The Macro Picture: Can the Bull Charge Further Forward?

The S&P 500 reached another all-time high, indicating a robust bull market. However, there’s an ongoing debate about whether this rally is sustainable. At present, though it is difficult to predict with certainty, it seems that we have dodged a recession, with the economy’s unexpected resilience providing strong reasons for optimism. Still, there are risks out there, and if the economy takes a turn for the worse, the stock market could be in for some trouble.

Unexpectedly Resilient America

The U.S. economy has weathered the sharp interest-rate increases with much more resiliency than was expected. The inflation has been trending downwards for months, the unemployment is low, and the Federal Reserve’s next policy change is expected to be an interest-rate cut. Consumer sentiment is robust, providing support for earnings, which are the single most important long-term driver of stock performance. A better rate environment, resilient consumers, and the projected productivity growth combine to provide a supportive macroeconomic environment.

Fresh data shows that U.S. business activity rose in January, with both services and manufacturing PMIs indicating expansion. The services sector, which has shown some weakening in prior months, has experienced a sharp increase of late. More strikingly, the manufacturing sector, which has been contracting since the end of 2022, now looks to be recovering, with the preliminary PMI crossing into the expansion territory. Since the PMIs are forward-looking, these increases add to a brighter economic outlook.

Strategists are increasingly optimistic, with projections for a “soft landing” being now sung in almost perfect unison. If that reminds you of the general consensus of an imminent recession that the same pundits argued that we were entering in 2023 (which was proven to be remarkably wrong), you are not alone. In addition to the uneasy feeling when facing such broad agreement, the fact that forecasters who predicted a recession in 2023 were wrong does not mean that those who predict no recession now are correct in their assessment.

Although the data is mostly positive, there is some weakness below the surface. The labor market is slowing down, with job gains narrowing and longer timeframes needed to find a job. On the other hand, prices have eased off more rapidly than was expected, allowing the Fed to cut rates if the economy shows more weakness than needed to sustain targeted inflation range.

Still, there is no certainty that inflation will keep trending down. The sharp price increases in 2022-2023 were caused primarily by the pandemic’s supply-chain disruptions, and further spurred by fiscal spending and monetary easing. The supply chains have recovered, helping the Fed in its disinflationary task, which means the absence of the disinflationary effect from the supply side from now on.

Meanwhile, we are in a Presidential Election year, with all the spending implications it carries. Even before taking into account all the geopolitical and other threats, there are no doubt other unknown risks that may topple the near-perfect economic balance the Fed has succeeded in reaching. There is a material risk of inflation returning with a vengeance, if the central bank is too hasty to ease interest rates.

All in all, we may have reached a much better place, economically, than where we were a year ago, but we are not totally out of the woods just yet.

Smaller Risks for Larger Caps

It may be that we have been taking the economy’s resilience at face value, instead of looking ahead. In essence, the recession everyone expected last year, and which has not materialized, was supposed to be brought on by the Fed’s monetary tightening measures. While no one believes that the Fed desires to trigger a recession, that is often the outcome of strong and fast rate hikes which depress demand and lending.

Although there is almost no indication of this happening at the moment, it may still occur. The rule of thumb is that it takes roughly 18-24 months for the monetary policy changes to work through the real economy. The Federal Reserve’s hiking campaign lasted from March 2022 to July 2023. This means that the economy should begin to feel a full impact from these raises only sometime between May and November 2024. While everyone expects the Fed to begin cutting by then, the effects of the cuts (outside of the sentiment lift) would also take 1.5 to 2 years to be fully reflected.

We have entered the hiking period with personal balance sheets fattened by Covid-19 federal checks and savings, giving significant insulation to consumers and permitting spending to increase (almost as if the Fed had not hiked). This is one of the main reasons for the economy’s resilience so far. However, the personal savings rate has now come down to below its long-term average as the pandemic windfall has been spent. Consumers are now more vulnerable, and so is the economy as well as earnings.

Additionally, one of the reasons for strong consumer sentiment has been the cushion for homeowners, stemming from the fact that many had locked in low, 30-year mortgage rates when the Fed’s rates were near zero. They have therefore been protected from the central bank’s heavy hand (as long as they do not need to move or refinance), while their home equity has been on the rise due to lower availability supporting prices. It is first-time buyers who are almost locked out of the market for the time being.

On the corporate front, many large U.S. companies refinanced their debts during the ultra-low rates period, insulating themselves from the impact of the Fed’s hikes. In addition, looking into the earnings reports’ details of American large-caps will reveal a secret ingredient of their unexpectedly strong results. These companies funneled their cash into investments that, thanks to rate increases, have produced more-than-acceptable returns.

