Stocks Shrug Off Inflation Heat: Cuts on Hold as Market Focuses on Earnings

Disinflation Sputters, But Strong Profits Keep Rally Going (For Now)

Market Maintains Equilibrium Despite Upward Inflation Revision

Tuesday’s release of the core Consumer Price Index (CPI) data revealed a higher-than-anticipated inflation reading.
This data point, historically prone to inducing market volatility, produced a muted response from the stock market.

Throughout 2023, a demonstrably inverse relationship existed between the S&P 500 and projected Federal Funds Rates. The market exhibited a downward trend when the Federal Reserve foreshadowed a sustained period of elevated interest rates (“higher for longer”) in late 2023. Conversely, the market experienced an upward surge in response to indications of potential rate reductions by the central bank.

However, the market dynamic in 2024 appears to have diverged. Despite a substantial reduction in the projected number of interest rate cuts for this year, the stock market has exhibited remarkable resilience.

This shift in market behavior is further substantiated by the terminal chart, which visually depicts the S&P 500 plotted against the anticipated Fed Funds Rate for next January (inverted scale). The pronounced inverse correlation evident in 2023 seems to have waned.

Fed Cautious on Rate Cuts Despite Chair Powell’s Recent Comments

Federal Reserve Chair Jerome Powell’s recent testimony before the Senate Banking Committee suggested a potential inclination towards future rate cuts. However, this stance appears contingent on the evolution of economic data.

The Bureau of Labor Statistics’ latest core CPI reading revealed a 0.4% increase in February, exceeding analyst expectations and highlighting persistent inflationary concerns. This data, coupled with a slowdown in the disinflation of core goods, underscores the need for a measured approach by the Federal Reserve.

Financial leaders, including prominent figures like Jamie Dimon of JPMorgan Chase and Ken Griffin of Citadel Group, have publicly echoed the cautious sentiment expressed by the Fed. The market’s muted response to Powell’s remarks further reflects this shared apprehension.

While Chair Powell’s comments hinted at a potential shift in the Fed’s monetary policy stance, ongoing inflationary pressures necessitate a data-driven approach. The recent core CPI data, alongside the concerns voiced by prominent financial figures, suggests the Fed is likely to maintain a cautious stance in the near future.

Stock Market Resilience Faces Inflationary Challenges: A Closer Look

The stock market’s recent surge, with the S&P 500 reaching new highs, might seem incongruous with persisting inflationary pressures. However, market behavior could be interpreted as a response to the ongoing disinflationary process, albeit at a slower pace than desired.

Financial experts like Lara Rhame raise concerns about the current economic climate. The pre-pandemic era of low inflation appears distant, with wages and service prices remaining elevated and hindering a swift return to the Fed’s 2% target.

Market participants have adjusted their expectations for rate cuts in 2024. Bloomberg’s data suggests a maximum of three potential cuts by year-end, mirroring the Federal Open Market Committee’s (FOMC) projections. The FOMC’s “dot plot,” where individual members visually represent their interest rate forecasts, also indicates a cumulative reduction of 75 basis points (three cuts) by December.

The upcoming Fed meeting holds significance beyond the expected decision to maintain the current federal funds rate. The updated “dots” will be closely scrutinized by investors, specifically the median projection. As highlighted by Joe Lavorgna of SMBC Nikko, a shift in stance by just two FOMC members could alter the median forecast for year-end 2024, potentially indicating either two or four cuts. A single member shifting their view could influence the 2025 forecast in either direction.

Fed Rate Cuts in 2024: Mixed Signals and Uncertain Path

The Federal Reserve’s projected rate cuts in 2024 face potential delays due to recent economic data. While some experts, like Nicholas Elfner, believe these cuts could still occur in the summer, others caution against a hasty approach.

Earl Davis highlights the risk of base effects, where seemingly lower inflation readings are inflated due to higher starting points in the previous year. This suggests potential for a temporary dip followed by a resurgence in inflation.

Guy Berger presents a more extreme scenario — the possibility of zero rate cuts in 2024 if key inflation indicators fail to improve significantly. This emphasizes the Fed’s commitment to data-driven policy decisions, potentially conflicting with market expectations for swift easing.

