Q2 2024 Quarterly Market Outlook: Embracing New Perspectives

Greetings from your new Directors of Investment Research, Kofi Kodua and Liz Levy! While this report has historically been a straightforward summary of the past quarter and expectations for the next, we are going to also spend some time this quarter discussing Clean Yield’s investment philosophy — what’s changing and what isn’t. 

The Path Forward

The second quarter marked the beginning of a new era at Clean Yield. As new Directors of Investment Research, we bring fresh perspectives formed over decades of socially responsible investment experience. Our primary responsibility remains the careful construction of portfolios that meet the needs of our clients, in line with the values Clean Yield has long held. As we are assessing our portfolios and the companies we invest in, the team expressed a desire to ensure that portfolios are exposed to a broader slice of the U.S. stock market, augmented by investments in international stocks as appropriate, to balance risk mitigation and investment opportunity. A tool that will help us provide this balance is paying more attention to benchmark U.S. stock indices to use as guideposts — not as mandates that we need to mirror, but as a measure of exposure to the facets of the economy we choose to invest in.

This approach is already showing up in portfolios. For example, we have begun increasing exposure to the Information Technology sector. While we remain concerned about market frothiness and high valuations, the shift to cloud computing over the past several years and the ongoing AI revolution have fundamentally changed the way global businesses operate, and they present investment opportunities that should be represented in our client portfolios. We will always be mindful of valuations and continue to seek high-quality companies. In this way, we will construct portfolios in a disciplined manner that balances risk mitigation and the potential for capital appreciation. 

What is also not changing is our unwavering commitment to sustainable, socially responsible investing. We are committed to the heritage and ethos that has driven Clean Yield for more than 40 years and that attracted both our clients and ourselves to the firm. We strongly believe in the impact that Clean Yield can have in the public markets through our shareholder advocacy and proxy voting practices, and in the right and responsibility of our clients to align their investments with their values.

Market Recap 

From the vantage point of the end of the second quarter, investors seemed to set sail into the summer in a good mood, with stock markets near record highs and bond market pricing reflecting optimism that the worst of recent inflation is past. The market had been a bit choppier earlier in the quarter, as stronger-than-expected economic data in April triggered fears that the Fed would need to delay interest rate cuts, but subsequent, weaker economic reports calmed fears, and stocks resumed their climb. 

By the end of the second quarter, U.S. stocks, as represented by the S&P 500 index, had notched solid gains, setting new highs near the end of the quarter and posting a 3.9% gain for the period. Digging a little bit deeper, though, the Nasdaq composite, a more Information Technology-heavy index, posted an 8.3% gain for the quarter, and the Russell 2000, which tracks smaller companies than the S&P 500, lost 3.3%. Semiconductor manufacturer Nvidia, Apple, Microsoft, and Google-parent Alphabet drove the Information Technology and Communications Services sectors to returns greater than 9%, while the only other two positive sectors were Consumer Staples and Utilities. On the fixed-income side, a firming expectation of rate cuts led to falling Treasury yields and, as a result, positive returns for bonds and Treasuries. The yield curve remains inverted, a classic recession omen, with short-term Treasuries yielding more than longer-term bonds. 

The interest rate path drama was one of the two main themes this quarter. For a year, investors have been laser-focused on when the Fed would begin cutting interest rates — and by how much. Fed officials have maintained that they are “data dependent,” meaning their decision on rates would be based on data they receive about their twin mandates: lowering inflation and maintaining employment. All year, investors have pored over employment and pricing data to gain a sense of what may be coming. At the beginning of the year, the bond futures market indicated expectations of up to seven interest rate cuts during the year, with the expectation they would have started by now. Of course, that hasn’t happened, and the bond market is now anticipating one to three cuts, starting this fall. 

The other theme during the quarter was the continuation of market narrowness, meaning just a few stocks made up the entirety of the index’s gain, while the rest of the market was treading water or declining. Or, said another way, the gigantic technology and internet stocks continued to dominate this quarter. Or, yet another way, AI (artificial intelligence) enthusiasm continues, unabated. 

To us, this seemingly strange combination of AI mania and overall skittishness is pretty indicative of where we are in the economic cycle right now.

As a reminder, the Fed normally lowers interest rates because the economy is weakening, with the intention to either enable a “soft landing” by reducing inflation without triggering a recession or to rejuvenate growth. So, at this point in the cycle, “bad news” (weakening economic data) is often seen as “good news” (indicating that rate cuts are coming). At the same time, hope and hype for AI right now are at incredibly high levels, as consumers and businesses are beginning to imagine what AI can do for them but still really don’t know. According to data from Factset, 199 of the S&P 500 companies mentioned AI on their quarterly earnings conference calls from March 15 to May 23, and those companies mentioned it an average of 11 times (and AI helped me find those statistics!). An interesting dynamic is that often as new technologies gain traction, it is new, innovative, and smaller companies that drive adoption. This time however, the network effects and high costs of developing AI mean that it is the large companies that are driving adoption. And so it is not surprising to us that investors are piling into AI as an attractive growth area in a time of unease regarding overall economic growth, or that the relative advantage of the larger companies operating in this space is contributing to the market narrowness. 

For Clean Yield portfolios, the continued outperformance of these large tech names has continued to hurt performance compared to benchmarks. As mentioned above, we have begun increasing portfolio exposure to Information Technology stocks in a measured way, being mindful of valuation and market positioning. 

Economists and forecasters have been talking about a looming recession for more than a year — so if one should develop, it will not have been a surprise. At the same time, many other countries’ central banks have already started cutting rates. While the U.S. economy may be weakening, it has been far stronger than that of other G7 countries in the post-pandemic recovery. The economic prognosticators have been debating whether the U.S. economy would be able to pull off the rare feat of the soft landing.

Whether a recession materializes or not doesn’t particularly matter — our perspective is that the U.S. economy is slightly weakening, which will allow the Fed to begin loosening rates over the next few months. While we cannot predict the future, we do not expect a severe downturn, and we believe that companies have had time to prepare. 

What about investors? Have we prepared? One way to measure the state of the market is to use the cyclically adjusted price-to-earnings (CAPE) ratio, also known as the “Shiller P/E” for the economics professor who developed it. This ratio is often used to judge whether a market is overvalued at any point in time. That ratio is currently nearly 36x, lower than it was a year ago but higher than at any other point since 2001. Does that guarantee weak returns? Unfortunately, it’s not that simple, but it is an indication to be wary of overvalued stocks, and it’s one that we are heeding.

Although it seems this is always true, now is particularly a time of uncertainty. On the economic side, we are awaiting an inflection point. But the influence of the real world on markets is undeniable as well, as this fall’s election is already casting its uncertain shadow. We believe that now, more than ever, is the time for taking a long-term perspective on investing in companies seeking to meet the challenges of tomorrow, in alignment with our firm’s values and heritage, and using our voice as investors.