By Ryan O’Donnell, CFP® and Mike O’Donnell, CFP®

Equities

Thanks to slowing inflation and hopes of near-term interest rate cuts, U.S. stocks continued their strong run for the year. U.S. equities gained +3.22 for the quarter ended June 30th. That raised the performance of U.S. stocks to over +23% for the past 12 months, significantly outperforming international developed stocks, global real estate, and most other asset classes during that time period. However, U.S. stocks underperformed emerging market stocks for the quarter ended June 30th (see charts below) as Taiwanese stocks returned nearly 13% thanks to strong investor interest in the AI/chips and Turkish stocks returned over 15% for the quarter thanks to a disciplined new central banking regime.

A closer look at U.S. equities

U.S. equities once again performed well across the board longer-term. U.S. stocks significantly outperformed non-U.S. stocks, real estate and bonds over 1-year, 5-year and 10-year periods.

Within the realm of U.S. stocks, value once again underperformed growth in Q2; small caps underperformed large caps; and REIT indices underperformed equity market indices, just as they did in Q1 (see chart below). Large growth and large cap U.S. stocks continued to outperform other sectors of the U.S. stock market over 1-year, 5-year and 10-year periods, handsomely rewarding long-term investors (see chart below). When Fed interest rate cuts finally arrive, that should give a big boost to small-cap and mid-cap U.S. stocks, which tend to be more heavily leveraged than larger-cap stocks.

U.S. real estate still outperforming global real estate

While commercial real estate continues to battle record-high vacancy rates in many major metros, U.S. real estate investment trust (REITS) declined only slightly during Q2. In fact, they significantly outperformed non-U.S. REIT’s by over 400 basis points during the quarter (-0.16% to -4.39%) and certainly longer term over 1-year, 5-year and 10-year periods.

As with most real estate investments, REITs are highly interest rate sensitive. When the rate tightening cycle officially ends – which many expect some time in Q3 -- REITs tend to perform well on an absolute and relative basis. After the Fed has reached rate stabilization, REITs historically return 20%+ over that next 12 months.

Fixed Income

Perhaps no other asset class has been monitoring potential Fed movements more than fixed income. On the short end of the yield curve -- still inverted -- the one-month U.S. Treasury bill yield decreased by two basis points to +5.47%, while the one-year U.S. Treasury bill yield increased 6 basis points to +5.09%. The yield on the two-year treasury note increased 12 basis points to +4.71%.

Many economists and market watchers believe an inverted yield curve signals a forthcoming recession, since a yield curve inversion has preceded all six U.S. recessions since 1976. HOWEVER, an inverted yield curve does not necessarily guarantee that a recession will occur as roughly 30% of the time, recessions have not followed yield curve inversions. In fact, the current yield curve inversion recently hit the two-year mark, the longest yield curve inversion on record.

Rate watchers attribute this statistical anomaly to two things: (1) high consumer savings as the economy exited the Covid-19 pandemic, which provided a buffer against rising borrowing costs and (2) the Fed managed to contain last year's banking turmoil - which was a result of changes in the shape of the yield curve - by offering emergency liquidity measures.

In terms of total returns, short term U.S. Treasury bonds returned +0.77% while intermediate term U.S. Treasury bonds returned +0.58%. Short term corporate bonds returned plus +0.96% and intermediate term corporate bonds returned +0.74%. Meanwhile the total returns for short and intermediate term municipal bonds were +0.35% and +0.92% respectively. Within the municipal fixed income market, general obligation bonds returned -0.30% while revenue bonds returned +0.07%.

Looking ahead

It’s no secret that the stock market rally since October 2023 has been fueled by the technology sector, particularly the “Magnificent Seven” mega-cap stocks (Apple, Microsoft, Google parent Alphabet, Amazon, Nvidia, Meta Platforms and Tesla). However, as Wes Crill, PhD, Senior Investment Director and Vice President, Dimensional Fund Advisors explains at the end of this report, “expecting Mag 7 outperformance to continue is to bet on these companies further exceeding the market's expectations period simply meeting expectations may result in returns more in line with the market, consistent with the history of top US stocks,” Crill added.

“Even the biggest companies have uncertain futures, highlighting the need for broadly diversified investments,” advised Crill last quarter. “And even if these companies stay at the top of the market, that’s no assurance higher returns will continue if their success is expected.”

As always, it pays to be well-diversified and fully invested. You never know which company, asset class, or sector will outperform and which will underperform. As the old saying goes: “Time in the market always produced better outcomes than timing the market.”

While many investors, fearful of a recession, have been holding on to cash since 2022, especially with money market rates returning over 5%. This is not a great strategy, considering that we’re coming up on 12 months since the Fed’s last rate hike. As the chart below shows, cash has historically returned less than 6% in the 12 months following the Fed’s final rate hike (it was July 31, 2023).Not bad, but bonds have historically returned over 11% over a comparable time period and stocks nearly 18%.