News & Insights

The Year In Review: A Reflection on Markets and the Economy

Equity investors have much to celebrate this year as indices continue to rise to all-time highs. The Federal Reserve cut interest rates in September for the first time since 2020, boosting investor optimism and supporting the strong rally in stock prices. In a reversal of recent trends, small-cap companies represented by the Russell 2000 index surged post-election, outperforming large-cap companies. Optimism for policies favorable to U.S. companies may have contributed to some of the outperformance as smaller companies tend to have more exposure to domestic markets.

Stocks were already trading near all-time highs prior to the election, after which markets took another leg higher. Overall, equities have been supported this year as the economy has held up better than many expected following the Federal Reserve’s interest rate increases to combat inflation. A combination of inflation tracking back towards the Fed’s 2% target and concerns about a softer labor market set the table for the Fed to kick off an easing cycle in September with a larger 0.5% cut, its first rate reduction in four years. Beginning the path toward less restrictive policy while consensus expectations reflect projected earnings growth of nearly 10% in 2024 and approximately 15% in 2025 make a relatively attractive backdrop for equities, helping to explain some of the bullish sentiment exhibited by investors.

The Fed continued down the path toward easier policy with a 0.25% cut in November with expectations for another 0.25% reduction in December. Market expectations are for an additional 0.50% of easing in 2025, which should help support equities. Additional rate cuts meaningfully beyond that over the coming year would likely be in response to unwelcome economic or geopolitical developments.

Judging solely by the U.S. stock market, economic conditions could hardly be any better. Year to date, the S&P 500 is up more than 22%. Investors may be taking their cues from economic data suggesting a desirable “Goldilocks economy,” one that is neither too cold nor too hot. Economists forecast U.S. Gross Domestic Product to be up about 2.5% for 2024. Inflation has been gradually ebbing.

Underlying statistics paint a murkier picture. Manufacturing has been in a recession for most of the past two years, and new factory orders continued to decline in August. The Institute for Supply Management’s Purchasing Managers Index showed continued contraction into September. The weakness is largely due to high interest rates that reduce demand for big-ticket consumer and industrial goods like cars, appliances, and factory machinery. The Federal Reserve’s goal in hiking interest rates in recent years was to slow down the economy by making large items more expensive to finance. Demand for services, about 80 percent of the economy, continues to rise steadily.

While the S&P 500 remains near all-time highs, markets have been choppy as sentiment has vacillated between belief in the Federal Reserve’s ability to achieve a soft landing versus concerns regarding a more significant slowdown. Progress on inflation set the table for the Fed’s half-point rate cut at its September meeting, as Chair Powell had noted that the balance of risks to the Fed’s two mandates, price stability and stable employment, have changed. Inflation has come down, trending toward the Fed’s 2% target, while the labor market has slowed. Given the increase in downside risks to employment, at the Jackson Hole gathering Powell stated the Fed “does not seek or welcome further cooling in labor market conditions,” clearly articulating the Fed has shifted its focus, opening the door to a rate cutting cycle.

The September rate cut was the first reduction since 2020, marking the end of the policy tightening the Fed embarked upon beginning in March 2022 to combat inflation. Rate hikes resulted in the target range for the federal-funds rate hitting 5.25%-5.5%, a two-decade high, and remaining there for 14 months prior to the recent cut. This hiking cycle had the desired impact as the Fed’s preferred measure of inflation, the core personal-consumption expenditures index (PCE) came down to 2.6% in July, the most recently available data, compared with a peak of more than 5.5% in 2022. Based on consumer and producer price data already released for August, economists expect the headline PCE for August will be approximately 2.3% with the Fed’s own preferred inflation measure, the core PCE, advancing 2.7%. While we are not yet at 2% inflation, the general trend has been in line with what the Fed would like to see, and policy remains restrictive, albeit less so than before the recent cut.

For much of 2023 and into 2024, markets experienced a low level of volatility in the face of the fastest interest rate tightening cycle in U.S. history. However, since reaching a peak on July 16 the S&P 500 recorded both its best and worst days since 2022 during the week of August 5-9. The reasons for higher volatility are a softer economy, Artificial Intelligence (AI) skepticism, global uncertainty, and a contentious election cycle.

Since 2022, the Federal Reserve has been able to focus on inflation as the employment market has enjoyed a strong recovery from the pandemic. The news here recently has been good. After inflation slightly increased during the first quarter, the CPI has now slowed for four straight months. July’s reading of 2.9% year over year marks the first time since March 2021 that the index has been below 3%. Progress on the core CPI, a measure that excludes the often-volatile food and energy components, is also encouraging, coming in at 3.2%. Other indicators confirm inflation’s downward path. The Fed’s preferred inflation index—the Personal Consumption Expendi­tures, or PCE—has fallen from a high of 7.1% two years ago to 2.5% in June. The Producer Price Increase, or PPI, rose 2.2% year over year in July and has cycled around 2% since early 2023.

