April 10, 2024
The U.S. economy remains surprisingly resilient, and the Federal Reserve, at its most recent meeting, seemed to affirm market hopes that it would begin cutting rates later this year. The financial markets are naturally euphoric over these developments, which has contributed to strong stock market gains during the first quarter.
During the quarter, we did see early signs of broadening market participation with all sectors except real estate showing positive returns. However, momentum remained the dominant market factor, fueled by heavy interest in the A.I. secular growth theme, with a continuation of strong gains in a handful of mega-cap technology stocks. While not as stark as what we witnessed last year, the top four performers within the so-called “Magnificent Seven” – NVIDIA, Meta Platforms, Amazon and Microsoft – accounted for roughly half of the S&P 500’s gain for the quarter.
The Atlanta Fed’s GDPNow real-time estimate of first-quarter real GDP growth was recently revised upward to +2.8% quarter-over-quarter annualized. This comes on top of +4% annualized growth in the second half of 2023. Despite a weather-induced dip in January, consumer spending has remained well-supported by growing employment and wages along with improving household balance sheets from rising home and stock prices. Private fixed investment, including a pickup in housing, appears to have strengthened in the quarter, while government programs for infrastructure, the EV transition, and the CHIPS Act continue to supply a steady flow of investment into the economy.
Looking ahead to the rest of the year, it is uncertain how long the consumer can sustain its spending habit, especially as savings continue to shrink. Slowing wage gains, growing credit balances, and rising interest payments and gas prices are becoming stiffer headwinds. The economy is therefore likely to become even more dependent on private and public investment as consumption starts to wane. We continue to expect the lagged effects of the Fed’s tightening to lead to further moderation in economic activity. Despite the recent uptick, housing is likely to remain challenged by a lack of supply and high mortgage rates, and auto production plans may get scaled back as dealer inventories continue to climb. Due to the stronger start, we have upgraded our GDP growth forecast for this year from +0-1% to +1-2%.
Meanwhile, after seeing steady progress in the second half of last year, inflation reaccelerated in January and February as the beneficial impact of goods deflation came to an end, fuel prices rose, housing inflation remained stubborn, and prices for core services, excluding housing, demonstrated additional stickiness. As a result, we estimate that inflation in March, as measured by the Consumer Price Index (CPI), should be +3.4% year-over-year. Excluding volatile food and energy prices, core CPI should be +3.7%, still well above the Fed’s 2% target. However, similar to our growth outlook, we expect to see a resumption in the disinflationary trend as we progress through the year. Core goods inflation should remain non-existent. Rents should gradually reflect the downward trend we have been witnessing in real-time rent measures, especially as the supply of new apartments increases significantly in coming months. We also expect slowing wages will allow labor-intensive services inflation to further moderate. We now expect CPI to fall in the +2.5-3.0% range by year-end, up from our prior forecast of +2.0-2.5%.
Enthusiasm for A.I. remains quite elevated, but investors appear to have begun differentiating between today’s actual beneficiaries, such as those supplying the infrastructure layer, and those further down the chain that one day hope to monetize applications built around the large language models that have been developed. Investors are likely to continue searching for real-world use cases and commercial deployment of A.I. for code writing, content creation, advertising, search, and smart assistants that can bolster confidence in the sustainability of the heavy investment we are currently witnessing.
UBS recently highlighted how most of the market outside of the technology and communication services sectors (referred to jointly as “TECH+”) has been in a mild earnings recession over the past twelve months while TECH+, led primarily by the “Magnificent Seven”, has enjoyed a robust earnings recovery coming out of its own profits recession in 2022. This helps to explain the huge divergence in relative stock price performance between the “Magnificent Seven” and the rest of the market over the past year. Looking ahead, however, profit growth for the “Magnificent Seven” is likely to moderate at the same time that earnings growth accelerates for the rest of the market. If so, this may provide a catalyst for a catch up trade by the “Not-So-Magnificent 493” over the coming 12 months.
The consensus bottom-up EPS estimate for the S&P 500 has moved very little so far this year, and at $244 still projects double-digit growth in 2024. Stronger economic growth and inflation to start the year has provided added support for this forecast. However, we continue to believe it is likely to prove too optimistic. We now estimate earnings of $232 for this year, up from our prior view of flattish earnings compared to 2023’s $220 per share.
While the economy continues to display impressive momentum, and inflation should soon resume its downward trajectory, these fundamentals seem to be more than fully reflected in valuations. The S&P 500 is currently trading at 21x forward earnings, implying an equity risk premium of just 54 basis points, which is historically low. Furthermore, our proprietary calculation of price-to-present value for the market currently sits at 136%, higher than any other time outside the late 1990’s tech bubble. These elevated valuations seem to reflect investor expectations for a best-of-all-worlds period of strong growth and Fed rate cuts. We remain skeptical that investors will get both.
Source: Montag & Caldwell, FactSet.
PVT=Present Value Total; P/PVT=Price to Present Value Total and represents our estimate for the S&P 500’s price relative to our estimate of its intrinsic value. ERP stands for equity risk premium. ERP is calculated by subtracting the 10 year Treasury Yield from the earnings yield for the S&P 500. ERP is the additional return that investors would expect to earn by investing in the stock market over a risk-free asset. This premium compensates investors for the higher risk of investing in stocks. Monthly data as of March 31, 2024
We believe it is unrealistic to expect the Fed to begin cutting rates when the economy is performing so well, unemployment is so low, inflation remains above target, and asset prices continue to surge higher. A premature easing by the Fed would run the risk of excessive speculation, which would then require more damaging corrective actions. Combining elevated valuations with investor surveys showing excessive bullish sentiment, we believe the preconditions are now in place for a long-overdue 5-10% correction, which could occur at any time. Anything more detrimental than that would likely require a recession-induced decline in corporate profits, which we currently do not see, but cannot rule out due to ongoing quantitative tightening, contraction in the money supply and a yield curve that remains inverted.
As such, we remain defensively positioned with additional cash reserves ready to be deployed opportunistically during any market pull-back. We continue to believe a diversified portfolio of reasonably-valued, high-quality durable growth stocks allows ongoing participation in the current bull market while offering superior downside protection amidst any bouts of market volatility that may arise.