Published March 29,2024
Below we offer a couple of perspectives on the current stock market and outlook for interest rates. Rate expectations have been a key driver for stocks over the past couple of years. First up, comments from Barron’s on the other driver of markets – the outlook for corporate earnings. That is followed by economist Claudia Sahm’s thoughts on how the Fed should approach the current economic environment, as investors look for upcoming cuts in short-term interest rates.
“The stock market rally this year has defied predictions. The second half of the year can either validate the market’s optimism—or ruin it.
The S&P 500 is up 29% from a recent low point in October, in a rally that has included more than just a few Big Tech stocks. The narrative is that corporate earnings can increase and that the Federal Reserve won’t damage the economy, which continues to grow amid expectations for interest rate cuts this year. The mood persists despite a trickle of higher-than-expected inflation data over the past three months that has the Fed holding off on its first rate cut. And yet the market so far has forgiven any news that could have pushed stocks lower.
Based on current consensus analyst forecasts for S&P 500 quarterly earnings, profits will rise this year and accelerate throughout the year. That’s partly because many companies have issued strong outlooks for the second half as demand just hasn’t gotten hit hard enough from higher rates.
“While there is clearly concern that an eroding economy could cause downward revisions, optimistic investors can rightly point to companies where Q1 estimates have been lowered, but full year 2024 guidance has not been reduced,” writes Trivariate Research’s Adam Parker. “This in effect creates an ‘implied’ second half of 2024 guidance that is perhaps excessively optimistic.”
After 2023 saw S&P 500 aggregate earnings per share grow not even 2%, analysts expect S&P 500 earnings per share to rise 11%, to $242, this year. That would come on the back of mid-single digit sales growth for the group, slightly higher profit margins as cost inflation subsides, and share buybacks.
That narrative relies heavily on the second half of the year. Analysts see the S&P’s first half earnings per share at $114. If companies sustained exactly that pace, full-year earnings would be on pace to hit just $228 a share, falling short of the current 2024 projection.
Instead, analysts are forecasting second half earnings of $128 a share for the S&P 500, growth of 12% from the first half. That represents the fourth largest second half rebound in the past 20 years, according to Trivariate. The average jump is 0.3%.
That’s why, for stock prices, the second half of the year is when the rubber hits the road. If earnings fail to accelerate, that could easily be the negative news that catalyzes a market drop.
“When you’re at these elevated valuations, there’s less room for forgiveness [of negative news],” says Lori Calvasina, chief U.S. equity strategist at RBC Capital Markets.
Stock investors are hanging their hats on a second half improvement in earnings. If it doesn’t see that acceleration, stocks will have nowhere to go but down for a bit.”
What role do the Fed and interest rates play? Here’s what the founder of the widely followed SAHM indicator thinks:
“Closely followed measures of U.S. inflation have come in hotter than expected so far this year, and economist Claudia Sahm is getting nervous: A recent batch of economic reports implies that pricing pressures aren’t abating steadily, which could give the Federal Reserve an excuse for what she views as “foot-dragging” on cutting the interest rates that have made mortgages, car loans and credit-card balances more expensive.
“I would really have them take 25 basis points off next week,” Sahm said in mid-March, after the release of the February consumer-price index.
In a series of recent conversations, Sahm said she wants the Fed to ease rates — which are currently in the range of 5.25% to 5.5% — ASAP. She’s not advocating for a dramatic cut but says the Fed needs to get the ball rolling on easing the tight monetary policy it has implemented over the past two years to help cool the economy and quash out-of-control inflation.
Given everything she’s heard from policy makers in recent weeks, Sahm suspects that the first cut might not come until July. The delay raises the risk that the Fed will cut interest rates too late and cause a recession, she said, by leaving a too-restrictive policy in place for too long. The Fed’s interest-rate increases have softened consumer demand as intended, mainly by raising borrowing costs.
Right now, the economy appears to be in a good place. More than three-quarters of business economists surveyed by the National Association for Business Economists on Feb. 12 forecast that the U.S. can avoid an economic recession even as inflation recedes.