Market Optimism: Unveiling the Underlying Factors

The current robust performance of the stock market can be attributed to two key drivers:

1. Expectation of Rate Cuts: Investors are displaying confidence due to the anticipated easing of monetary policy by the Fed. While the disinflation process might be gradual, the prospect of future rate cuts fosters a positive market sentiment.
2. Robust Corporate Earnings: A significant surge in corporate earnings, particularly within the technology sector (represented by the Nasdaq-100), is providing a strong foundation for the market’s current trajectory. Companies are experiencing substantial profit growth, bolstering investor optimism.

Diverging Fortunes: US vs. International Markets

Market Performance:

• The S&P 500 (representing the US market) exhibits strong performance, fueled by factors like anticipated rate cuts and robust corporate earnings, particularly in the technology sector.
• MSCI EAFE Index (representing developed markets outside the US) presents a contrasting picture.

Key Differences:

• Profits: Unlike the US market, companies within the MSCI EAFE index haven’t surpassed their pre-2008 financial crisis profit levels.
• Growth: The overall growth trajectory for the MSCI EAFE index remains sluggish.

Possible Explanations:

• Slower Economic Recovery: Developed economies outside the US might be experiencing a slower post-pandemic economic recovery compared to the US.
• Geopolitical Tensions: Ongoing global conflicts and uncertainties can hinder economic growth in certain regions.
• Sectoral Differences: The composition of the MSCI EAFE index might include sectors with a slower growth rate compared to the US market’s tech-heavy composition.

US Market Rally: A Look at Underlying Factors and Potential Risks

Market Momentum:

The US stock market, particularly the S&P 500, is experiencing a strong rally driven by several factors:

1. Sustainable Corporate Profits: If the current high profitability of major US companies proves sustainable and future earnings forecasts are accurate, the market anticipates a prolonged rally.
2. Momentum Investing: The market exhibits significant momentum, with the S&P 500 experiencing its longest streak (since October 2023) without a 2% peak-to-trough decline. This trend encourages further investment based on the “winners keep winning” mentality.

Potential Risks:

• Higher Interest Rates: While robust profitability might lessen the immediate need for rate cuts, the market seems comfortable with the prospect of slightly higher rates as long as they are accompanied by substantially increased corporate earnings. However, excessively high rates could hinder future growth.
• Momentum Reversal: The historical dominance of momentum-based strategies (betting on winning companies) raises concerns about a potential reversal. Similar trends preceded the dot-com bubble burst in 2000, highlighting the inherent risk associated with excessive market exuberance.

Herd Mentality:

• The current market environment is characterized by a strong “herd mentality,” where investors are reluctant to miss out on the ongoing rally. This behavior can exacerbate market volatility and potentially lead to a correction if underlying fundamentals don’t justify current valuations.

Market Concentration: Nuances Beyond Headline Growth

Market Expansion Claims:

• Bulls (optimistic investors) argue that the US market is exhibiting signs of broader participation, potentially reducing reliance on a select few large technology companies.

Nuances and Data:

• While the overall market appears to be expanding, the dominance of large tech firms remains undeniable.
• An equal-weighted S&P 500 (all companies hold the same weight) shows the “average stock” slightly outperforming the traditional cap-weighted version (companies weighted by market capitalization).

Limited Impact:

• However, this outperformance is modest and unlikely to significantly alter the established trend of large-stock dominance.

Alternative Viewpoint:

• Skeptics argue that the recent outperformance of smaller companies might be temporary and not indicative of a substantial shift in the market’s fundamental structure.

Conclusion: A Cautious Look at the US Market Rally

The current US market rally is fueled by a confluence of factors:

• Expectation of sustainable corporate profits: Healthy corporate earnings bolster investor confidence and fuel market optimism.
• Market momentum: The extended period without a significant decline and dominance of momentum-based investment strategies contribute to the current market upswing.

However, a cautious approach is essential:

• Verifying profit sustainability: Scrutinizing whether corporate profits can maintain their current growth trajectory is crucial. Overinflated valuations not supported by fundamentals can lead to sharp corrections when the market sentiment shifts.
• Potential for momentum reversal: Historically, strong momentum can precede significant market downturns. Investors should be mindful of this inherent risk.

While the market exhibits positive momentum, caution is necessary due to:

• Uncertainty surrounding long-term interest rates: Even with the possibility of slightly higher rates, excessively high interest rates could hinder future economic growth.
• Potential overvaluation: Overheated markets can be susceptible to corrections if underlying fundamentals don’t justify current valuations.

Therefore, while the current market conditions present opportunities, investors should prioritize a data-driven approach and maintain a degree of cautious optimism.