Global markets ended the second quarter mostly higher, with large US stocks gaining ground as stocks related to artificial intelligence (“AI”) rallied in the second quarter. At the same time, some other market sectors slightly retreated amid increased concern about interest rates remaining high. Within the S&P 500 index of the largest US stocks, for example, companies related to AI jumped 14.7% this quarter while the rest of the S&P 500 slid by -1.2%. The overall result: a net gain in the S&P 500 of 3.9%.
Investors outside of the technology sector turned more cautious in the second quarter. The market had been buoyed by expectations for interest rate decreases, which would be a tailwind for stock prices, but those expectations have cooled off. According to CME Group data, investors are pricing in only a 30% chance of short-term rates being 1% lower (or more) by March of next year, while back in February, investors were almost 100% certain that rates would be at least 1% lower by March of next year.
A significant factor in the projected pace of interest rates declines, in turn, is the path of inflation. The Federal Reserve is still waiting to see whether inflation will continue to trend lower in 2024 before it begins lowering rates. As of the latest figures released in June, inflation’s rise has slowed, to 3.3% year over year, but the pace of decline has been hampered by the continued high cost of housing. Housing costs (named “shelter” in the Consumer Price Index reports) were up 5.4% for the 12-month period, and they make up a significant part of the overall inflation figure. The fact that housing prices have not retreated as much as would be expected in the face of the Fed’s hiking of rates since 2022 is complicating the Fed’s next move.
Finally, as the US elections come into view, we have received a number of questions about how the elections might impact markets. Historically, whether a Republican or a Democrat is in the White House has not had a clear impact on subsequent market direction. More recent evidence suggests the same – markets rose in the short and long run after President Trump was elected in 2016, and markets rose in the short and long run after President Biden was elected in 2020. The most recent example might be the impact (or lack thereof) of the Thursday, June 27th presidential debate. President Biden performed so poorly that it initiated controversy about replacing him as a candidate but there was little impact on the market the next day, as the S&P 500 initially rose a bit, then ended the day slightly lower.
Stocks
The Russell 1000 index of large US companies gained 3.6% in the second quarter of 2024. The market was led by technology stocks, as mentioned above. Other outperforming sectors included communication services and utilities. Several sectors, including financials, energy, industrials, and materials lost value in the quarter. Smaller company stocks overall lost value also, as the Russell 2000 index of small US stocks declined 3.3%.
Developed international stocks, as represented by the MSCI EAFE Index, declined -0.4% for the quarter. Since the low point at the end of the third quarter in 2022, however, the MSCI EAFE index has gained a cumulative 46.2%, which is just a bit shy of the Russell 1000’s remarkable 55.0% cumulative return over that period.
Emerging market stocks, as represented by the MSCI Emerging Markets Index, were up 5.0% for the quarter. Since the recent market bottom at the end of the third quarter of 2022, emerging markets are only up 29.5% cumulatively, due to China’s market weakness. Excluding China, emerging markets are up 40.5% since that date.
Bonds
US Treasuries were little changed over the quarter, and prices for bonds were almost flat. As a result, the US Aggregate Bond Index gained 0.07% this quarter.
Bond yields remained higher than they have been for most of the past decade. The 10-year Treasury yield reached 4.7% in April, after nearly reaching 5% last October for the first time since 2007, before pulling back to 4.4% at the end of the quarter.
Currencies and Commodities
Oil prices flattened out over the quarter, with WTI crude oil prices starting the quarter at $83 per barrel and ending at $82. Gasoline prices actually fell slightly, which was helpful in reducing headline inflation.
Gold prices have continued to rise – with gold picking up almost 5% for the quarter and 13% for the year. Since late 2022, gold prices have increased almost 50%, despite factors that traditionally spell trouble for gold: higher interest rates and a strong US dollar. The emerging answer to this mystery is that China is buying large amounts of gold.
China’s central bank bought more gold last year than any other central bank in the world, adding more to its reserves than it had in nearly 50 years. It is buying gold to reduce dependence on the US dollar – as of March, China had $775 billion of US debt, down from $1.1 trillion in 2021. Additionally, Chinese consumers have been buying gold, as confidence in traditional investments like real estate and stocks have faltered there.
Looking Ahead
Nvidia, the leader of the AI boom, has gained nearly 600% since the start of 2023. In June, it briefly surpassed Microsoft as the world’s most valuable publicly listed company. Does this represent a bubble comparable to the internet bubble of 25 years ago?
On the one hand, no. Nvidia’s earnings have soared just as quickly as its stock price, seemingly justifying its current valuation.
On the other hand, yes, if the bubble is in the purchase of Nvidia’s chips: about $50 billion has been invested in Nvidia’s chips since the boom began according to Sequoia Capital, a venture capital firm, while generative AI start-up companies have brought in only $3 billion in total sales. It’s still early days in the AI boom, but if all these chips don’t start producing some revenue, demand will eventually fall off.
Regardless of whether the AI boom is a bubble or not, the US large company rally has been going on quite long, and valuations are high compared to historical averages for the S&P 500. The S&P 500 index currently trades at 26 times the last 12 month’s earnings. Other indexes are much lower – for example, the MSCI index of international stocks trades at 16 times the last 12 month’s earnings, and the Russell 2000 index of small company stocks trades at just 14 times the last 12 month’s earnings.
The AI boom may have more room to run. Artificial Intelligence has clearly broken through to new levels of usability in many industries. That said, as investor and author Seth Klarman once remarked, “At the root of all financial bubbles is a good idea carried to excess”. There is no question that the internet bubble of the late 1990s was rooted in a real transformation – the internet has changed the world – but valuations were carried to excess. The AI boom may also be carried to excess, and it will be helpful to be diversified and also have exposure to other asset classes if and when that happens.