News & Insights

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. 

The S&P 500 closed above 5,000 for the first time in history on February 9. The index has risen more than 50% since the end of 2019. The Russell 2000 index of smaller companies has only slightly underperformed the S&P over the past month. The persistent rally finally broadened out.  

Valuations are stretching, though. According to FactSet Earnings Insight, authored by John Butters, the S&P’s estimated forward P/E ratio has risen to 20.3, above the 5-year average of 18.9. With three quarters of the S&P having reported fourth quarter earnings, the composite Q4 growth rate for earnings stands at 2.9%. That modestly lags consumer price inflation over the same period, meaning the purchasing power of corporate earnings remains in modest decline. Markets look ahead, suggesting improved earnings growth will be necessary to justify the optimism baked into current valuations. 

Last year the market rebounded from what was a challenging 2022. Investor sentiment going into 2023 was decidedly negative, as the Federal Reserve’s aggressive rate hiking campaign to quell inflation led market participants to broadly anticipate a recession that still has not arrived. Instead, the economy proved more resilient than many expected while the Federal Reserve’s campaign against inflation showed progress. Falling inflation coupled with the anticipation of easier Fed policy has raised investors’ spirits heading into 2024. The possibility of inflation returning to more normal levels while the economy remains healthy has increased hopes for a “soft landing,” something that historically has been difficult to achieve. 

Recent data on inflation has been encouraging, trending toward the Federal Reserve’s customary 2% target. The consumer price index for December showed headline inflation increased 3.4% on an annual basis, an acceleration from 3.1% growth the prior month. That is the wrong direction, but in more encouraging news, the core consumer price index, which excludes volatile food and energy prices, fell to a 3.9% annual increase in December, a modest tick lower from 4.0% growth in November. The Fed’s preferred inflation measure, the core PCE price index, rose 3.2% in November versus the prior year, down from 3.4% in October. Notably, the November PCE inflation data took the core six-month annualized rate of inflation down to 1.9%. 

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.

Since late October, the stock market has rallied off multi-month lows and is now back near its 2023 highs, giving something extra for investors to cheer about as we head into this holiday season. Third quarter earnings are largely in the books, with Q3 2023 marking the first quarter of year-over-year earnings growth since Q3 2022 according to Earnings Insight by FactSet’s John Butters. The recent rally has returned S&P 500 valuations to approximately their five-year average of 18. That feels a little rich considering what has happened to interest rates over the last five years.

Investors in long-term bonds feel like they are repeating a bad song while investors in stocks are likely not doing as well as the media headlines assume.

In 2022, the Federal Reserve began its campaign to tame inflation by increasing the Federal Funds rate from zero to 4.25% by year end. The 10-year Treasury followed, ending at a yield of 3.88%, up from about 1.5% at the start of the year. Because the price of a bond moves opposite to yields, this dramatic increase in rates led to double-digit losses for bond investors.

After a bit of a reprieve in 2023, bond investors are feeling the pain again. The 10-year Treasury yield fell to 3.25% in April but has since steadily increased to about 4.8%, as the Fed has further increased the Federal Funds rate to 5.25%. With inflation still above the Fed’s 2% target and economic growth strong, it isn’t likely that bond investors will escape another year of losses.

As we head into the fall, 2023 has left egg on the face of most forecasters. The seemingly inevitable recession on the heels of a turbulent 2022 hasn’t materialized. The economy continues to grow, inflation is abating, and the stock market has had a remarkable year. Interest rate increases haven’t torpedoed the employment market. Government, consumers, and the market have coalesced around a “soft landing” narrative. However, as always, there are risks.

Since March 2022, the Federal Reserve has executed eleven separate increases to the Federal Funds rate, bringing it to a range of 5.25% to 5.5%. This rapid pace of increases is having the desired impact on inflation and a red-hot labor market.

Long-term interest rates were choppy with no clear trend in 2023 through the end of July but broke to the upside in August. The 30-year Treasury’s yield recently surpassed its 5-year high of 4.2%, with the 10-year also nudging above 4%. Long-term rates have not traded above these levels for an extended period since the financial crisis of 2008-09. It will be interesting to see whether investors treat this like a ceiling for rates or keep allowing them to rise.

