Market Commentary: March 2024

Written as of April 12, 2024.

Highlights this Month

• Impressive market gains and consistency prompt future return speculation.
• U.S. economy displays robust growth, signals promising outlook.
• Bullish signals strengthen amidst U.S. manufacturing expansion.
• Persistent inflation and a robust economy are complicating the Fed's case for rate cuts.
• Investor interest in fixed income is evident, particularly in loans.

Executive Summary

The recent performance of the stock market has been impressive, with both the S&P/TSX and the S&P 500 posting gains in March. The S&P 500's first-quarter return was particularly noteworthy, marking its best performance since 2019. Additionally, signs of a broader rally and a shift towards more cyclical stocks hint at better times ahead, both in the U.S. and Canadian markets. 

Despite concerns about the sustainability of the bull market, certain historical data suggests that similar market momentum tends to be a positive indicator for future returns. Still, investors remain cautious, particularly regarding inflation, which continues to be a primary concern. However, potential risks, such as higher inflation, could derail this optimism. 

While the U.S. economy has shown resilience, certain indicators, such as the Conference Board's leading economic indicators, raise concerns about future economic growth. Nonetheless, rising consumer spending and a robust labour market provide reasons for optimism. 

The Federal Reserve faces challenges in managing inflation and determining the appropriate timing for rate cuts, especially considering political pressures. Despite market expectations for rate cuts, the Fed remains cautious, weighing the need for economic stimulus against the risks of inflation. 

While there are opportunities for investors, risks such as high market valuations and potential economic weaknesses need to be considered. The Federal Reserve's stance on rate cuts, influenced by political considerations, further complicates the investment landscape. Overall, investors face a complex decision-making environment as they navigate the evolving market dynamics. 

March in Review

As the stock market faces turbulence to begin the month of April, it's worth reflecting on the recent bullish trend of the first quarter. The bull market kept charging ahead last month, with the S&P/TSX up by 4.1% (total return in Canadian dollars) and the S&P 500 up by 3.2% (total return in U.S. dollars). March wrapped up with the S&P 500 posting its best first-quarter return since 2019, with a gain of 10.6%. This marks only the fifth instance in the last 30 years where the S&P 500 saw first-quarter returns exceeding 10%. It's also noteworthy that this quarter marked the first time since Q1 2022 that the S&P 500 outperformed the technology-heavy NASDAQ, which still managed a respectable return of 9.3%. According to Strategas, the market rally extended beyond AI, with 86% of stocks in the S&P 500 trading above their 200-day moving average by the end of March, the highest level in three years. A broader rally is positive news for Canadian stocks too. Although the S&P/TSX only saw a 6.6% gain in Q1, its outperformance compared to the S&P 500 last month could indicate better times ahead. 

Impressive market gains and consistency prompt future return speculation.

We have to admit, we're quite impressed by the market's strength and resilience. The strong gains in the first quarter follow an even more robust performance in the fourth quarter of 2023. With the S&P 500 hitting new highs, it's now on a five-month winning streak. Bloomberg notes that the S&P 500 has gone 277 daily trading sessions without a drop of 2% or more, the longest such streak since 2018. Maybe the market deserves a polite golf clap for showing such consistency. However, as in golf, you're only as good as your next shot. Below, we'll discuss what recent performance might be telling us about future returns for the market. 

With U.S. stocks surging 27% in five months, it's natural to worry that the market has set a hurdle too high for even this bull market to overcome. However, as highlighted by Strategas, in the 130 prior instances where the S&P 500 increased more than 27% over five months, only once did it fail to post positive returns over the following 12 months, with an average return of +15% during that period. Moreover, after a strong Q1 (greater than +8%), the S&P 500 has historically averaged a 7.4% gain for the rest of the year, according to Strategas. Carson Investment Research also notes that two big quarters have historically been quite bullish, with subsequent 12-month returns averaging 12.3%. It seems that momentum truly is a friend to investors. 

However, it's worth considering when such bullishness might be warranted. The market dislikes being misled, and according to Bank of America's Fund Manager Survey, higher inflation remains the biggest tail risk for the market and the most likely factor to lead to disappointment. In January, the risk of a hard economic landing and geopolitical tensions were seen as greater threats, but in March, only 11% of investors believe the U.S. is headed for a hard economic landing in the next 12 months. A larger portion, 23%, actually foresee a scenario where the U.S. avoids even a soft landing. Traders seem to agree, with JP Morgan highlighting the market's growing complacency, as option-implied probabilities of a 20% drop in the S&P 500 one year ahead continue to decline. 

