Below, we revisit vital issues that we have outlined in previous reports.
Issue #1: Inflation Trajectory
Inflation is moderating, with signs of continued disinflation into 2025.
In September, CPI increased by 0.2% month-over-month (2.4% year-over-year), while core CPI rose 0.3% MoM (3.3% YoY). The Fed’s preferred inflation measure, Core PCE, was up 0.1% MoM and 2.7% YoY in August. If fiscal policy remains stable, inflation is expected to continue easing throughout Q4 2024 and into 2025.
Bond yields have fallen sharply from their April highs, with the 10-year Treasury yield down to 4.1% from 4.7%, though still above the recent 3.6% low in September.
The Fed implemented a 50 bps rate cut in September, and economists project an additional 150 bps of cuts by the end of 2025.
Issue #2: Economic Growth
Economic growth is slowing, but a soft landing remains the base case.
GDP growth is expected to stay below 2% in 2025, with economic activity having rebounded in recent months despite earlier weakness.
The US labor market remains resilient, with unemployment at 4.2%, up from a low of 3.4%. However, historically, a 50 bps increase in the unemployment rate often signals a recession within 6-12 months. Spending among upper-middle-class and wealthy consumers is strong, while lower-income households face rising credit card and auto loan delinquencies.
As inflation continues to subside, rate cuts should help mitigate potential slowdowns.
In Europe, economic recovery is underway but uneven. Q2 GDP rose by 0.2% quarter-over-quarter (0.6% YoY), with Germany near contraction, while France, Spain, and Italy saw stronger growth.
Manufacturing PMIs have been negative since July 2022, showing renewed weakness in recent months despite earlier improvements. In contrast, services PMIs remain positive, and consumer confidence has strengthened with stable employment and lower inflation.
Issue #3: Corporate Earnings
Corporate earnings are robust, but 2025 poses tougher comparisons.
S&P 500 earnings grew 12% YoY in Q2, with growth extending beyond the “Magnificent Seven” tech firms.
Analysts forecast 4.1% earnings growth for Q3 2024 and 14.2% for Q4, though Q3 will likely exceed expectations sharply and Q4 projections may be revised modestly lower.
Analysts are currently forecasting 15% earnings growth for 2025. Analysts tend to be optimistic regarding future earnings and generally reduce their forecasts closer to earnings releases. In 2025, earnings growth comparisons for the Magnificent Seven become more challenging.
As such, non-Magnificent Seven companies will need broad earnings growth to deliver 2025 earnings near consensus expectations. Rate cuts could support recovery across sectors, assuming a recession does not materialize.
Issue #4: AI Adoption
AI is driving 2024 market performance, but future growth remains uncertain.
Sectors such as semiconductors and technology hardware have significantly benefited from AI-related spending.
While the near-term outlook for AI hardware is strong, sustainability beyond 2025 is uncertain. Some companies have strengthened their competitive positions through AI leadership (e.g., Apple, Microsoft, Alphabet), despite limited current impact on financial results.
The main beneficiaries thus far include semiconductor firms (Nvidia, Micron, Broadcom) and cloud companies (Amazon, Meta, Google). Software companies associated with AI have shown muted stock performance.
Upcoming earnings reports will be closely watched for signs of sustained demand, cost pressures, and shifts in competition.
Issue #5: China Government Policy
China’s economy remains weaker than expected with several structural challenges. However, the government recently announced large scale stimulus measures that may restore consumer confidence and drive improved growth.
The property sector remains weak, with ongoing declines in new home prices and consumer spending.
In response, the government has implemented significant stimulus measures, including lower borrowing rates, property incentives, and efforts to stabilize equity markets through a stock stabilization fund and share buyback incentives.
Chinese equities surged 40% over three weeks through early October on optimism about the stimulus, but momentum has faded as policy details fell short of expectations. Further large-scale fiscal measures are needed to boost domestic consumption.
Issue #6: Geopolitical Conflicts
Geopolitical risks are intensifying, with conflicts in the Middle East and Ukraine.
Israel is engaged in escalating conflicts with Hamas and Hezbollah, with the risk of a direct escalation involving Iran.
The Russia-Ukraine war appears to be in a stalemate, with uncertain outcomes. The U.S. presidential election could significantly influence U.S. policy toward Ukraine, potentially altering the conflict’s trajectory.
