Market Commentary: January 2024

Written as of February 13, 2024.

Highlights this Month

• How sustainable is the Magnificent 7's performance?
• Looking at stocks vs. bonds.
• The market's misinterpretation of rate dynamics.
• Calls for Federal Reserve rate cuts during economic challenges. 
• Political implications of Federal Reserve rate cuts in the lead-up to the presidential election. 
• Navigating rate cut expectations and economic uncertainties.

Executive Summary

Market performance at the beginning of the year reveals a landscape marked by selective strength. While the S&P 500 saw a modest gain driven by larger companies, smaller-cap and value stocks experienced declines. Large-cap growth stocks dubbed the "Magnificent 7," notably performed well, led by Nvidia and Meta. However, concerns arise regarding the sustainability of their momentum amid narrowing market breadth. 

Earnings projections for the S&P 500 remain optimistic, as some bottom-analyst estimates project earnings growth of 11% in 2024 and 14% in 2025. Valuation comparisons between stocks and bonds suggest that stocks may be overpriced relative to bonds. Yield curve dynamics further underscore the attractiveness of cash yields relative to S&P500 dividend yields.

Market sentiment continues to be influenced by expectations of Federal Reserve rate cuts, with widespread support across various sectors and government entities. However, conflicting data trends and uncertainties regarding inflation and economic indicators complicate the Fed's decision-making process. The delicate balancing act faced by the Fed highlights the importance of carefully navigating rate cut expectations to mitigate risks of economic slowdown or inflationary pressures. 

While market optimism persists, challenges remain, particularly concerning inflation and consumer sentiment. The strength of consumers and their purchasing power amidst rising prices are under scrutiny, posing potential challenges to economic stability. Despite uncertainties, a cautious approach to rate adjustments may provide stability and benefit fixed-income investments in the short term. 

While the desire for rate cuts is evident, careful consideration of economic indicators and market dynamics is crucial to navigating uncertainties in 2024.  

January in Review

At the outset of 2024, market performance displayed selective strength. The S&P 500 gained 1.7% (total return in U.S. dollars), primarily driven by larger companies. Conversely, the S&P 500 Equal Weight index declined by -0.8% in January. Small-cap value stocks performed even worse, with the Russell 2000 Value ETF experiencing a loss of 4.6%. On the contrary, large-cap growth stocks, dubbed the Magnificent 7 (Apple, Alphabet, Amazon, Meta, Microsoft, and Tesla), saw a rise of 2.5%. Excluding these seven names, the S&P 500 would have returned +1.3% last month. According to a January survey by Bank of America (BoA) Global Fund Managers, investing in the Magnificent 7 is currently perceived as the most crowded trade. In second place was shorting Chinese equities, which were the worst-performing market last month. Conversely, Japanese stocks emerged as the best-performing market, securing a podium finish in the BoA crowded trade survey, albeit narrowly. The S&P/TSX gained a respectable 0.5% (total return in Canadian dollars). 

How sustainable is the Magnificent 7's performance?

Despite the overall strong performance of the Magnificent 7, certain names within the group exhibited varied outcomes. Nvidia notably gained nearly 28% last month due to advancements in AI technology, while Tesla experienced a decline of nearly 25%. Additionally, Apple saw a modest decline of 0.7%, resulting in Microsoft surpassing Apple as the largest company by market capitalization in the S&P 500. Meta followed Nvidia with a 12.7% gain in January but experienced a substantial 20% increase after a favourable earnings release on February 2nd pushed the stock up, marking the largest single-day market gain for any stock. According to Raymond James, the outperformance of the Magnificent 7 is justified by significant year-over-year earnings growth, particularly in contrast to the rest of the S&P 500, which experienced a decline in earnings. However, going forward, it may become increasingly difficult for names like Meta and Nvidia to sustain their momentum, as market breadth continues to narrow, placing even the Magnificent 7 under scrutiny. 

Eventually, earnings for the Magnificent 7 will need to normalize, which isn’t necessarily negative if the rest of the S&P's earnings start to compensate, as forecasted by strategists. According to Strategas, the top-down 2024 earnings estimate for the S&P 500 reached $235 per share last month, with a narrow $29 range between the lowest and highest forecasts. Bottom-up analyst estimates project earnings growth of 11% in 2024 and 13% in 2025. Regarding valuation, while the market-weighted S&P 500 P/E ratio is currently inflated by mega-cap stocks, the equally weighted S&P 500 index reflects a more reasonable valuation. 

Looking at stocks vs. bonds.

Stocks appear expensive compared to bonds. The equity risk premium, a measure of stock valuation, is at its lowest level in 20 years, indicating that investors may be paying a premium for stocks relative to bonds. Despite 10-year U.S. Treasury yields hovering around 4% last month, investors aren't being adequately compensated for risk, as both investment grade and high yield spreads remain tight. Cash yields now exceed S&P 500 dividend yields by their largest margin in 23 years, making cash and short-term investments more attractive than bonds, particularly since the yield curve remains mainly inverted. 

Yield curve dynamics and investment implications. 