Basic supply and demand for government debt may force a new equilibrium at higher rates, meaning lower bond prices, as the U.S. fiscal deficit will balloon to more than $1.5 trillion in the government’s fiscal year that ends in October. Deficits as a fraction of GDP have averaged 3.6% since 1973. This year’s deficit is likely to be more than 6% of GDP. That is a lot of supply.

Since early 2020 the economy has undergone a series of shocks. First came the Covid-19 pandemic, which continues to impact the economy more than three years later. Next came the war in Ukraine, impacting global oil and wheat markets.

Most recently the emergence of Generative Artificial Intelligence (GAI) is a technological development that some have said could be as profoundly positive as the invention of the internet, mobile devices and cloud computing. Only time will tell if GAI lives up to the hype, but these shocks have brought tremendous volatility to the economy and financial markets.

Unprecedented monetary and fiscal support in response to the pandemic has brought elevated inflation. Since March 2022, the Federal Reserve has been pursuing monetary tightening, resulting in the fastest pace of rate hikes in U.S. history, eleven separate increases bringing the federal funds rate to a range of 5.25%-5.5%. The Fed is attempting a soft landing for the economy, raising rates just enough to slow growth without causing a recession.

The U.S. economy is still feeling the after-effects of the Covid emergency more than three years after it began. In the early going, consumers hoarded items they feared would be in short supply like toilet paper and cleaning products. Demand for many types of services like travel and dining collapsed. In the next phase, component shortages caused prices of many goods to surge. Then, as Covid restrictions eased and demand returned, labor shortages led to further price increases. The war in Ukraine exacerbated growth and price challenges.

The government played a role as spending levels and easy monetary conditions were left in place for too long even as the worst of the crisis had clearly passed. The Federal Reserve was caught flat-footed, assuming the nascent surge in inflation two years ago to be “transitory.”  It has spent the last year and a half making up for its initial failure, raising short-term interest rates from around zero to 5.00%.

The chattering class in the media and in Washington D.C. is wailing about the debt ceiling, but stock and bond market behavior suggests little concern. Treasury Secretary Janet Yellen says that there is only enough financial flexibility to avoid default until early June, so this matter is coming to a head. President Biden and the Democratic Senate insist on a “clean” bill to raise the debt ceiling which seems unlikely to pass the Republican-controlled House. Republicans insist on spending cuts and a slowdown in future spending growth as a condition of raising the debt ceiling.

The concept of a debt ceiling has not always been part of U.S. finance. From the founding of the Republic until 1917, each and every bond issuance was approved by Congress. Article I of the Constitution specifically empowers only Congress “To borrow money on the credit of the United States.”  During World War I, Congress enacted the Second Liberty Bond Act, permitting the Treasury Department to borrow without prior congressional authorization, as long as total debt didn’t exceed the approved amount. The debt ceiling was born.

The Economist, a British news magazine, put a cowboy on the cover of its April 15 issue and sang the praises of America’s resilient economy. They wrote, “America remains the world’s richest, most productive and most innovative big economy. By an impressive number of measures, it is leaving its peers ever further in the dust.”

Indeed, while Britain and much of continental Europe are experiencing recession, U.S. GDP expanded 2.6% in the fourth quarter, with the Federal Reserve Bank of Atlanta forecasting 2.5% growth for the recently-completed first quarter. After a volatile period during the pandemic, we appear to be regaining our old form of consistent real GDP growth above 2%. Although some forecasters are contemplating a late-year recession, almost no one expects a deep or long-lasting one.

The bill has seemingly come due for the Federal Reserve’s mistaken belief inflation was “transitory.”  A late start in tightening policy to combat inflation led to the fastest rate hikes in forty years, and it should come as no huge surprise the stress from such a move might break something. The collapse of Silicon Valley Bank (“SVB”), the 16th largest bank in the U.S., was the headline casualty, but Signature Bank was also shut down by regulators and the impact was evident across the sector, notably regional banks where share prices declined sharply.

Given the potential for widespread market disruption, regulators stepped in with a package of emergency measures to calm fears among depositors and help prevent contagion. The actions taken brought back unwelcome memories of the financial crisis. The government announced the FDIC would guarantee all deposits held at SVB and Signature Bank, even those beyond the $250,000 limit, by invoking a “systemic risk exception.”