Despite Middle East turmoil, oil prices have remained stable due to muted global demand amid weak European and Chinese economies and rising U.S. supply. However, a sustained increase in oil prices could reignite inflation and raise the risk of a global recession.
Issue #7: US Presidential Election
The upcoming election could increase market volatility and alter policy directions.
Historically, equity markets experience higher fluctuations during election years, particularly around the election.
So far, market volatility has been lower than expected, possibly because both Trump and Harris are well-known figures with familiar policy positions. Nonetheless, unexpected policy shifts remain a risk.
For instance, broader tariffs favored by Trump could negatively impact equity markets and drive up bond yields, while Harris’s proposal to let certain tax cuts expire in 2025 and raise corporate taxes could weigh on consumer spending and corporate earnings.
Shorter-term View: Scenarios
We envision multiple potential trajectories for equity returns over the next twelve months, with the S&P 500 positioned at 5,815 as of October 11, 2024.
Scenario A: Optimistic Case
The optimistic scenario assumes aggressive Fed rate cuts will accelerate economic growth without aggravating inflation.
In this case, the Fed cuts rates by 50 bps or more through the end of 2024, followed by an additional125+ bps in 2025, spurring economic growth above 2% while core inflation continues to decline toward the 2% target.
Rate Cuts and Economic Growth: The easing cycle supports healthy consumer spending, modest wage growth, and improved profit margins as companies continue to manage costs effectively.
Earnings Outlook: AI demand remains robust and the Magnificent Seven continue to generate strong earnings growth which is accompanied by improving earnings growth across the broader market.
S&P 500 earnings could grow from $222 in 2023 to $248-$255 in 2024, $270-$285 in 2025, and $300-$315 in 2026, with equity multiples holding at 21x-23x forward earnings.
Market Implications: Under these conditions, the S&P 500 may reach 6,300-6,800 by mid-2025, delivering a total return of 10%-18% from current levels.
Scenario B: Base Case
The base case projects slowing growth but no recession, with the Fed continuing gradual rate cuts.
The Fed is expected to cut rates by 50 bps through the rest of 2024, followed by a 100 bps reduction in 2025. Economic growth slows to 1.5%-2.0%, with unemployment rising modestly, but significant economic contraction is avoided.
Economic and Employment Trends: Consumer spending is projected to slow without substantial declines, while GDP growth stays between 1.5%-2.0%.
Earnings Outlook: AI demand modestly slows from current levels. Magnificent Seven earnings growth cools from torrid 2023 levels while broader market earnings growth continues to improve.
S&P 500 earnings may reach $240-$248 in 2024, $260-$275 in 2025, and $280-$300 in 2026, with equity multiples at 19.5x-21.5x forward earnings, resulting in an S&P 500 index level between 5,500 and 6,000 and a total return of -4.0% to +4.5%.
Scenario C: Pessimistic Case
The pessimistic scenario anticipates a deeper economic slowdown, possibly leading to a recession.
Economic deterioration accelerates due to depleted consumer savings, triggering layoffs, or external factors like a European recession or resurgent inflation that could prompt new Fed rate hikes.
Recession and Market Decline: The recession would be more profound, with S&P 500 earnings forecasted at $240-$245 in 2024, followed by a 10% decline in 2025 before potential recovery in 2026.
Market Implications: The S&P 500 could drop by 20% within 6-12 months as expectations adjust, but a quicker Fed pivot to easing may trigger a strong market rebound.
At present, Scenarios A and B appear more plausible than Scenario C, with markets increasingly pricing in a “Goldilocks” scenario—characterized by robust earnings growth alongside declining inflation and interest rates.
Supporting Factors: The U.S. consumer remains generally healthy, with unemployment still at historically low levels, strong AI-related demand reamins robust and corporate earnings growth remains strong. Additionally, easing cycles by the Fed and other central banks provide a favorable macroeconomic backdrop. Historically, the fourth quarter has tended to be a strong period for equity markets.
Caution Advised: Despite these positive dynamics, the significant increase in equity valuations over the past 18 months, coupled with ongoing macroeconomic and geopolitical risks, suggests caution. We recommend avoiding substantial new equity allocations at current levels.
Longer-term Outlook: 7-year expected returns for equities are in the range of 6.0%-7.0%, which is lower than historical averages, reflecting elevated valuations. There is potential for heightened volatility.
