Weekly market wrap

What changed?

Key points:

• Inflation readings so far in 2024 have revealed that the back of inflation has yet to be broken. Last week, the Federal Reserve held interest rates steady but indicated conditions are not improving at a pace that would support a change in policy setting anytime soon. We still believe the next Fed rate move will be a cut. But we suspect it will be much later in the year than we anticipated before a cut can confidently be considered.
• The labor market played both the villain and the hero for the markets last week. Early week labor cost data stoked concerns of ongoing inflation, while the end-of-week jobs report came in cooler than anticipated, soothing concerns while still exhibiting signs that employment conditions remain supportive for consumers. 
• With the lion’s share of S&P 500 companies having reported first-quarter results, the profit picture continues to brighten. While the Fed and jobs report grabbed most of the attention last week, incoming quarterly announcements have largely been beating expectations, while management commentary and outlooks have been rather upbeat, supporting recent upward revisions to estimates for 2024 profit growth.

After five months of sharp and steady gains beginning last November, the mood in the financial markets has shifted in recent weeks. The catalysts for the swing — Fed policy, the jobs market and corporate earnings — were all in the spotlight last week. And while the net result was a gain for stocks (starting May off on an up note following April’s decline, which was the first monthly loss since this past October), recent market swings reflect a new set of facts emerging from incoming data.

So what changed? And does this change our opinion on the outlook for the markets? Here’s our take: 

Fed policy: From “when” to “if”

• What was the story?
  • Coming into 2024, markets were inspired by the prospect of Fed rate cuts. This was the catalyst that arrested the rising-rate-driven market correction last fall and jumpstarted the rally at the end of October. While it was widely recognized that there was more work to do on inflation, the trend had been one of consistent improvement. Core CPI (consumer price index) moderated for 11 straight months and fell below 4% in December for the first time since May 2021.
  • As a result, at the start of the year, markets were pricing in six Fed interest rate cuts in 2024, with the first expected in March. We did not share this view, as we’ve long believed the Fed will err on the side of caution to avoid declaring a premature victory and risk reigniting inflation pressures. Nevertheless, we came into the year directionally aligned that the Fed would begin easing policy this year, cutting rates three times starting in the back half of the year.
• What changed?
  • Even our more cautious expectations for a Fed pivot to rate cuts proved to be optimistic. Inflation readings so far in 2024 have revealed that the back of inflation has yet to be broken. We’re not seeing — nor do we expect to see — a resurgence in inflation pressures, but it’s become clear from recent data that the trend of improvement has stalled out of late.
  • Last week, the Fed held rates steady (as expected) at its latest policy meeting but changed its assessment of progress in core inflation returning to its intended target, indicating it is less confident of achieving its target this year. Monetary policymakers didn’t suggest a new, worrisome trend in inflation is afoot but did emphasize conditions are not improving at a pace that would support a change in policy setting anytime soon. So whereas 2024 started with markets debating which month rate cuts would begin and how many cuts there would be, incoming data have shifted that debate toward “will they or won’t they cut this year?”

Recent sticky inflation pushes back the Fed’s rate cut timeline

Shelter prices must moderate more to help lower inflation.

