risk of re- accelerating inflation seeming relatively low, Fed cuts are likely to come despite any major weakness in aggregate for the economy. The Fed’s goal is to slay inflation first and foremost, and it appears it is falling in line with their goals.

US Election

Before opining on this subject too much, out of any of the drivers, this is by far the least predictable of all the major drivers of markets. We have found any correlations found between presidential terms and stock market performance to be predominantly spurious. The TLDR (too long don’t read) is that markets often like certainty; if you can have a split congress, it’s no mystery that the market’s forward projected returns have a far tighter distribution of outcomes and less volatility given the likelihood of any broad policy changes becoming far less likely. For us, the main concern for the economic/market impact of the US election is two-fold, (1) Industrial policy, specifically will Trump have the ability to unwind much of the IRA bill passed during Biden’s Presidency, (2) in the event Biden is re-elected, what occurs with the Trump era Tax Cuts and Jobs Act that was both a boon for corporate profits and lowered tax bills substantially for both middle to high-income wage workers (as long as you weren’t a property owner East or West Coast).

Addressing (1) first, you’d likely need a Republican sweep of Congress as well as some broad support party wide. Sure, there are parts of the IRA bill that might be scrapped, like the EV tax credits, but when it comes to the manufacturing subsidies, there is a bit more nuance involved. Specifically given many of the benefactors of these subsidies happen to be Republican-led states. Furthermore, it has long been the case that the most economically viable green energy, Solar Energy, is heavily reliant on raw materials from China. A large part of the IRA bill was designed with the express interest of eliminating them from our supply chain, an area Trump and Biden are consistent on. Not to mention Natural gas and the oil industry love Solar as you can’t have one without the reliability of the other to supplement. Without getting too much in the weeds and speculating, we feel that most of the domestic manufacturing and industrial benefits will stay intact and therefore will continue to benefit the US economy. Any other detractions will likely be offset entirely by the benefits the extension of TCJA will have on the private sector.

On the subject of (2), Biden’s plan clearly states that upper middle- and lower-income consumers will be protected under the same tax rates found under the current TCJA, household income below $400k of AGI Anyone above that, not so much it appears… ouch… As for corporate profits, and the taxation of capital over labor, Biden has the desire to move forward with reverting to the pre-Trump era corporate tax rate of 28%, taxing unrealized capital gains at death, and raising capital gains taxation to marginal income tax rates if AGI is above $1 million per year, amongst other things. Using history as a guide, it is very unlikely all of this gets through. In aggregate, it’s clear the biggest detractor for economic growth would be raising the corporate tax rate. For a president who has the desire to stoke a domestic manufacturing renaissance in the US, it’s a bit counterintuitive. Encouraging domestic manufacturing with subsidies when our cost of labor is already high, while simultaneously increasing their cost of business further with additional tax burdens seems potentially zero-sum. Regardless, if there is any positive externality it would be the potential that under a second term for Biden, the fiscal deficits might be something a bit more likely to be reduced. But again, one must ask if the additional revenue is simply going right back out the window via jobs and corporations moving back offshore.

We are monitoring developments here, but in either case, we find that the impacts will be difficult to predict. We never underestimate a corporation’s ability to navigate changes to tax code or public policy in general to maximize or maintain shareholder value. Corporations will find a way, hence the reason it’s been a fool’s errand attempting to predict.

Corporations both lobby and pay many professionals to plan to insulate themselves from any of these major changes. Unfortunately, it’s often the smaller businesses that struggle to navigate and stay competitive.

Markets

Now, onto the bottom line: how has the portfolio done for this mid-year recap? Pretty darn well! As we had outlined in our previous Capital Markets Update, we ended Q4 ‘23 incredibly strong with the remaining deployment of our money market position in late October/early November at peak rates of 5% on the 10-year US treasury. Long-term bonds turned out to be one of the best-performing asset classes to close out the year. The excitement of carrying longer duration (which are generally longer-term bonds) fixed income quickly faded after a nearly 30% rally once the market realized how silly it

was pricing in 6-7 cuts by mid ’24. US 10-year Treasury rates spent the next 5 months whipsawing back and forth from as low as 3.8% in January to as high as 4.7% in late April as the market tried to digest incoming resilient economic data.

Since April, the bond market has settled out with the 10-year at 4.4% given recent weaker economic data from the consumer and most inflation components cooperating.

As we briefly touched on, skyrocketing auto-insurance premiums were the culprit for a few higher inflation readings than were anticipated, thankfully we are overweight financials/and more specifically insurance. The likelihood of a major recession seems to be a far less probable outcome currently; thus, we have chosen to focus on capturing as much high- quality yield as possible in the interim. We can accomplish this by bar-belling our longer-term core US treasury ETF with short or ultra-short higher-yielding credit. Coupled with a bit of emerging market sovereigns for their favorable 8-9% yields and better relative quality/value vs domestic HY, we anticipate relative dollar weakness will be an additional return driver.

On the equity side, we continue to favor the US over Foreign, with 70% of our equity sleeve falling domestic, 22% Foreign Developed, and 8% in Emerging Markets. We prefer to capture our growth exposure domestically and continue to see favor in the US tech space. However, we are carefully monitoring domestic growth stocks for any material weakness in earnings, revenue, or profit margins, as their current valuations require it. As we have alluded to earlier, with the current infrastructure/manufacturing cycle, the global transition to cleaner energy generation, and AI, growth opportunities will likely continue to broaden far outside the technology sector. What was once considered “Value-

Centric” industry groups, could possibly turn into the next decade’s growth companies… potentially companies in Emerging Market economies at steep discounts to the US.

