July 2024 Market Perspective
When the June consumer price index (CPI) was announced earlier this month, it very well may signal the beginning of the conversation changing with regard to the outlook for inflation and the direction of the Federal Reserve (Fed). June saw a month-over-month decline of 0.1%, the first monthly decline since May 2020, and headline CPI rose 3.0% over the last 12 months. While one month’s CPI is not going to persuade the Fed to begin cutting interest rates, it did rejuvenate the expectation of lower inflation to come in the balance of 2024 – which is what the Fed has been waiting for to begin the rate cuts. As of July 15, the CME FedWatch Tool estimates the probability to be only 8.8% that the Fed will cut interest rates at their July 30 and 31 meeting, but 100% probability they will cut in September 17 and 18 meeting by at least ¼% (or 25 basis points).
We have to stop to realize that the cause of much of this year’s volatility in the investment markets was due to unfulfilled expectations of declining inflation and cuts in interest rates which has been the case most of the year. CME FedWatch Tool’s estimate that with 100% probability that the Fed will begin to cut rates in September may be cause for some concern should the Fed not move in that direction because we’ve seen the market’s kneejerk reaction to unfulfilled expectations – April being the best example so far this year. But in comments reported by CNBC, Jerome Powell, the Chair of the Federal Reserve, stated that the Fed will not wait until CPI reaches the Fed’s goal of 2% to begin to cut interest rates due to the long lag effect of rate cuts.
As we have noted all year, a small handful of large capitalization stocks continue to generate the lion’s share of the market’s performance. The significance of an interest rate cut to the investment markets cannot be overstated, and expectations are high that such cuts will surely benefit those areas of the stock market that have underperformed, i.e., make for a broader rally, and an ailing bond market that is fighting to produce positive results in 2024.
Our perspective:
As long as gross domestic product (GDP) stays relatively strong, the Fed may very well have accomplished the “soft landing” of bringing inflation down without pushing the U.S. economy into recession. Although GDP declined from 3.4% in the 4th quarter of 2023 to 1.3% in the 1st quarter of 2024, we are expecting GDP to end this year in the 2.5 – 3% range. With regard to inflation, we are not expecting CPI to decline much more from current levels, perhaps in the 3 – 3.5% range.
The struggle between earnings growth and valuations will be a key theme for the second half of 2024. According to FactSet consensus estimates as of May 31, 2024, S&P 500 earnings could rise 9.2 percent in the second quarter and 8.3 percent in the third quarter—figures that will likely impact returns. Fourth-quarter earnings (reported in 2025) will be a major factor in valuations, where the expectations call for 17.5 percent growth. Combined with expectations for 14 percent growth for 2025, this could support equity valuations despite their elevated level of more than 20x forward earnings projections.
In terms of portfolio construction, we remain overweight in large capitalization (cap) stocks relative to mid and small-cap stocks. Interest rate cuts are likely to benefit smaller cap stocks, and we have noted a mild rally in the Russell 2000, the index that follows small cap stocks, since the buildup of expectations for rate cuts later this year. Although the high-flying, large cap tech stocks are likely to continue to perform (as long as their earnings continue to grow), we are expecting the markets to be less concentrated and for a larger segment of the market to participate in a late-year rally.
The U.S. bond market is at an inflection point after historically poor performance for most of the last three years. Interest rates and bond prices are inversely related, so if interest rates decline, bond prices should benefit. For our more conservative, balanced portfolios, we have maintained an allocation of shorter duration bonds (duration is the measurement of a bond’s sensitivity to rising or falling interest rates) in order to minimize the negative effects of high inflation and interest rates. Should rates begin to decline, we will focus on more mid-duration and long bonds that may benefit more from the falling rates.
As always, please don’t hesitate to contact our office should you have any questions or want to discuss further any topics mentioned in this Market Perspective.