If 4% 10-year Treasury yields look appealing, then 3-month T-Bill yields of nearly 5.4% should be even more enticing. According to Bloomberg, cash yields exceed S&P 500 dividend yields by their largest margin in 23 years. With yields of around 5.4% and no term or credit risk, cash remains an attractive investment option. However, this moment of attractiveness may be fleeting, especially if short-term rates fall, leading to lower reinvestment rates. 

Fed rate cut expectations and market sentiment. 

The duration of this trend is pivotal for markets in 2024. Apart from T-Bill sales and traders, there is widespread desire for the Fed to cut rates. According to Apollo, the average time between the Fed’s last hike and the first cut is 8 months, suggesting a potential cut in late March. However, market sentiment has fluctuated, with the odds of a March cut falling. Despite this, financial markets continue to anticipate rate cuts, influenced by beliefs that rising real rates will prompt the Fed to act. 

Economic implications and sectoral considerations.

In a January Bloomberg MLIV Pulse survey, 66.4% of respondents deemed bets on an early Fed rate cut for 2024 as potentially misguided. However, as highlighted in a recent Wall Street Journal article and chart, it's worth noting that nominal rates don't necessarily need to increase for real interest rates to rise. Even with steady nominal rates, if inflation falls, real rates can still increase. A survey conducted by Scotiabank revealed that the predominant reason their institutional clients anticipate Fed rate cuts in 2024 is the prospect of falling inflation and a soft economic landing, which could lead to a rise in real rates. 

The market's misinterpretation of rate dynamics.

The market's conviction that a rise in real rates will compel the Fed to cut rates has led to an early easing of financial conditions, as evidenced by both the Goldman Sachs and Bloomberg U.S. Financial Conditions indices now signalling loose financial conditions. Essentially, the market has preemptively acted, alleviating the need for immediate rate cuts by driving up stock prices and tightening credit spreads. While it's true that real rates may be increasing as inflation declines, there's also the possibility that higher real rates are necessary to rebalance the U.S. economy. This suggests that the market might be misinterpreting the urgency for Fed rate cuts. 

The natural interest rate, which aligns the economy in the long term without being overly restrictive or stimulative, may have risen. Considering this, it's noteworthy that the Fed currently appears more dovish than the market by 107 basis points regarding their long-term rate projections. While the Fed foresees the neutral rate remaining unchanged at a nominal 2.5% over the long term, the market anticipates it being much higher. Inflation will play a significant role in determining which perspective is correct. If concerns about inflation persist, it's likely that the natural interest rate has indeed increased.

Calls for Federal Reserve rate cuts during economic challenges. 

There's widespread support on Wall Street, Main Street, and Pennsylvania Avenue for the Fed to cut rates, which could address several pressing issues. Commercial real estate is facing significant pressure, with over $2.2 trillion in real estate debt due by the end of 2027, according to Trepp. Fitch Ratings forecasts that default rates in the office sector could reach 8% in 2024 and nearly 10% in 2025. Corporations are also feeling the impact of higher rates, with $276 billion in corporate debt set to be refinanced in the second quarter of 2024. Investment-grade coupons are expected to rise from 3.77% to 5.75%, the highest since 2007, while yields for high-yield borrowers could increase from 5.8% to 9%, as reported by the Daily Chartbook. 

Federal Reserve's supportive measures for banks amidst lower interest rates. 

Banks stand to benefit from the Federal Reserve's decision to lower interest rates. Given their significant exposure to upcoming loan repayments and substantial holdings in government bonds, which have incurred losses, banks face financial strain. To alleviate this, the Federal Reserve implemented the Bank Term Lending Program, enabling banks to access capital without liquidating their bond assets. Loans were extended at favourable rates, allowing banks to borrow funds inexpensively and reinvest them for profit. While the Federal Reserve intends to discontinue new funding under this program soon, it has provided a timely lifeline to banks amidst economic challenges. 

The impact of Federal Reserve rate reductions on U.S. government debt management. 

Even the Federal Government could reap benefits from a reduction in the Fed Funds rate. Rising deficits necessitate increased debt issuance by the U.S. Treasury Department, often at higher interest rates, drawing attention from financial markets. The Treasury Department's quarterly refunding announcements have evolved into significant market events, with Bloomberg recently noting their impact on both stocks and bonds. For instance, the need for additional funding in August led to stock market declines and rising bond yields, whereas a decision in November to issue more short-term Treasury Bills and fewer long-term bonds spurred stock market gains and lowered bond yields. 

A recent Wall Street Journal article featured Josh Frost, the Treasury Department's assistant secretary for financial markets, highlighting his crucial role in setting the composition of U.S. government bonds sold to investors. Previously inconsequential to markets, this decision-making process is now eagerly awaited by traders. The latest quarterly refunding announcement in late January, which revealed plans for reduced borrowing, further boosted stocks. However, Strategas noted that the Treasury's forecasts of debt issuance have become less accurate since 2020. 

Regarding Josh Frost's recent announcement, the Treasury plans to maintain the current levels of T-bill issuance, reassuring bond traders concerned about a potential reduction in bills and an increase in bond supply. 

Political implications of Federal Reserve rate cuts in the lead-up to the presidential election. 