U.S. economy displays robust growth, signals promising outlook.

It seems the U.S. economy has managed to steer clear of any major downturns, bypassing them altogether. According to the Bureau of Economic Analysis, both Gross Domestic Product (GDP) and Gross Domestic Income (GDI) showed robust growth towards the end of 2023. GDP rose by 3.4% in Q4, while GDI increased by 4.8%, marking the highest income and costs generated from producing goods in two years. Stifel reports that estimates for Q1 U.S. GDP growth have been consistently rising, along with the Federal Reserve's Summary of Economic Projections for 2024 U.S. GDP growth. 

There are still areas of concern, particularly with certain predictive indicators favoured by economists and strategists. According to Bloomberg, the Conference Board's leading economic indicators have historically been reliable predictors of future economic recessions, especially when they remain negative for an extended period. The LEI has never trended lower for this long without a contraction in economic growth. Additionally, the New York Federal Reserve's analysis of the yield curve currently puts the odds of a recession at 58%, although only about a third of economists agree. 

In March, U.S. ISM Services growth also provided some hope for the bears, declining by 1.2 points to 51.4. While it remains above 50 and in expansionary territory, the March figure was lower than all but one of the respondents in Bloomberg's survey of economists. Prices paid were even more disappointing, falling to their lowest levels since March 2020. 

Bullish signals strengthen amidst U.S. manufacturing expansion.

Bolstering the case for the bulls was U.S. manufacturing with the PMI Index rising above 50 and into expansionary territory for the first time since 2022. Strategas also highlights rising CFO confidence as hinting at the increasing potential for a soft landing or even no landing. Apollo recently highlighted the rising trend for the National Association for Business Economics' Business Conditions Index as a sign that business confidence is trending higher. 

The key barometer of economic growth is the labour market, which remains tight. The U.S. added a net 303,000 jobs in March, the most since May, with the unemployment rate falling to 3.8%. According to Apollo, the labour market has been trending higher since the Fed turned dovish late last year. Perhaps more importantly, while wage growth has slowed, it remains higher than the Fed's comfort zone, with the Atlanta Fed's monthly Wage Tracker still running around 5%. Additionally, while job switchers are no longer receiving significant raises, the gap between pay increases for part-time and full-time workers has been virtually eliminated. However, there have been some signs of cracks forming in the job market, and the decline in survey responses raises questions about the quality of the reported data. Consistent initial and continuing unemployment claims provide a good check, as they are hard data and do not rely on surveys. As recently pointed out by Bloomberg, forecasters can take comfort in the fact that unemployment insurance claims have remained mostly unchanged for the past nine months. 

A robust job market typically leads to a strong consumer, and this has largely been the case. According to the Bureau of Economic Analysis, personal spending increased by 0.4% in February, surpassing estimates, while March consumer sentiment rose to its highest level since July 2021. Strong market returns have also contributed, with Bank of America reporting that household net worth increased by 7.9% in Q4/23. Apollo estimates that U.S. stocks have added $10.9 trillion to wealth since the November FOMC meeting, with bonds contributing an additional $2.6 trillion. 

There are signs that the U.S. consumer is facing increasing pressure to sustain its current spending pace. The Federal Reserve Bank of New York reports that they expect 12.5% of consumers to miss an upcoming debt payment over the next three months, the highest level in four years. According to Moody's Analytics, credit card delinquency rates have been on the rise, which is not surprising given that interest rates on outstanding balances reached a record 22.8% at the end of 2023. 

As previously mentioned, inflation has become the primary concern for investors, as overall growth has led to inflation persisting above the Federal Reserve’s 2% target. The Dallas Fed’s trimmed mean PCE index, which excludes outliers and averages the rest, indicates that the Fed is making slow progress in curbing price increases. Bloomberg reports that the recovery in ISM manufacturing is now driving up manufacturing prices. Additionally, supply chain bottlenecks and higher commodity prices pose threats of further inflationary pressure in the coming months. For chocolate lovers, the situation with Cocoa futures prices might be particularly distressing.

