We revisit vital issues that we have outlined in previous reports below.
Issue #1: Inflation Trajectory
US inflation has resumed its disinflationary trend following a brief spike earlier in the year. June CPI was at -0.1% MOM, with core CPI at +0.1% MOM (both lower than expectations). The Fed’s favored gauge Core PCE was up 2.6% YOY in May, with further progress towards 2.0% YOY likely in June. Barring any material changes in fiscal policy, we believe that inflation will continue to trend down over H2 2024 and into 2025.
Bond yields have retreated sharply from April highs. Ten-year Treasury bonds are now yielding 4.2%, down from 4.7% in April.
The Fed is likely to begin cutting rates in September of this year, and economists are now forecasting two cuts in 2024 with further reductions in 2025.
Issue #2: Economic Growth – no landing, soft landing, mild recession, or hard landing?
In the US, our base case forecast is for a softer landing with sub-2 % GDP growth in H2 and decelerating inflation. However, the risks of a recession are increasing.
On the one hand, employment remains historically healthy, with the unemployment rate at 4.1%. On the other hand, the unemployment rate has increased to 4.1% from its 3.4% prior lows. In previous instances where the unemployment rate has risen by 50bps of earlier lows, recession has ensued in 6-12 months.
Spending by upper-middle-class and wealthy consumers remains robust, and consumer and corporate balance sheets are generally healthy. There is apparent stress for lower-income consumers with credit card and auto loan delinquencies picking up meaningfully. Rate cuts as inflation recedes should mitigate slowdowns in economic activity.
Europe’s economy is experiencing nascent growth in H1 after emerging from a mild recession in 2023. Q1 GDP was better than expected, and service PMIs have remained solidly positive for several months.
However, the recovery shows signs of stalling as French and German data for May and June has disappointed expectations.
Issue #3: Corporate Earnings
Corporate earnings continue to perform well. Several Magnificent Seven have delivered impressive YOY earnings growth of 50%-100% in Q1. Excluding the Magnificent Seven, S&P earnings growth would have been down YOY in Q1.
Analysts are forecasting a broadening of corporate earnings growth in Q2. Analysts are forecasting 10% YOY growth for the S&P 500 and are projecting that S&P 500 ex-Magnificent 7 companies are expected to deliver their first YOY quarterly earnings growth since Q4 2022 (+6.7%).
Comparisons become more onerous for the Magnificent Seven in H2 and into 2025. For the S&P to meet consensus expectations in H2 2024 and 2025, earnings growth of sectors beyond technology and communications services will need to improve.
Interest rate cuts may lead to broadening earnings growth across various sectors, assuming recessionary conditions do not emerge.
Issue #4: AI Adoption
AI and its actual or perceived beneficiaries continue to play a significant role in stock and sector-level performance thus far in 2024.
Certain sectors (semiconductors) have benefitted substantially in operating results from AI spend to date. It remains to be seen whether their torrid earnings growth is sustainable.
Several companies are perceived to have strengthened their long-term business moats due to their AI leadership, even if actual benefits are yet to materially affect reported financial results (Apple, Microsoft, Alphabet).
The biggest AI winners have been semiconductors (Nvidia, Micron, Broadcom, etc.) and hyper scalers / cloud companies (Amazon, Meta, and Google). Software companies thought to have AI leadership positions have demonstrated muted performance early in the year.
Earnings reports from early AI winners this upcoming earnings season will be heavily scrutinized for demand sustainability, cost creep from expense and capital expenditure pressures, and changes in competitive dynamics.
Issue #5: China Government Policy
China’s growth disappointed in Q2 after exceeding expectations in Q1. Manufacturing growth has been strong, while consumption remains weak. The property sector shows weakness with continued YOY price declines for new homes across major cities.
Stabilization has been a key goal for policymakers this year, leading to a slew of supportive policy measures. These include lowering interest rates, subsidies for EVs, and numerous moves to shore up the property market.
