December Investment Comments
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.
Despite the weaker than expected employment reports for both July and August contributing to the initiation of rate cuts, a strong September jobs report helped quell concerns surrounding a softening labor market. Still, the unemployment rate in October stood at 4.1%, up from 3.7% at the end of 2023. History suggests that once the unemployment rate rises, there can be some persistency to the move. The Fed is extremely focused on achieving a soft landing and concerns in response to increased unemployment led to a shift toward a less restrictive policy stance. If, as expected, the Fed cuts rates in December, the target rate would stand at 4.25%-4.50% versus a longer-term expectation from Fed members for a target rate of approximately 3.0% and market-implied expectations of approximately 3.75%. This suggests continued room for Fed easing over the next couple of years provided inflation doesn’t return as an issue.
The October jobs report was notably weak, with just 12,000 jobs added. This was well below modest expectations and significantly fewer than recent months. By comparison, the average monthly jobs gain in the prior three months was 155,000. The disappointing jobs report for October was somewhat overlooked by investors because of distortions caused by hurricanes and strikes. However, when combined with the downward revisions for August and September, which totaled 112,000 jobs, the report provided additional evidence that the labor market is softening. Consistent with this view, Fed Chair Powell has said the labor market is not currently a source of significant inflationary pressure.
Inflation as measured by the Fed’s preferred personal-consumption expenditures price index (PCE) was up 2.1% in September, down from a 2.2% increase in August and closing in on the 2% target. The September core PCE, which excludes food and energy, was up 2.7% versus the prior year, matching August. This marks substantial improvement versus headline PCE inflation in excess of 7.2% in June 2022 and readings in excess of 5% in early 2023. However, the October consumer price index was somewhat less encouraging with headline prices up 2.6%, higher than the prior month, while core prices increased 3.3%, flat with September.
U.S. GDP grew at a solid 2.8% annualized rate in the third quarter, down slightly from 3.0% growth in the Q2. Consumer spending, which makes up most of economic activity in the U.S., remained resilient increasing 3.7% in Q3 marking the fastest rate since early 2023. Strong exports and spending on defense also helped support growth. The housing sector remained weak, impacted by high mortgage rates. Final sales to private domestic purchasers, a measure of consumer and business spending that strips out inventories, trade, and government spending, rose at a 3.2% annual pace in Q3 versus 2.7% in Q2.
In the initial wake of the election, markets moved higher on hopes of a deregulatory agenda and the possibility of corporate tax cuts. According to Bank of America, $20 billion flowed into U.S. equity funds the day following the election, the most in five months. Small cap stocks were also noticeable beneficiaries, as the Russell 2000 had its best day in nearly two years. Banks moved higher in anticipation of a more favorable regulatory environment and cryptocurrencies also have seen increased interest. Donald Trump said during the campaign he would ease the regulatory burden on crypto and create a national bitcoin reserve. Following the election bitcoin has broken through $90,000 and is now up more than 115% year to date. The dollar has also moved higher on the prospect of stimulative fiscal policy and the potential for fewer rate cuts.
Based on its agenda there is a chance the policies enacted by the Trump administration could prove inflationary. Higher tariffs, deportations impacting the supply of labor, and lower taxes could all put upward pressure on prices. With inflation currently running ahead of the Fed’s target there is some risk this pressure could curb the ability of the Federal Reserve to further cut rates.
The bond market has sniffed out that risk. 10-year Treasury rates have moved higher since the election and are now greater than 4.40%. Implied 5-year inflation expectations have also ticked higher. Given elevated multiples for stocks, investors are closely watching the 10-year Treasury yield. If Treasury yields continue to increase it could pressure stocks. A general consensus is it would take a 10-year yield in the neighborhood of 4.5%-5.0% for equity investors to potentially experience some indigestion. However, the reasons behind a move higher in yields from here matters. Are yields moving higher because of inflation expectations increasing or concerns regarding the deficit (bad reasons) or expectations of better growth (a good reason)? Additionally, the rate of change for yields is often more important for markets than the ultimate level.
While uncertainty is always present in markets, the current environment is seemingly characterized by more than is typical. Growth that has proven more resilient than expected, corporate earnings that are set to accelerate next year, and the Fed continuing to ease monetary policy all offer support for bullish sentiment and reasons for markets hovering near highs. This is countered by higher long-term Treasury yields, with the potential for greater inflation, as a source of potential risk. The forward P/E ratio for the S&P 500 is just over 22x, elevated relative to the 5-year average of 19.6x. However, given current Treasury rates a question investors might ask themselves is what looks more attractive, a fixed 4.4% yield over 10 years for Treasuries or a current 4.5% earnings yield on stocks with the potential for further growth? The answer to that question depends on each investor’s circumstances but history would suggest buying quality, growing companies trading at reasonable prices is a rational way to approach investing for long-term success.
James M. Skubik, CFA®