Meanwhile, smaller, riskier borrowers that have to work with what they are offered have faced swiftly rising interest costs. With the bulk of refinancing needs for the junk-bond borrowers coming due in the next three years, the market optimism could be dented by a wave of defaults if the costs of financing remain high. At the same time, SMEs are already in trouble, having to pay much more for loans. These businesses’ fortunes are strongly entwined with the broad economic conditions, as they are responsible for about half of the private-sector employment in the nation.

The Proof is in the Earnings Growth

After a surprisingly strong stock rally in 2023, valuations have risen far above their long-term averages, leaving investors cautious and quick to secure profits at any hint of trouble. To confirm the viability of the rally’s extension into 2024, firms must display stronger profit growth. Outside of cutting-edge technological advances (AI, GLP-1) or non-elastic demand (utilities, discount retailers) companies, this would require faster economic growth, supporting stronger overall earnings growth.

One of the main factors behind the ongoing tech rally is the expected effect of Artificial Intelligence on corporate productivity. Over the long run, productivity growth is what raises the standard of living since greater productivity helps justify increased inflation-adjusted wages without weighing on profitability. This is why AI has kindled such a blowup in earnings expectations: the technology is slated to have a greatly positive impact on productivity. However, smaller companies, as well as firms in the less technologically advanced sectors, are expected to be much slower in reaping the AI fruit, leading to a lag in earnings expectations – as well as lower investor interest.

Moreover, as technology stocks continue their surge, there are concerns about a potential bubble, reminiscent of the late 1990s Dot Com craze. The market-leading tech megacaps that have already reported earnings are mostly confirming the merits of their rally. However, to be viable, the rally should be much more broad-based, and this outcome needs stronger input from earnings (and, more importantly, guidance) than we are seeing so far.

According to FactSet, the Q4 2023 earnings season is off to a weak start, with firms reporting their lowest net profit margins in more than three years. For now, the IT sector has shown margins that significantly surpass their 5-year average, with Communication Services, Industrials, Consumer Discretionary, and Energy performing slightly better than their average margins; the remaining six sectors are lagging, however. That being said, at present, only 10% of SPX companies have reported their earnings, so these numbers could change significantly in the coming weeks.   

Analysts have been strongly cutting earnings projections before the reporting season’s onset, making it easy for the majority of companies to beat them. However, according to JP Morgan’s strategists, this is not enough, and firms will need to show earnings upgrades for the SPX to significantly advance further. We are already seeing investor weariness from the regular cycle of “analysts cut projections – companies report a beat – stock rises”; in this earnings season, on average, earnings beats have not been rewarded by markets as much as in prior cycles. 

Sentimental Spending

Since the economy’s and market’s wheels are moved not only by hard data but also by sentiment, soft data also needs to be taken into account. As the outlook brightens, risk sentiment increases, moving money through the economy, which lifts the mood further, producing a positive “snowball effect”. Thus, startups that were seemingly locked out of options a few months ago are now optimistic about receiving financing. The IPO market is also unfreezing.

Even more notably, consumer sentiment soared in January to its highest level since July 2021, supported by confidence that inflation is subsiding while a robust economy strengthens income expectations. Consumer spending is responsible for about 70% of GDP, so household feelings toward the economy directly affect its future path.

With inflation subsiding, the pressure on the Fed to start cutting is on the rise. The policymakers as much as confirmed their inclination to ease rates in a report by the Atlanta Fed that said: “With inflation approaching its target—albeit in a bumpy fashion—and with relatively strong growth in employment and real GDP, it does not seem prudent to tighten policy due to concerns about the last mile being more arduous. Such tightening would needlessly increase the risk of a hard landing for the economy.” Whether this means “immediate cuts” or just “no more hikes” is yet to be seen.

The Investing Takeaway

The national economy is very complex, with different sectors, industries, and markets producing volatile numbers that mostly make sense only when they combine into a trend. Thus, at almost any given time one can find data points that confirm starkly contrasting outlooks. While pundits are paid to produce clear-cut views, individual investors do not need to rely on someone else’s bias. There is nothing wrong with being undecided, and in many cases it produces better investing results than blindly following someone else’s forecasts, however convincing they may sound.

While currently most of the hard and soft data reflect a fairly optimistic picture, a positive prognosis should not be taken for granted. Follow the economic and earnings reports and adjust your positions accordingly, if needed. If you are unsure how the economy is going to look in the months ahead, look for quality companies you can count on, and protect your income with dividend-paying stocks.