After taking a break from our weekend readings, we are back. Today we are
going to bring everyone back up to speed starting with last quarter’s economic
progress, earnings, and our viewpoint looking into Q2. I want to thank both
Sam Milette, who we quote all the time, and Rob Swanke for their commentary
and data herein.
The two big topics that have seemed to captivate market observers for the last
two years are interest rates and inflation. You can’t leave your house without
noticing how the cost of goods has been increasing. In addition, high interest
rates (at least as compared to the last 20 years) are described as being a
burden on the economy. But when we put these things in context, what we
have is actually encouraging.
Simply put, interest rates are not “extremely” high in a historic context. I’d
describe them as being moderately elevated when compared to historical
rates, as well as being elevated as a defense against inflation due to a
“stubbornly strong” economy. Below is a graph of the Fed funds rate over the
last 70 years or so.
As you can see, rates are high. However, rates appear to be much higher
comparatively if you isolate the last 15 years or so, primarily due to rates
staying near zero following the housing debacle and the global economic
meltdown that started in 2007.
While inflation is also historically high, it seems to be much higher than we
remember it being in recent years due to inflation being uncharacteristically
low following the crisis of 2008.
It’s important that we situate this data in its proper context because, if we
agree that these two metrics are high but not extreme, we look to other
related metrics to provide a better holistic picture of current conditions. Among
the most prominent metrics that we consider here at MORWM is
employment. Quite simply, it’s hard to describe an economy as weak when we
are at (or in this case, above) full employment.
Full employment is generally considered to be 96% rather than 100% which
common sense might suggest. This is because, like many things in life, there
will always be a certain amount of employment mismatches. Like the perfect
employee for Oliver Wealth Management who unfortunately lives in the wrong
part of the country. According to the U4 data, we are currently at 96.2%
employment, which is higher than full employment. Is this a concern of
sorts? Absolutely. The simple law of supply and demand dictates that when
there is greater demand, prices go up. Naturally, with full employment, there
is a lot of demand for goods. We’ll also acknowledge that there have been
some pretty tricky issues with the global supply chain following the COVID
shutdown. However, that disruption is largely over, and the demand side of
the supply/demand curve still affects the two-pronged relationship with or
without supply chain disruption.
Below is the historical American unemployment rate. You can see that we are
currently at ~4% unemployment (since we are currently at 96.2%
employment). As we’ve previously written, a small amount of unemployment is
an unavoidable economic reality.
We can plainly state that we are currently experiencing a strong economy. In
fact, it is this very employment data point that encouraged us to dip buy
aggressively in June and October 2022. Though the inflation rate was
considerably higher then (well into “terrifying” territory), it was the
employment rate alone which influenced us to go all-in during the 2022
market downturn. At that time, the low on the S&P 500 was 3,650. Today, it
is 5,200. (P.S. It was not just this one metric. Though it was the most
influential of the metrics we observed at the time, we’re not that obtuse. But it
does make the article more interesting to say that it was.)
Let me wrap up this introduction by saying that it is very important that we
measure the current climate in multiple ways. The weather can be cloudy and
ugly, but still hot with sun rays strong enough to burn a person right through
the cloud cover. It seems this is an apropos analogy especially given the
truckload of geo-political chaos in the world at present.
So, let’s get into the core of our conversation. Sam and Rob, the floor is
yours…
March was another positive month for markets, continuing the rally to start the
year. Improving corporate fundamentals and a supportive economic backdrop
drove solid single-digit returns for U.S. markets during the month. This capped
off a strong quarter for U.S. stocks, an encouraging sign that the economic
and market momentum from 2023 has carried over into 2024.
While stocks performed well during the month and quarter, fixed income was a
bit more mixed. Investment-grade bonds were up in March but ended
modestly down for the quarter due to rising interest rates. High-yield bonds,
typically less driven by interest rate movements, ended both March and the
quarter in positive territory.
Looking Back
Strong economic growth. U.S. stocks benefited from stronger-than-expected
economic growth at the end of last year and the start of this year. GDP growth
came in above economist estimates in the fourth quarter, and we saw solid job
growth and consumer spending to start 2024. More than 500,000 jobs were
added between January and February, which was strong on a historical basis
and above economist estimates.
High inflation. The economic growth in the first quarter was largely positive,
but it also caused inflation to remain stubbornly high. While there were modest
improvements in getting year-over-year inflation down in 2024, both headline
and core inflation remained above the Fed’s 2 percent target, and the pace of
improvement slowed. This result caused investors to reassess their
expectations for monetary policy going forward, contributing to the rising
interest rates we saw during the quarter.
Looking Ahead
A shift in market expectations. Given the impressive economic resilience and
still-high inflation we saw in the first quarter, markets have adjusted their Fed
expectations for the rest of the year. We started the year with futures markets
pricing in six interest rate cuts by the end of 2024; we ended March with
futures markets calling for just three interest rate cuts by the end of the year,
which is in line with Fed guidance. This adjustment helped explain the rising
rates we saw during the quarter and may lower the risk of Fed-driven volatility
for the rest of the year.
