It’s hard to believe it’s nearly July. As we cross the midpoint of 2024, we wanted to pause to reflect on how the markets have fared this year and acknowledge a few data points we’ll be keeping an eye on in the latter half of this year.
One of the biggest stories of this year has been the rise of Nvidia, which we’ve been viewing within the broader story of market concentration. One of the historical tenets of both market and business theory is that companies follow business cycles by which they enter the market, experience a growth phase where customers adopt the new product or service, and eventually enter a phase of maturity where they often reach a stable cash flow phase before eventually phasing out as new businesses and innovations enter the market.
Source: Harvard Business Review: Exploit the Product Life Cycle
This is a simplified explanation of the business cycle, and there are many exceptions – with some firms failing during early phases or firms having a lengthy maturity phase (for example Coca Cola has been going strong for decades now). What’s worth noting about the cycle is its implications for markets. In the past, the top ten companies in the S&P 500 rarely stayed the same for more than a decade. If you consider the list over the last 50 years, you’ll find a constantly changing list, that is, until recently.
Over the last 20 years, we’ve seen significant staying power from tech firms like Microsoft and Apple, which now boast market caps of over $3T. Not only are these firms maintaining their dominance, but their dominance is incredibly concentrated. Today the top 10 firms by market cap comprise over 30% of the S&P 500.
Source: JPMorgan Guide to the Markets
This means that significant gains, and losses, by a singular firm can lead to notable market swings, somewhat negating the value of differentiation. Add to that exuberance for AI, and it’s easy to see why many analysts anticipate heightened stock market volatility for the foreseeable future.
Speaking of AI, there has been a lot of talk lately on both market and economic implications. Our view, consistent with many economists, is that while AI is poised to disrupt industry, it’s still early in the game. A few weeks ago, I traveled to the University of Michigan to participate in an innovation residency as part of my master’s program. During my time there, many discussions surrounding innovations centered on the role that AI had to play. At one point, I had the opportunity to experiment with utilizing AI to achieve a simulated business solution. I observed that while the software is certainly novel, it’s still not quite capable of providing a quality output. If you squint from far away, the output looks and sounds great, but it starts to break down under scrutiny. While AI has enormous implications for how we will work and engage in the future, for now, we view it as a novel piece of technology with unknown potential that will still take some time to realize.
Of course, that doesn’t mean that markets aren’t keen to bet on who the winners will be in the AI race. While we don’t know how it will broadly impact various industries, and we aren’t yet seeing much movement in stock prices of companies that will likely find ways to utilize AI for efficiency gains, there has been a lot of movement in the players producing the technology. Nvidia, Microsoft, and Apple’s market caps continue to reach new heights. While there is some justification, it’s also incredibly difficult to know how much. At the end of the day, market caps must be justified by expectations for future cash flows, and how those companies will convert their AI technology into revenue remains to be seen. Nevertheless, it’s an integral part of the market to watch, and we want to be grounded in fundamentals, particularly regarding capital preservation.
The other big story we’re watching this year is interest rates. While many predicted significant cuts to the Fed Funds rate earlier this year, those cuts have yet to materialize, in part due to stickier than anticipated inflation. Despite higher borrowing costs, the U.S. economy continues to hum along, with GDP expected to grow 2.6% in 2024, according to the OECD. That said, the long-term expectation is that the Fed will still cut rates as inflation normalizes, given that they continue to target a long-term rate of 2.6% - roughly half of the current rate.
Source: JPMorgan Guide to the Markets
The implications for this move are much clearer than those of AI. In a vacuum, a drop in interest rates causes borrowing yields to rise as the price of debt rises because future debt is issued at lower rates. This should result in better returns for bondholders than we’ve seen in many years.
Lower interest rates also have implications for record-high returns on cash and money market funds. As interest rates fall, checking and savings account yields will also fall, leading those piled into cash into a sticky situation. While it may be tempting to continue holding large cash positions, real returns could lead to a decline in purchasing power. For example, as inflation normalizes, we expect it to hover between 2 and 3%. If cash yields drop to similar returns, those yields will be canceled out by inflation, and the real return on cash will drop to zero. As such, cash management will be an essential topic in the coming months.
As we look to the second half of the year, we remain focused on the interplay between rates, inflation, market expectations, and the specifics of our client’s financial plans and goals. If you have any questions regarding these topics or others, we encourage you to reach out.
Sources
Economic outlook: Steady global growth expected for 2024 and 2025. (n.d.). https://www.oecd.org/newsroom/economic-outlook-steady-global-growth-expected-for-2024-and-2025.htm
Levitt, T. (2024, April 18). Exploit the product life cycle. Harvard Business Review. https://hbr.org/1965/11/exploit-the-product-life-cycle
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