After spending much of the year lagging behind the Magnificent 7, a broader array of stocks joined the party and pushed the market to all-time highs. The reason appears to be investors’ growing belief that the Fed will start cutting interest rates in September in response to falling inflation and a softer employment market. Interest rate cuts would improve the prospects of non-technology stocks by spurring economic activity and increasing the appeal of those paying dividends. 

Investors take cues from the Fed’s data dependency when setting interest rates to fulfill its dual mandate:  full employment and stable prices. The Fed started the year expecting three rate cuts in 2024, but inflation’s rise and a solid employment market in the first quarter led the Fed in early June to revise its expectations to just a single quarter-point cut. 

Economic growth has been steady, unemployment is relatively low, and the stock market is flirting with all-time highs. Yet, 68% of Americans rated economic conditions as fair or poor in a recent survey. Meanwhile, 32% said the economy was good or excellent.

The problem isn’t the overall economy, but different perspectives based on one’s position in the economy. An investor with a substantial stock portfolio considers conditions to be pretty good because their personal circumstances are likely favorable. Someone who doesn’t own stocks might not share that rosy point of view.

The S&P 500 has rebounded to all-time highs, up over 10% year-to-date after recovering from a dip of over 5% in April. Earnings season is upon us, with over 90% of companies already reporting results. Using FactSet’s blended formula that combines reported earnings with remaining estimated earnings, analysts expect 5.4% year-over-year earnings growth in the first quarter. The index's top five contributors to earnings growth are Nvidia, Alphabet, Amazon, Meta, and Microsoft. Excluding these five compa­nies, year-over-year earnings growth is estimated to decline 2.4%. Medium-size companies represented by the S&P 400 have advanced 8% this year, broadening the rally. Small companies remain far behind, with the S&P 600 up only 1% year-to-date.  

The Dow Jones Industrial Average looks to pierce through 40,000 for the first time in history. The index of 30 blue chip companies, up nearly 5% in 2024, is price-weighted rather than market-cap-weighted. The Dow has lagged other indexes for many years as market-cap indexes continue to benefit from the outperformance of mega-cap companies. However, the potential of these large companies to spend hundreds of billions of dollars on hardware and software in the next few years to develop artificial intelli­gence and alternate reality environments is a source of great anticipation. It will be interesting to see how this investment will shape their future earnings growth.  

The first quarter of 2024 was largely a continuation of the strength the stock market exhibited in 2023. The S&P 500 advanced nearly 11% in Q1, following a strong 2023 that saw the index rise 26%. Large-capitalization technology companies again led the way, as the Magnificent Seven averaged a 13% gain for the year through March, while the remainder of the S&P 500 was up a more modest 6%. In contrast to the lockstep move amongst the Magnificent Seven last year, the dispersion of returns amongst this celebrated group in the first quarter was notable. Nvidia was the strongest performer, riding investor enthusiasm over artificial intelligence to a greater than 80% gain in Q1. At the other end of the spectrum, Tesla shares fell 29% as demand for electric vehicles cooled.

Overall investor sentiment has been supportive of risk assets, as belief has increased the Federal Reserve will be able to engineer the historically difficult “soft landing” by bringing down inflation without a meaningful economic slowdown. Inflation has come down from the peaks achieved in 2022, the economy has remained resilient, and consensus expectations reflect double digit earnings growth in each of the next two years. Add to this Fed’s indications it has likely reached the end of its hiking cycle along with expectations for multiple rate cuts this year and it makes sense why market participants have been bullish.

Expectations for rate cuts in 2024 have moderated since the beginning of the year. Based on the CME FedWatch Tool, the current expectation is for three 0.25% rate cuts in 2024 with the first cut occurring in June. This is down from expectations at the start of the year for six rate cuts with the first reduction occurring in March. One might expect the revisions since the start of the year would spell trouble for equities, but stronger than expected economic data has helped propel the market while calming fears regarding an imminent recession. 

Real GDP increased 2.5% in 2023 and economists tracked by Bloomberg now expect real GDP to grow more than 2% in 2024, reflecting the view that the risks of a near term recession are remote. Regardless, the Fed appears ready to step in upon signs of a meaningful downturn in the economy while fiscal policy also remains stimulative, helping support risk appetite.