Continued earnings growth. Improved earnings growth for U.S. companies
partly drove the stock market rally to start the year. Earnings growth for the
S&P 500 came in well above analyst estimates during the fourth quarter of
2023. And further earnings growth is expected ahead, with analysts calling for
earnings growth in all four quarters this year. Over the long run, fundamentals
drive market performance, so this anticipated return to consistent earnings
growth could be a positive sign for investors in 2024.
Political and international risks. Despite the solid start to the year for markets
and the economy, some risks remain for investors. The continued conflicts in
Ukraine and the Middle East could spark further uncertainty in these regions
and pressure the shaky global supply chains. The November election will also
be worth watching, as we’ll likely see further political uncertainty as we
approach the end of the year. Ultimately, while these risks are real and should
be acknowledged, they’re not necessarily pressing at this time.
Optimism in the Air
Looking at the first-quarter earnings season, markets are certainly taking an
optimistic view, with S&P 500 valuations just over 20x forward earnings
estimates. Of course, these are not quite the levels we saw at the beginning of
2022. But with interest rates much higher than they were then, we’ll likely
have to rely on earnings growth to drive the S&P 500 higher from its current
levels.
FactSet consensus analyst estimates are for 11 percent growth in 2024 and 13
percent growth in 2025. So, there is certainly reason for optimism from an
earnings perspective. Much of this growth is expected to be driven by margin
expansion, as revenue is anticipated to see growth of only 5.1 percent and 5.9
percent for 2024 and 2025, respectively. Margins had slipped to a postpandemic
low in 2023, so a bounce back could be reasonable. But margins are
still well above their 20-year averages. Companies have been investing to
improve productivity, and additional AI investments could also pay off to help
improve margins.
Setting the Tone for the Year
Last year, we had low expectations for much of the year. In the second half of
the year, we saw earnings beats, but those would be offset to a degree by
lowered expectations for the following quarter or by pushed-out growth
expectations to future quarters. The bar remains low in the first quarter, with
earnings expected to grow by only 3.2 percent over the last year. Still, this is a
higher bar than we’ve seen for the past few quarters.
Earnings expectations then pick up significantly for the rest of the year and
are expected to see growth of 9.4 percent, 8.5 percent, and 17.5 percent in
the second, third, and fourth quarters, respectively. Forward guidance by firms
will play an important role in how the markets view earnings given the
markets' high expectations for the next few quarters. Beating the first-quarter
number alone likely won’t be enough to see a significant boost in stock prices.
Keep an Eye on the Growth Sectors
Growth companies and sectors have been driving much of the gains in stock
prices and earnings over the past year. Tech, consumer discretionary, and
communication services make up 71 percent of the Russell 1000 Growth Index
and nearly 50 percent of the S&P 500. Each of these sectors is expected to see
first-quarter earnings growth of more than 15 percent and will play a major
role in whether we see a positive quarter for earnings.
These sectors also have some narrow leadership. Earnings growth from Nvidia
(tech), Meta (communication services), and Amazon (consumer discretionary)
are expected to make up half or more of the growth of their sectors. Analysts
expect the consumer discretionary sector to report a loss without accounting
for Amazon’s growth. Valuations will also play a role in returns, with tech
trading at a 54 percent premium to its 20-year history on a forward P/E basis.
Consumer discretionary is also trading at a 27 percent premium.
Source: FactSet Consensus Analyst Estimates (as of April 5, 2024)
Don’t Overlook the Value Sectors
Earnings season will kick off on Friday with several of the big banks reporting.
Like several other value sectors, expectations aren’t high for financials. Last
quarter began with some surprise losses from the banks due to FDIC charges,
but those were quickly forgotten as other sectors reported earnings beats. This
quarter, it will be important to watch how the banks are provisioning for credit
losses on consumer credit and commercial real estate to look for cracks in the
health of an otherwise strong economy.
Materials and energy are expected to see significant losses in the first quarter,
but they make up less than 7 percent of the S&P 500. Health care is an
interesting one to watch. One of the larger weights in both the Russell 1000
Growth and Value Indices, earnings are expected to fall by 7 percent in the
first quarter but grow by 14 percent for the year. Several pharmaceutical
companies are expected to start seeing losses bottom, which could be an
inflection point for the sector. On the whole, however, the sector is still trading
at a premium to its long-term averages. Energy and real estate are the only
two sectors trading at slight discounts to their 20-year averages.
Our takeaways
In consideration of the prevailing metrics and Q1 activity, MORWM remains
cautiously optimistic regarding both the markets and the economy. We’ve
witnessed improvement in corporate fundamentals, and we look forward to
economic growth stimulating further market appreciation. That being said,
because we’ve seen momentous market appreciation over the last year and
half, we expect considerable market volatility and a potential 10% correction
very soon. We have no idea when that will happen, but rest assured that when
it does, we will happily take advantage of that dip (assuming that employment
remains robust). After all, as Shelby Davis once said: “You make most of your
money during bear markets, you just don’t realize it at the time.”
In closing, we wish everyone a wonderful weekend.
-Your team here at MORWM