Overcoming Hurdles
The U.S. stock market maintained its momentum in early 2024, with the S&P 500 Index notching a second straight double-digit quarterly return — a feat not seen since 2012. In recent months, improving economic news has led investors to increasingly embrace the idea that the economy may have weathered the worst of the spike in interest rates and dodged a recession.
Cutting to the chase
Market strength persisted despite two events that, at first glance, should have dampened sentiment and derailed the rally. First, the Federal Reserve punted on interest rate cuts. Initially, investors expected six cuts in 2024, with the first as soon as this past March. That mindset had fueled the year-end rally. Instead, the Fed has kept the short-term policy rate at its elevated level and foresees the need for only three cuts this year.
The Fed’s lack of urgency to reduce rates and stave off a potential recession reflects an economy that keeps surprising to the upside. Fourth quarter GDP grew by 3.4% (annualized), driven by buoyant consumer spending. And this followed a 4.9% surge in the third quarter. Consequently, the central bank revised its 2024 GDP growth outlook from 1.4% to 2.1%. However, inflation has been sticky and remains well above the 2% target level, explaining the Fed’s hesitancy to lower rates prematurely.
Gang of 4
Second, the stock market rally persisted despite cracks in the Magnificent Seven trade. Tesla plummeted 30% in the first quarter, becoming the worst-performing holding in the S&P 500. Apple’s stock price also fell by double-digits while Alphabet needed a late-period rally to eke out a gain. Nonetheless, the remaining four (Amazon, Meta, Microsoft, Nvidia) still accounted for about half of the index’s return over the first three months.
Last year, weakness among the leaders could have easily short-circuited the stock market. However, in 2024, the market has so far shrugged off these challenges. Strong U.S. growth has encouraged investors to diversify, scooping up a broad array of stocks, not just a handful of technology companies riding the A.I. wave. Indeed, in March, over half of S&P 500 constituents hit new highs, and all major industry sectors outside of real estate saw gains.
The transition from a narrow market to one with a greater dispersion of strength represents a positive signal. Bull markets cannot be sustained by a handful of companies or one or two sectors; they must either extend to other pockets of the market or perish.
Profits or else
Can this rally endure? There are signs that investors have become overly optimistic. Risk appetites have jumped across a variety of asset classes in both public and private markets. At the end of March, the AAII Investor Sentiment survey indicated that half of individual investors shared a bullish near-term outlook while only 20% were bearish. Moreover, by most measures, stock valuations are on the higher side of long-term averages. History suggests that while such an environment can persist, it also implies the possibility of a pullback or, at the very least, a pause.
The next leg up in stock prices will require ongoing support from rising corporate profits. A resilient economy and robust consumer demand are expected to fuel an increase in earnings growth for S&P 500 companies for a second straight quarter, following three quarterly contractions. Based on analyst estimates, FactSet Research and S&P Global both expect earnings to expand at an accelerating annual rate through the year, reaching 20% growth by the fourth quarter after starting at a low single-digit pace.
At this point, Wall Street forecasts that S&P 500 operating profits will rise 10-11% in 2024. Collectively, the Mag 7 are expected to achieve very solid but slowing earnings growth as the year progresses. Conversely, the remaining 493 companies are expected to post accelerating growth, surpassing the Mag 7’s pace by the fourth quarter. If so, investors should continue to rotate towards other areas of the market.
As goes the consumer
Of course, one should be skeptical of forecasts, particularly those issued by Wall Street. Regardless, after helping the country avoid recession in 2023, the American consumer will remain critical to the growth outlook. A steady rise in household finances has boosted consumer confidence. For many, it must seem like the Roaring 2020’s: Home values, stock prices, and household net worth are at or near all-time highs while savers can earn 5% on their cash.
A surprisingly strong labor market has also supported consumer spending. Job creation has been solid, and the unemployment rate stands below 4%. Nevertheless, there are some subtle fissures indicating a softening labor market. While still elevated, the number of job openings has dropped significantly over the past two years. A reduction in openings often precedes layoffs. Additionally, the number of quits has declined sharply, suggesting that workers are less willing to leave their current jobs.
Tug of war
Since the Fed embarked on its aggressive campaign to tame inflation, financial markets have fixated on the threat of an ensuing recession — for that is typically how such cycles have played out. While those fears have largely dissipated, the tug of war between growth and inflation persists.
Core inflation continues to come in too hot for the Fed’s liking. In March, the core Consumer Price Index advanced 3.8% year-over-year, surpassing market expectations. Once again, higher shelter costs (+5.7%) drove more than half of the overall increase. Core inflation has stubbornly settled around a 4% pace for the last seven months.
Recent inflation figures, coupled with a strong March jobs report, have further jeopardized the timing of a Fed pivot. Policymakers have not seen enough evidence that inflation is on a solid path to the 2% goal. Interest rate cuts will likely be pushed even further out, which could cause bond yields to reset higher temporarily while throwing some water on the blazing stock market.
Stay tuned
Fortunately, a hardy economy with gradually decelerating inflation provides the Fed with flexibility, including the option of delaying rate cuts. And based on trends in wage growth and rent prices, headline inflation numbers should continue to trickle down. The alternative scenario — a strong economy with accelerating inflation — could force Powell’s hand, producing rate hikes and additional rounds of pain for financial markets. Thus, eyes will stay glued to the monthly inflation prints.
Over the last two quarters, equity investors have benefited from a series of favorable economic reports that propelled stock prices higher. As Federal Reserve policy has yet to become a tailwind, stocks will primarily take their cue from corporate profits trends. And perhaps more so than usual, investors will also need to be attuned to the potential impact from external factors — such as the conflicts in Europe and the Middle East, rising tensions between the United States and China, and of course, the 2024 U.S. presidential election.
— Christopher J. Singleton, CFA, Managing Director
April 15, 2024