But recessions are like snowballs, Sahm said: They start very small but can grow big enough to trigger avalanches, which can then sweep down on the economy — wiping away jobs, economic growth and income for millions of people.
“They are taking risks that I have a hard time wrapping my head around,” she said of the Fed, which is led by Jerome Powell.
Sahm knows a thing or two about how recessions begin. The economist and former Fed staffer created the Sahm rule, a popular indicator that is considered the best — and earliest — warning system for recessions.
She noticed that recessions, both severe and mild, shared one characteristic: They started when the three-month average of the unemployment rate rose by at least half a percentage point from the minimum three-month average of the previous 12 months.
A slight uptick in unemployment in February’s jobs report — from 3.7% to 3.9% — immediately brought the Sahm rule back into discussion early this month. Sizable downward revisions to December and January job growth, which some economists said resembled recession-type weakness, added to the concern.
Jason Furman, a former White House chief economist who served in the Obama administration, said that the “balance of worry” in the February jobs report tilted “ever so slightly away from inflation and towards recession.”
Economists have generally been expecting a recession since the Fed started raising interest rates in spring 2022. When the unemployment rate jumped a few times last year, most notably in May and August, talk of the Sahm rule resurfaced. But in both instances, the rise in the jobless rate reversed.
Today, the three-month moving average of unemployment is 3.8%. That average minus the lowest three-month moving average of the past 12 months stands at 0.27 percentage point, well below the Sahm rule’s trigger of 0.5 percentage point.
Deterioration in the labor market can be slow at first, Sahm said, but it has the potential to steadily accelerate.
“The labor market’s bottom [won’t] fall out all of a sudden,” she said. “But if the bad momentum gets going and you wait to see it clearly in the data, you’ve probably waited too long. Because once that snowball gets going downhill, nobody can stop it.”
Other areas of the market that are sensitive to interest-rate changes, such as the insurance industry, have already started to show signs of the stress created by restrictive rates, she said.
Powell’s press conference last week and Fed officials’ projections point to three rate cuts this year, maintaining hope for a series of cuts that Sahm said would alleviate some of the stress from higher rates. “I had no hope they would cut, because they weren’t going to cut,” she said after the Fed meeting. “But I got what I wanted, which is no drama.”
That said, nine out of 19 Fed officials are skeptical about the need to cut rates in June.
Despite her worries, Sahm said she still believes there will be a soft landing for the economy and continued low unemployment. Inflation is on track to reach the Fed’s 2% target by the end of the year, which will allow the central bank to cut rates three or four times this year. But the later the Fed starts cutting, the fewer cuts it will make.
“My main risk for the Fed is the Fed — that they just go too slow,” she said. “Every time they wait, they are turning up the dial on a recession risk, which they cannot stop once it gets going.”
Market Update
Another AI-fueled rally lifted shares Monday after a report suggesting that Apple could use Google’s AI engine sent the search company’s stock sharply higher. The broad market rode the rally to a +0.6% gain. The move higher continued Tuesday (+0.6%) with energy shares continuing their recent lift. The rally accelerated Wednesday when the Fed confirmed a projection for three interest rate cuts in 2024. Given recent sticky inflation reports there has been some concern that any cuts would be off the table. The broad market indexes rose +0.9% with a higher move among more interest rate-sensitive sectors, like financials, which broke out again. Another gain Thursday on news that Switzerland became the first major central bank to cut interest rates. Semiconductor maker Micron posted sharp gains on better earnings while European and Japanese stocks hit record highs. The broad U.S. market added +0.2% Thursday weighed down by a -4% drop in Apple shares while smallcap stocks continued their surge on lower interest rates. Friday saw markets digest the week’s gains with a mixed performance while smallcap shares gave back a portion of their sharp two-day run. FedEx became the latest company to post strong earnings and see their stock surge higher.
The Fed reiterated their message from December, which seemed to please investors this week leading the S&P 500 (SPY) to a +2.45% weekly rise. The Nasdaq 100 (QQQ) rose +3.17% while smallcap stocks (IWM) gained +1.99%.
Warm wishes and until next week.