Another advocate for a Fed rate cut is U.S. President Joe Biden. With less than a year until the November Presidential election, Biden finds himself trailing former President Trump in the polls. While there's still time for Biden to reverse this trend, the economy must cooperate, and lower interest rates can play a crucial role in preventing a potential recession in 2024. A significant economic downturn could seriously harm Biden's re-election prospects, especially as it would reinforce the perception among many Americans that Trump and the Republicans are more adept at managing the economy. 

However, according to a recent Economist article, Biden's re-election chances might be better than current polls suggest. Several economic and social indicators affecting Americans are showing signs of improvement. Inflation is on the decline, U.S. crude oil production is at its peak, the stock market is thriving, and although still elevated, the homicide rate is decreasing. Real wage growth appears to be turning positive, though further progress is necessary. 

Despite these positive trends, illegal immigration remains a contentious issue that Republicans can attribute to Biden and the Democrats. Consequently, they show little interest in cooperating on new immigration legislation before the election. 

Overall, Americans may be in a better state than they realize, and Biden needs to emphasize this to bolster his electoral prospects. 

The (economic) implications of Trump’s potential presidency. 

Trump also advocates for lower interest rates, but with the condition that he returns to the presidency. However, based on his past actions, a Trump presidency would likely exacerbate deficits and inflation. Biden has observed from Trump's tenure that budget deficits can expand even in periods of low unemployment. 

Although lacking in detailed platform specifics, Trump has suggested implementing a 10% tariff on all imports, a move that Bloomberg Economics estimates could reduce U.S. GDP by 0.4% as trading partners retaliate. Bloomberg's analysis noted that such a tariff could benefit China; however, this was before Trump proposed a 60% tariff on all Chinese imports, which would effectively eliminate the U.S. trade deficit with China. 

Bridgewater highlights that Trump's tariff proposals would elevate inflation, potentially complicating the Fed's ability to implement rate cuts. 

While the appeal of rate cuts is apparent, the Federal Reserve must carefully weigh their potential impact on both the economy and inflation, given recent conflicting data trends. Despite the U.S. economy ending 2023 on a positive trajectory, several soft indicators, such as the ISM manufacturing index, indicate contraction. Additionally, reports from The Bear Traps Report suggest that U.S. Leading Indicators persistently point toward a looming recession. 

Evaluating consumer challenges.

Concerning inflation, there are mixed signals indicating that it has not yet been fully contained. In December, the core Personal Consumption Expenditures (PCE) price index, a key measure used by the Federal Reserve to gauge inflation, rose by 2.9% compared to the previous year. However, the 3-month and 6-month annualized Core PCE indices fell below the Fed's target of 2%, registering at +1.5% and +1.9% respectively. Although the trimmed mean PCE, which excludes extreme outliers, remained elevated at +3.3%, it has shown some decline in recent months. 

Despite these statistics, households are still grappling with the impact of rising prices. According to Morning Consult, they estimate needing an 8% increase in income to maintain their purchasing power compared to last year and anticipate a 5.8% rise in income to offset expected price increases in the coming year. Strategas has shed light on consumers' concerns, suggesting that their "Common Man" price index, which includes essential items, has risen higher than the reported Consumer Price Index (CPI), currently standing at +4.2% compared to the headline CPI of +3.4%. This discrepancy underscores the challenges faced by consumers, as the Common Man CPI has outpaced wage growth by almost 7% since the beginning of 2019. 

Data regarding the U.S. consumer presents a mixed picture. Consumer sentiment surged in January, accompanied by December retail sales surpassing forecasts and the January University of Michigan Consumer Sentiment Index reaching its highest level since July 2021. However, there are signs that the U.S. consumer may be under strain. The Federal Reserve Bank of Philadelphia reported a significant increase in credit card balances, while U.S. banks have noted rising delinquency rates. These indicators suggest that while consumer confidence may be high, there are underlying concerns about the financial health of households. 

Navigating rate cut expectations and economic uncertainties.

The desire for rate cuts from various sectors, including real estate, banks, and overleveraged companies, as well as the U.S. government and its incumbent President seeking re-election, is evident. Lower interest rates are generally favoured by markets, as they can provide a boost to economic activity. However, the Federal Reserve faces a challenging task in balancing the potential risks of maintaining high rates and causing an economic slowdown versus cutting rates too soon and fueling further inflationary pressures. 

Recent commentary from Apollo underscores the delicate balancing act the Fed must perform. While Wall Street hopes for rate cuts, as noted by Bespoke Investment Group, market predictions about the Fed are often unreliable. The economic path ahead in 2024 appears uncertain, with questions looming about whether the economy is heading towards a soft landing or already in recession, and whether inflationary pressures have been effectively subdued or are poised for resurgence. 

The strength of consumers is also under scrutiny, with concerns about the impact of inflation on their purchasing power. While the Fed may eventually opt for rate cuts, the timing and magnitude may differ from market expectations. A temporary pause in rate adjustments may not necessarily harm markets, especially if corporate earnings continue to grow. Additionally, a pause could benefit fixed-income investments, particularly T-bill traders.