Persistent inflation and a robust economy are complicating the Fed's case for rate cuts.

Stifel notes that the market is currently assigning only a 6% probability of a rate cut in May and a 56% probability of a cut in June. At the beginning of 2024, traders anticipated seven rate cuts (1.75%), compared to the Federal Reserve's forecast of three cuts (0.75%). Although the Fed still anticipates three 25 basis point cuts, the futures market is now pricing in fewer cuts, with some traders even expecting only one or two cuts. Some speculate that the Fed may not cut rates at all in 2024. In the longer term, the Fed remains steadfast in its belief that Fed Funds will converge toward the 2.5% level, although recent estimates from the Fed dot plot suggest rates may reach 2.6% in the longer term. However, the market projects even higher rates. This discrepancy is significant because if the long-term neutral (or equilibrium) rate is higher, current rates may not be as restrictive as the Fed perceives, reducing the necessity for rate cuts. 

While some observers may interpret the Fed's reluctance to cut rates as a response to persistent inflation, the strength of the economy and the market arguably justify greater patience. Despite elevated Fed Funds, financial conditions remain accommodating. From the Fed's viewpoint, while short-term rates are high and potentially restrictive, longer-term corporate borrowing rates have remained stable. As highlighted by Bloomberg, the ICE BofA Corporate Index effective yield is approximately at the same level as the Fed Funds rate, and not significantly elevated from a historical standpoint. Apollo also argues that looser financial conditions, such as narrower corporate spreads and easier bank lending conditions, have helped to keep high yield default rates in check. In a typical tightening cycle, higher rates would often lead to increased corporate distress. However, this has not been the case so far in the current tightening cycle. According to Bloomberg, even a 5% Fed Funds rate is not particularly high from a historical perspective. For instance, in the 1990s, overnight rates were around 5%, and economic growth remained robust. 

Political considerations add complexity to Fed's rate cut decision.

As if the Fed didn't have enough on its plate, political considerations also come into play when deciding on rate cuts. A strong economy historically boosts an incumbent President's reelection chances, so President Biden needs to avoid any economic downturn before November 5th. Rate cuts from the Fed could help in this regard. On the flip side, former President Trump might perceive any rate cut as a political move aimed at keeping him out of office. Pew Research indicates that 84% of Republicans prioritize the economy, compared to 63% of Democrats. A recent Wall Street Journal poll found that 54% of registered voters believe Trump is better equipped to handle the economy, while only 34% favour Biden. Republicans generally hold a more pessimistic view of the economy than Democrats, with many believing that only Trump can address economic challenges. Federal Reserve Chairman Jerome Powell claims to be apolitical, having been appointed by Trump and reappointed by Biden. Trump has stated he won't reappoint Powell if he is reelected. Despite this, Powell is likely to strive to avoid any perception of bias to avoid influencing the election outcome. Futures markets indicate that full rate cuts aren't expected until the September FOMC meeting, the last before the election. The December meeting may offer another opportunity for rate cuts, but the window for the Fed to act is narrowing. 

Markets seem to be anticipating that interest rates will remain elevated for an extended period. This is welcomed news for investors who have parked trillions of dollars in money market funds, estimated at around $6.5 trillion by Crane Data. While equity valuations had previously factored in expectations of lower rates, the realization of "higher for longer" hasn't prompted investors to flee stocks. Bloomberg notes that U.S. stocks appeared to be buoyed by hopes of rate cuts, even though expectations for cuts have waned since the beginning of 2024. According to Goldman Sachs, U.S. households have allocated 48% of their financial assets to equities as of Q4 2023. Interestingly, Goldman also observes that U.S. households' cash allocations have remained largely unchanged, suggesting that investors may have simply shifted their cash from low-yielding bank accounts to higher-yielding money market funds. 

The current market upswing has been prolonged as traders adopt the reflation trade narrative.  This shift is evidenced by the performance of stocks aligned with inflation and those sensitive to increasing bond yields, as indicated by Societe Generale’s Inflation Proxy Index. This trend suggests that investors are becoming more comfortable with the prospect of sustained higher interest rates, provided that economic growth and corporate profits continue to progress positively. According to analysis from Strategas, the data supports this sentiment, with S&P 500 earnings expected to increase nearly 11% in 2024 and slightly over 13% in 2025. 