• What now?
  • We still believe the next Fed rate move will be a cut. But we suspect it will take at least three or more consecutive months of improving inflation readings before the Fed will take that step, meaning a fall or even late 2024 cut is a reasonable, but not inevitable, timeline. Markets have been obsessed with the precise timing, but we think the more important factor is direction.
  • Timely data indicate that some relief on services and shelter inflation will take shape as we progress, which tells us that six to 12 months from now, monetary policy settings will be less restrictive. That is the outlook upon which the 25%-plus market rally from October through March was built. And while that has been delayed, it’s not been derailed, in our view. As such, some volatility and even market weakness is reasonable as expectations recalibrate. But we think a Fed moving toward rate cuts (at some point) is more of a tailwind than a headwind for the markets ahead.
  • A word on rate hikes: Some chatter emerged ahead of last week’s Fed meeting that suggested the Fed may need to resume rate hikes to quell inflation. This certainly can’t, and shouldn’t, be ruled out, but we think the likelihood is still low at this stage.
  • For one, current policy settings appear to be restrictive but clearly need more time to fully seep through the economy. Two, the next leg lower for inflation will be tougher than the initial-stage decline from the 2022 peak, but this will require some help from moderating consumer demand (more on this below), which we think is in the cards as we advance. And third, while we think a rate hike would be a clear negative for the stock and bond markets in the near term, we don’t think hiking policy rates by another 25 basis points (0.25%), with the policy rate already above 5%, would change the math on the inflation backdrop. As such, we don’t think the Fed will be quick to do so and instead will view existing policy settings, maintained for a longer stretch, as a necessary approach for lowering inflation from here.
  • Speaking of holding rates at current levels for longer, prior instances offer some encouragement. The Fed held the Fed Funds rate steady from September 1992 to January 1994, with the stock market returning 16% during that time. After hiking rates aggressively through 1994, the Fed kept its policy rate on hold from February 1996 to February 1997, with stocks gaining 26% over that stretch. Following a brief hike, the Fed paused again from March 1997 to August 1998, with stocks adding 45%. The Fed remained on hold again from June 2006 to August 2007, with the S&P returning 16% in that time.* While the markets have experienced some recent indigestion with the prospect of delayed rate cuts, these instances suggest an extended pause by the Fed doesn’t have to be detrimental to market performance.

Labor market: Looking for Goldilocks

• What was the story? 
  • Perhaps the most consistent element of the investment backdrop for the last few years has been the significant strength of the labor market and the resulting boost that has provided to the consumer and overall GDP growth. We started 2024 with unemployment only slightly above historic lows and monthly job gains that averaged 250,000 through 2023, key factors that enabled the economy to avoid a recession, which we thought was a reasonable outcome after the Fed’s historic policy tightening (rate hike) campaign through 2022.
  • As far as favorable conditions go, a healthy labor market is near the top of the list. Our view has been that the labor market can remain in sufficiently healthy shape to support an ongoing expansion. Our prior expectation for an economic slowdown was largely based on other segments of the economy (manufacturing, capital investment, housing investment) that were contracting following 2022’s rate hikes. There is evidence that these areas are now rebounding, taking some of the pressure off the consumer to hold up GDP growth. At the same time, based on our assessment of underlying employment trends, our expectation has been that the labor market will soften as we move through 2024, showing up in the form of slower hiring and a modest uptick in the unemployment rate.
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• What changed?
  • The labor market played both the villain and the hero for the markets last week. While we noted that a healthy labor market is positive overall, worries over recent stubborn inflation have been accompanied by the “good news is bad news” market reaction, meaning good employment conditions and consumer demand are bad for the Fed’s ability to cut rates.
  • Early last week, the release of the first-quarter employment cost index (ECI) data showed that labor costs have firmed recently. Markets responded with a Tuesday sell-off, with elevated wages viewed as a pressure point for inflation. Friday’s release of the latest jobs report came to the rescue, however, spurring a late-week rally as cooler employment figures eased those fears.
  • The U.S. economy added 175,000 jobs in April, notably below consensus estimates looking for roughly 240,000 new payrolls. This was the second-lowest print in the last 12 months and a notable downtick from the 276,000 average in the first three months of the year. Thanks to an increase in the labor force, the unemployment rate edged up to 3.9% (from 3.8%) but remained below 4% for the 27th consecutive month. 
  • The real headliner, however, was the trend in wages. Year-over-year wage growth ticked down to a three-year low of 3.9% (from 4.1%), helping offset the concerns from the Q1 ECI reading.

Monthly job gains slowed in April but remain consistent with a healthy labor market

Slower wage growth is helping ease inflation concerns.

