January Investment Comments
Markets have rallied since late October on the increasing belief the Federal Reserve has completed its rate hiking campaign intended to quell inflation. The Fed last raised rates in July to a range of 5.25%-5.50%, reaching 22-year highs. As inflation comes down investors are looking ahead to multiple rate cuts in 2024 with markets pricing in the likelihood of the first rate cut coming in March and five more rate reductions later in the year. Propelled by this belief, the S&P 500 has advanced more than 14% since just before Halloween, achieving new highs for the year and the highest levels since late 2021. The yield on the 10-year Treasury has also retreated from approximately 5% in late October to under 4%, helping support equities and other risk assets. As one sign of the risk-on environment, bitcoin is up more than 20% since late October.
Economic data has been generally consistent with a soft-landing scenario in which the Fed will be able to tame inflation without triggering a recession. Inflation has continued to come down, with the Fed’s preferred measure of inflation, the core personal-consumption-expenditures price index that excludes food and energy, falling to a 3.5% increase versus the prior year in October, down from a 3.7% increase in the twelve months ended September. This remains ahead of the Fed’s 2% inflation target, but the trends are favorable. The six-month annualized core inflation rate fell to 2.5%, down meaningfully from earlier in the year and a sign the Fed’s fight against inflation is on the right path.
The November data for the consumer-price index and the producer-price index imply further downward pressure on the Fed’s preferred measure of inflation in November, with six-month annualized core inflation about in line with its 2% target. Longer-term inflation expectations have also come down since the start of the year. The five-year breakeven inflation rate, a measure of investors’ annual inflation expectations, has fallen from approximately 3% earlier this year to nearly 2%, highlighting the progress on inflation and a belief the Fed will accomplish its goal of returning inflation to its target level.
As intended, rate increases have slowed the economy, but not as much as some feared. The jobs market has cooled but remains resilient. Employers added 199,000 jobs in November, though the return of striking auto workers added approximately 30,000 to this figure. Adjusting for the impact of auto workers, the approximately 170,000 jobs added is below the monthly average of 240,000 over the past year but remains above the 75,000-100,000 jobs per month needed to maintain growth in line with that of the working population. It is reasonable to expect job gains to continue to moderate, but any significant deterioration in the near term would be a surprise.
The unemployment rate also fell to 3.7% from 3.9% in November, even with the labor force participation rate growing modestly, as those entering the labor force were able to find jobs. The November jobs data also showed average hourly earnings rose at an annual rate of 4%, which is hard to reconcile with inflation returning to 2%. Something closer to 3% growth would be more consistent with the Fed’s target but will require job weakness to bring this number down.
At the Federal Reserve’s December meeting it held rates steady, which was largely expected. More interesting are the projections from investors and the Fed for the coming year. The CME’s FedWatch Tool, which reflects expectations from investors in the interest-rate futures markets, suggests no more rate increases with rate cuts beginning as early as March 2024. While the Fed’s projections released following its December meeting suggest three quarter point rate cuts in 2024, the market is pricing in six. Fed Chair Jerome Powell continues to push back against the idea of imminent rate cuts but has pivoted to a more dovish stance as the Fed manages a difficult balance in timing its next move.
As inflation comes down, the belief is the Fed will need to loosen monetary policy so that rates, adjusted for inflation, do not become overly restrictive. If it waits too long to cut rates, it could unnecessarily weigh on economic growth and cause a recession that results in job losses. If it cuts too soon, it would put in jeopardy the work it has already done to bring down inflation and risk damaging its own credibility, as Powell has repeatedly emphasized the Fed will do what it takes to get inflation back to 2%. It certainly appears the Fed is biased toward waiting longer to cut rates to ensure inflation remains on track to return to its target, but if there are signs of weakness in the labor market in an election year, there will likely be significant pressure to act.
There are two other potential scenarios that could force the Fed’s hand in the coming year. First, it could be that after significant progress to date the “last mile” of returning inflation to 2% will prove particularly difficult to achieve, requiring further increases. The second is that the “long and variable lags” with which rate increases work on the economy bite more than anticipated in coming months, damaging the case for a soft landing and resulting in rate cuts to counter a meaningful slowdown in the economy. To be sure, these are less likely scenarios, but they cannot be completely dismissed, even if the market is seemingly choosing to largely ignore both.
The S&P 500 reported third quarter earnings growth of approximately 6%, marking the end of three consecutive quarters of declines. Looking ahead to the fourth quarter, earnings are also projected to be modestly higher, leading to full year EPS growth of approximately 1%. The outlook for 2024 reflects optimism surrounding the potential for a soft landing. Revenue in 2024 is forecast to grow more than 5% with earnings up nearly 12%. Multiples remain slightly elevated relative to historical levels with the forward 12-month P/E multiple for the S&P 500 approximately 19x versus the 10-year average of approximately 17.5x.
Clearly the market this year has been led by the “Magnificent Seven,” as investors concerned about a potential recession hid out in large cap growth stocks. A soft-landing scenario would argue for small- and mid-cap stocks to help close the performance gap.
While some companies have specifically called out pressures the consumer is facing, these appear to be the exception more than the norm and have been largely concentrated on companies serving those on the lower end of the economic spectrum. Many companies serving customers at the higher end continue to see positive trends but have also highlighted conservatism in their outlooks given the macroeconomic environment. As always, there is uncertainty, but investing in growing, reasonably valued companies remains a sensible plan for the road ahead.
James M. Skubik, CFA