We expect the government to increase policy support in H2, especially as the tariff environment around manufacturing remains unclear and has the potential to worsen. Policy support measures may exceed expectations and lead to a short-term rally in Chinese stocks.
Issue #6: Geopolitical Conflicts
The war between Israel and Hamas seems to have reached somewhat of a stalemate. However, there have been increased skirmishes between Israel and Iran or Iranian proxies. A widening conflict would negatively affect global equity market confidence, likely leading to surging oil prices that may reignite inflationary pressures.
As of now, both Israel and Iran have shied away from significant escalations.
The Russia / Ukraine war seems to be in a stalemate, as well, with outcomes uncertain.
Outcomes in the US presidential election could markedly alter the direction of US policy towards Ukraine and, thus, the trajectory of the conflict.
Issue #7: US Presidential Election
The US equity market has generally experienced higher-than-normal volatility during presidential election years. It remains to be seen whether either Trump or Biden will make unexpected policy changes.
Policy proposals espousing more widespread tariffs (favored by Trump) would negatively affect equity markets.
Biden favors letting some of the tax cuts enacted under Trump expire in 2025. If that happens, it may negatively affect consumer and business spending.
Shorter-term View: Scenarios
We see multiple potential paths for equity returns over the next 6-12 months (with reference to the S&P 500 which stands at 5,585 as of July 11, 2024).
Scenario A: Optimistic Case
As the Fed cuts rates by 50bps or more over H2 2024 and into 2025, economic growth accelerates (Real GDP growth of 2.0%+) yet core inflation continues to fall faster towards the Fed’s 2% target. Fed continues cutting rates in H1 2025. Consumer spending remains healthy, wage growth remains modest, and companies enact productivity measures to restrain costs resulting in margin improvement.
Under this scenario, S&P earnings could expand (from $222) in 2023 to $248-$255 in 2024, $270-$285 for 2025, and $300mm-$315mm in 2026. Equity multiples hold at 21x-23x forward earnings. Under those assumptions, the S&P 500 index could appreciate to 6,200 to 6,700 by mid-year 2025 (12%-20% total return from today).
Scenario B: Base Case
Fed cuts by 50bps in H2 2024 (starting September 2024). Economic growth slows, but the US avoids a recession. Real GDP growth ranges between 1.0%-1.5%. Unemployment modestly rises, and consumer spending slows but does not decline meaningfully.
Under this soft-landing scenario, S&P 500 earnings could expand to $240-$248 in 2024, $260-$275 in 2025, and $280-$300 by 2026. Equity multiples range between 19x-21x forward earnings, with the S&P index between 5,300 and 5,800 (total return of -3.5% to +5.0%).
Scenario C: Pessimistic Case
Consumers exhaust remaining excess savings, causing the economy to slow faster than expected and leading to intensified layoffs. European weakness may speed the onset of a global recession. Another pessimistic outcome could be a reacceleration in inflation which leads to additional fed hikes which then leads to a hard landing in late 2024 or early 2025. Either scenario leads to faster and deeper equity market declines followed by a sharp rebound once Fed policy pivots.
Under this scenario, the resultant recession will likely be more profound. S&P 500 earnings may reach $238-$243 but decline 10% in 2025 before rebounding in 2026. In these scenarios, the S&P 500 could fall 20% from current levels over the next 6-12 months as investors grapple with where corporate earnings will trough. However, such events also increase the chance for a swift Fed pivot with declining interest rates, ultimately leading to sharp equity rallies.
At this stage, while Scenarios A or B look more likely than Scenario C, markets are increasingly pricing in the Goldilocks scenario of robust earnings growth coupled with declining interest rates. However, several uncertainties and external variables make this scenario difficult to predict.
Given the significant increase in equity valuations over the last 18 months, coupled with significant remaining macroeconomic risk factors, we recommend that investors avoid adding substantially to equities at these levels.
7-year expected returns of 6.0%-7.0% are lower than historical averages.