If the next leg in the bull market is to be driven by stronger economic growth and earnings, we would expect leadership to broaden and change. The S&P 500 outperforming the NASDAQ could be early signs this is taking place, as well as Exxon outperforming the Tech sector year to date and recently moving into fourth place amongst the Magnificent 7. According to Charles Schwab, analysts expect earnings growth for the overall MCSI World Index to exceed the Magnificent 7 by Q4. Another potential indicator of economic growth taking center stage is the recent observation by the Wall Street Journal that the S&P GSCI global commodities index is outperforming the S&P 500 so far this year.

A stronger economy typically also favours credit, with ASR’s Asset Allocation Survey indicating asset allocators’ preference for high yield over investment-grade bonds. According to Apollo, coverage ratios for leveraged loans have recently improved as a result of a robust economy, strong earnings, and easier financial conditions, which have helped borrowers balance their books. Concerns about a wall of refinancing facing high-yield issuers have gradually diminished as a vibrant credit market has enabled companies to refinance debt at reasonable rates. Not only have government bond yields remained stable, but tighter credit spreads have also led to a decline in the overall cost of refinancing. According to Bloomberg, a company selling non-investment-grade bonds to replace existing ones is now facing an additional 177 basis points of interest costs compared to 463 basis points in October 2022. 

Investor interest in fixed income is evident, particularly in loans.

Bank loans (leveraged loans) and Private Credit have the advantage of being floating rates, meaning their yield is based on a fixed spread over short-term rates, benefiting from a higher-for-longer environment. An inverted yield curve, where short-term rates pay more than long-term rates, further enhances their appeal. Bloomberg reports a significant influx of funds into U.S. leverage loan funds, with Invesco’s senior loan ETF alone gaining $2.6 billion in assets over the past five months, and Blackstone’s SPDR senior loan ETF attracting $1.3 billion. According to Goldman Sachs Asset Management’s annual survey of global insurance companies, Private Credit is even more sought after, ranking as the top-favoured asset for the first time, with 53% ranking it among the top five asset classes for returns over the next 12 months. Bridgewater notes that Private Credit has managed to fill a void left by a reduction in lending appetite by banks, resulting in Private Debt yielding approximately 300 basis points more. However, liquidity poses a challenge, as do credit quality considerations, given that Private Credit typically lends to smaller borrowers and deals are less transparent. A recent analysis by KBRA Direct shows that private credit loans that defaulted over the past year were valued at an average of only 48 cents on the dollar compared to 55 cents for loans by bank-led syndicates. Fortunately for Private Credit investors, more companies are opting for reorganization rather than liquidation when facing bankruptcy. Apollo notes that this has been a growing trend since the Fed began raising rates, with a record 70% of U.S. bankruptcy filings resulting in restructurings so far this year. 

Overall, both stocks and fixed income investments are proving beneficial for investors in the current environment of prolonged low interest rates. However, the market is delicately balanced between the allure of low rates and potentially improved economic growth. Last year, the anticipation of rate cuts by and large drove bond yields down and boosted stock valuations. This year, the prospect of increased earnings is propelling overall stock prices higher, while tighter credit spreads and appealing coupons are mitigating the impact of rising rates for fixed income investors. 

A broadening rally and a shift towards more cyclical stocks could prolong the upward trajectory of the stock market. Moreover, with short-term rates expected to remain higher for longer and a favourable credit environment, leverage loans and private credit are becoming increasingly attractive. Nonetheless, there are risks to consider. 

Goldman Sachs suggests that a significant factor behind the recent rise in 10-year yields is a reassessment of long-term equilibrium rates, driven by policy changes. While the general market has continued to climb amid diminishing hopes for rate cuts, any substantial economic weaknesses or earnings downturns could dampen the bullish sentiment, even if rates are lowered. 

Considering the market's already high valuation, investors shouldn't rely on further valuation increases to rescue their investments. However, there's a contrasting view from the Federal Reserve, which still anticipates three rate cuts in 2024. If the Fed's belief in a long-term neutral rate of around 2.5% holds true, there's ample room for further rate reductions. Even a move by the Fed towards neutrality could provide significant easing and extend the bull market. However, the Fed's desire to cut rates is tempered by political considerations, with the window of opportunity gradually closing. 

Investors have much to contemplate if they intend to continue riding the wave.