Our all-equity portfolio has captured similar performance to domestic benchmarks like the S&P500 or the Russell 1000 performance with well-distributed performance drivers, but a clear preference for domestic large cap. Additionally, SAF is carrying a moderate overweight to Small and Mid-Cap Value stocks both domestically and abroad, both of which have been additive, not detractive, from performance. We plan on touching a bit more on this in our year-end recap, but our methods to portfolio allocation differ quite a bit from our peers. We do not believe in diversification purely for the sake of diversification, particularly if an asset class has poor relative value and thus lower forward projected returns… Instead, we seek to diversify our return drivers, spreading your assets into areas with low interdependence and performance correlation, but a high likelihood of above average returns. Sometimes this might look far more focused or concentrated, other times, the opportunity set might be far wider. Currently, our foreign exposure is nearly exclusively focused on small/mid cap value stocks with tremendously high share buybacks and dividend yields. As a result, we have outperformed our benchmark by over 5% for our all-equity allocation YTD, with 30% allocated outside the US. We continue to believe that allocating abroad in a measured way, with value-centric, small/mid-cap exposure will be quite additive to performance, without needing the Mega-Cap tech names to do all the heavy lifting. As you might notice when looking at statements, we choose to have a Shareholder Yield/Quality overlay to our exposure, as it has historically been one of the most reliable ways to achieve outperformance vs benchmarks. Remarkably, our Foreign/Emerging Market Small/Mid-Cap has an average discount to the S&P500 Growth Index of over 65% (8x) with over 4x the dividend yield (5.8%) of the S&P500 and 2x the net-buyback yield. (2.75-3%+). What does that mean? Well, without a single bit of multiple expansion or earnings growth, this asset class should be capturing nearly a double-digit annual return before adjusting for currency fluctuation.

We continue to favor the sectors in which these asset classes are overweight: Insurance/Specialty Finance/Financial Services, Energy, Industrials, Materials, and Specialty/Luxury Retail. As is the case for most US investors, we continue to carry significant exposure to Technology and have recently chosen to add a sleeve of disruptive growth, represented by Cybersecurity. We believe this category and its total addressable market opportunity are SUBSTANTIAL for many years to come. Its growth rates are much higher and on average, double that of most the Mega-Cap tech names, and should add considerable portfolio value over the long haul, with a potential boost in the interim in a non-recessionary cutting cycle.

2024 Economic Outlook

As most of our clients are aware, we have a risk reduction strategy we employ during times of serious stress for financial markets. It’s predominantly technically driven (price trends) and is designed to take catastrophic drawdowns off the table for our clients. Threaded into this strategy our Investment Committee monitors incoming data and builds a probability matrix for potential events that could result in a bear market.

Possible Outcomes for the economy moving forward (1-3 = risks or negative outcomes): **Most likely Positive Outcome**

Stagflation, slowing growth, re-accelerating/high Would likely be proceeded by a bear steepening of the Yield Curve (long-term rates rise substantially). (negative for stocks and bonds)
Taiwan Blockade or Invasion by China or escalation and broadening of conflict in the Middle (negative for high yield bonds and equities)
Fed Policy Mistake, creating a deep recession driven by the labor market and high (negative for mostly equities, but some lower quality bonds too)
**Soft-Landing/No-Landing. (no-recession, eventual economic re-acceleration or mid-cycle expansion)**(positive for most all financial assets)

We are monitoring all these material risks (1-3) but find many to be relatively low in probability (less than 10% for (1) and 5% (2), with (3) being the most likely of the risks @ 25-30% probability). As a result, we are left with a 55-60% or better chance for a softish landing or a no-landing, a positive outcome for stocks and bonds alike, scenario 4.

Irrespective of the 2024 economic outlook, we have positioned many of our clients, specifically those with much shorter horizons before retirement, in a more balanced allocation of equities to bonds given the forward projected returns for bonds in scenarios 2-4 are likely still upper-single digits at worst, to low double digits at best … As one could imagine, (1)

“stagflation” is the most difficult to address, with both stocks and bonds suffering in the event we have high inflation and low economic growth. It is likely the only potential solution being ultra short bonds, and commodities or gold.

Despite these dynamics, we feel incredibly thankful for the diverse group of asset classes now available to investors offering not only protection from uncertainty, but also handsome above-inflation returns to boot.

Closing

We believe ’24 should shape up to be another favorable year for equities/economy with pockets of weakness and some modest risks outstanding that could drive us into a bear market drawdown. We find it likely an economic normalization, followed by potential mid-cycle re-acceleration if the Fed cuts by Q3/Q4 of this year. There is no doubt Mega Cap 8 has some healthy expectations embedded that could prove to be hard to beat, thankfully the rest of the market is far from over-valued or over-hyped. Furthermore, given the broader opportunity set in fixed-income and value-centric sectors abroad, the probability of favorable returns for balanced allocations over the next 12 months is still elevated. SAF and its Investment Committee will continue monitoring the opportunities at hand to offer healthy, risk-adjusted returns amid the uncertainty. Contrary to popular opinion, some market technicians might be pointing to the lack of breadth in favorable stock performance as a warning sign, but to us, this is simply an indication that investors writ large have a low bar set for the majority of companies, one can quickly see this when comparing the S&P500 to the Small and Mid-Cap index’s in both Valuation and price performance Yet, we are seeing fundamental improvement in their

earnings/margins beginning in late ‘24 and into ‘25 Our research has shown that stocks tend to perform best when expectations are low, thus magnifying the potential for which any single company could beat the targets set for them. We look forward to checking in later this year where we plan on recapping the entire year in more detail and provide our outlook for ’25 and beyond.