As we said in last quarter’s missive, the rally at the end of 2023 has been predicated in large part on the thinking that the Fed will be cutting rates in 2024. This set the table for the market to continue climbing higher in 2024 in anticipation of the rate cuts. Taking the 30,000 foot view, the positive returns on the market during the first quarter of the year would indicate that what we wrote three months ago has come to fruition, especially considering that the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite have all set new record highs. Also worth mentioning is that stocks are up across the board with small-cap, mid-cap, and large-cap indices all higher for the year. Stylistically, both growth stocks and value stocks have also risen.
In brief, the stock market has been governed by a bullish bias so far in 2024 despite some notable surprises.
Arguably, the biggest surprise so far in 2024 has been the shift in the market’s rate cut outlook. To be more exact, the biggest surprise is that the stock market has run to record highs even though the market has adjusted its thinking to expect three rate cuts before the end of the year instead of the six rate cuts expected when 2024 began. In other words, what the market began to discount following Fed Chair Jerome Powell’s rather dovish statement in December was wrong.
To understand how the market (and the Fed) got this so wrong, let’s examine how economic expectations have evolved over this timeframe. A bit over a year ago, consensus views were of a hard landing occurring in mid-2023. That then shifted to the expectation of a soft landing occurring in late 2023 or early 2024. However, recent economic data and a strong stock market have demonstrated a shift towards a no landing scenario. The blatantly weak economic data that the economists kept saying was right around the corner has not materialized.
This has been correlated with a shift in investors’ expectations for when the Fed will begin a rate cut cycle. Six months ago, the thought was that the Fed could perform its first rate cut at the January 2024 meeting. Once we go into January, expectations had been pushed out to the Fed’s March meeting. Soon after, the market priced in the first cut to occur in June. By the end of the first quarter of 2024, investors have now become split as to whether the first cut will be in June or in September. If the economic data still points to a resilient economy while inflation remains above the Fed’s 2% target, the Fed has no incentive to prematurely begin cutting rates.
Although there has been a clear delay in the start of a rate cutting cycle, we suspect the stock market hasn’t reacted negatively because investors haven’t felt a threat to the earnings outlook. Part of the reason is that S&P 500 earnings growth is being buoyed by the mega-caps. The 10 largest S&P 500 companies are expected to grow sales by 15% year/year and post EPS growth of 32%. In contrast, the remaining 490 firms are expected to grow topline by just 2% year/year and deliver EPS growth of -4%. These 10 stocks are expected to expand margins by nearly 400 bp year/year while the remaining 490 firms in the index will see margins fall by 57 bp. Higher interest rates can be a headwind for the stock market, yet the move since the start of the year has been tolerated because of the aforementioned earnings power and momentum that has propelled stocks like NVIDIA, and META. These magnitude of returns are hard for investors to ignore and allow them to look past the prolongation of the next phase in the interest rate cycle.
Date of report: April 10th 2024