• What now?
  • We don’t love it when the market roots for bad news. After all, looking for weaker economic data just so the Fed can cut rates in hopes of stimulating — wait for it — better economic data is not a particularly sustainable dynamic. Nevertheless, we don’t think it’s necessarily negative for the labor market to cool a bit. The bulk of the disinflationary trend coming from improving supply chains and post-shutdown normalization has likely been experienced. From here, to get inflation to a sustainable level, we think we’ll need to see some moderation in the relentless consumer demand that has transpired over the last few years.
  • The ideal path ahead is a Goldilocks one in which the labor market softens enough to allow wage growth to fall further, but doesn’t soften so much that job gains turn to declines and unemployment rises meaningfully. This is far from a guarantee, but encouragingly, we think this is a very plausible outcome.
  • The continual growth in labor supply, along with rising labor force productivity (another notable trend recently), is a powerful one-two punch that can allow for ongoing low unemployment alongside falling wage growth and inflation. Data out last week confirming the further downtrend in job openings and quit rates signal to us that there will be less upward wage pressure ahead. That, combined with the fact that excess household savings have been significantly reduced, tells us that consumer demand is poised to moderate but should remain in positive territory, supporting ongoing economic growth this year.

Earnings: Quietly adding support

• What was the story?
  • As mentioned, the strong run in the equity markets has been hitched to the enthusiasm around the coming rate cuts. While there have been plenty of other factors at play, the Fed has occupied the majority of the spotlight. Meanwhile, the health of the economy has been adding support to corporate profit growth.
  • Weakness in the ISM Manufacturing index in 2022 and 2023 was accompanied by weakness in corporate profits. But the rebound in manufacturing activity, along with ongoing strong household demand and a boost from mega-cap tech profits, has driven corporate earnings to new highs.
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  What changed?
  • With the lion’s share of S&P 500 companies having reported first-quarter results, the profit picture continues to brighten. While the Fed and jobs report grabbed most of the attention last week, incoming quarterly announcements have largely been beating expectations while management commentary and outlooks have been rather upbeat, supporting recent upward revisions to what we think was an already positive estimate for 2024 profit growth.
  • What looks particularly compelling to us are the signs of broadening across the earnings landscape. In recent quarters, the tech sector — namely the Magnificent Seven** mega-cap companies — have been supplying the earnings firepower. Earnings growth for the Magnificent Seven has topped 50% in the last two quarters, while earnings for the remainder of the S&P 500 have been flat to down.
  • That tide looks to be turning, with earnings across other sectors gaining some momentum. In fact, earnings growth in the most recent quarter has been strongest in the consumer discretionary, communication services, health care and industrials sectors, a positive sign that earnings support is broadening out across the market.

Stocks slipped as Fed rate cut expectations were dashed.

• What now?
  • Markets have been surprisingly and encouragingly resilient over the last month as rates have risen and expectations for Fed rate cuts have been pushed out. The fact that the market has gone from pricing in six rate cuts to one rate cut in 2024 over just the last few months with only a 5% pullback is, in our view, a reflection of the fact that the earnings growth outlook remains quite favorable. Similar or even smaller adjustments to Fed expectations during the last two years produced much larger negative reactions in stocks.

Earnings growth should set the tone for market performance this year.

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  • We think the market can be tolerant of high rates for longer as long as the economic backdrop remains sufficiently solid to support current expectations for earnings growth. With valuations having already risen in anticipation of higher earnings, we think this year’s market gains will be largely driven by the pace of earnings growth. This suggests to us solid upside for equities this year, though unlikely to match last year’s sharp gain. In any event, our overweight recommendation to equites reflects our view that stocks can outperform bonds and cash ahead, even though we think lower rates over time will also support more compelling bond returns.
  • This won’t, in our view, come without additional bouts of volatility ahead, so portfolio diversification and an opportunistic view of temporary pullbacks looks to us to be an appropriate stance. We’re encouraged to see both earnings and performance leadership broadening beyond mega-cap tech, as we think this builds a healthy base for the bull market to extend.

Valuations have risen but don’t look overextended to us if earnings growth remains strong.

Market leadership has broadened beyond tech to cyclicals and defensives. 
 

Craig Fehr, CFA
Investment Strategist

^{Sources: *FactSet, total return of the S&P 500 index. **The Magnificent Seven are Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA and Tesla.}

Weekly market stats

^{Source: FactSet, 5/3/2024. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *4-day performance ending on Thursday.}

The week ahead

Important economic releases this week includes the Michigan Consumer Sentiment Survey and outstanding consumer credit data.

Review last week's weekly market update.