In our last quarterly report, we outlined several issues that could impact equity market performance in 2024. We revisit these issues below.
Issue #1: Inflation Trajectory
Thus far in 2024, US inflation has been higher than expected (especially for services). Bond yields have increased sharply with 10-year Treasury yields increasing from 3.87% at YE 2023 to 4.63% presently. Forecasters have dialed back expectations for rate cuts during 2024.
Thus far, equity markets have taken higher than expected inflation largely in stride. The S&P 500 was up 10.4% in Q1 as strong earnings growth more than offset initial higher than expected inflation. However, the S&P 500 has pulled back 5.4% in April (by 4/19) as strong economic data suggests that the last mile towards achieving the Fed’s 2% annual inflation target may be difficult to achieve.
We believe that US markets will be more driven by earnings data rather than inflation data unless inflation spikes and investors believe additional rate hikes are needed (rather than higher but stable rates for longer).
Issue #2: Economic Growth – no landing, soft landing, mild recession, or hard landing?
In the US, chances for no landing (strong growth but slower progress to 2% inflation target) or a soft landing (moderating growth but faster progress towards 2% annual inflation target) have markedly improved. Consumer spending is robust, and enterprise technology spending has increased following a lull in 2022. Manufacturing data has also strengthened in recent months.
The European economy is performing slightly better than expected with both Germany and France having positive GDP growth in Q1. While risks certainly remain and Europe is more exposed to global macro slowdowns should they occur, there is cautious optimism for accelerating growth throughout 2024.
Issue #3: Corporate Earnings
Corporate earnings continue to perform well. In fact, S&P 500 earnings returned to YOY growth in Q3 and Q4 (+7.5% in Q4) after declining YOY in H1. A combination of steady to increasing demand, cost reduction initiatives, and catch-up price increases coupled with stabilizing or declining input costs led to margin stabilization or increases.
Analysts are forecasting 5% revenue growth and margin expansion driving 8% earnings growth for the S&P 500. We believe this is quite achievable with potential upside should current trends hold. Of course, risks surrounding the sustainability of demand and any resumption in input cost increases remain.
Thus far, Q1 2024 earnings season is off to a strong start with a higher percentage of companies delivering earnings beats relative to normal periods.
Issue #4: AI Adoption
AI and actual or perceived beneficiaries continue to play a big role in stock and sector-level performance thus far in 2024.
However, markets are becoming more discerning in analyzing AI-related companies and there has been more disparity between companies showing benefits vs. those that had previously experienced AI-driven stock price hype but failed to deliver actual earnings results.
The biggest AI winners have been semiconductor companies (Nvidia, Micron, Broadcom, etc.) and the hyperscalers / cloud companies (Amazon, Meta, and Google). Software companies thought to have AI leadership positions have demonstrated muted performance early in the year.
The earnings reports this upcoming earnings season from early AI winners will be heavily scrutinized for sustainability of demand, cost creep from expense and capital expenditure pressures, and any changes in competitive dynamics.
Issue #5: China Government Policy
On the margin, China has increased stimulus in the form of lowering bank reserve requirements and lowering interest rates.
However, more credit is flowing into production rather than into consumption, reducing the effectiveness of monetary policy tools in stimulating demand and growth.
Q1 GDP growth (+5.3%) surprised to the upside (consensus at 4.6%). However, much of this growth was fueled by infrastructure expenditures. Retail sales only grew 3.1% YOY in March and missed expectations.
It remains to be seen whether China undertakes aggressive fiscal and monetary stimulus (as they did post GFC and in 2016).
Large scale stimulus would likely lead to rallies in Chinese equity markets and emerging markets more broadly. Additionally, European markets may also benefit under this scenario as Europe is a large exporter to China.
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 and likely lead to surging oil prices which 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 with outcomes uncertain.
Outcomes in the US presidential election could markedly alter the direction of US policy to towards Ukraine and thus could alter the trajectory of the conflict.
Issue #7: US Presidential Election
US equity market have generally experienced higher than normal volatility during presidential election years. It remains to be seen whether there may be unexpected policy changes from either the Republican nominee (most likely Trump) or the incumbent (Biden).
As a mitigating factor, both candidates are well-known, and markets have already experienced their economic policies.
Policy proposals espousing a more widespread application of tariffs (favored by Trump) would negatively affect equity markets.
Biden favors letting some of the tax cuts enacted under Trump expire in 2025. Should that transpire, there may be negative effects on consumer and business spending.
Shorter-term View: Scenarios
We see multiple potential paths for equity returns over the remainder of 2024 (with reference to the S&P 500 which stands at 4,967 as of April 19, 2024).
Scenario A: Optimistic Case
Better than expected economic growth (Real GDP growth of 2.0%+) coupled with continued moderation in inflation. Fed cuts rates by 75bps or more despite stronger growth as inflation resumes falling towards 2.0% target levels. 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 to $245-$253 in 2024 and $270-$280 for 2025 (versus $220 in 2023). Equity multiples may expand to 20.0x-21.0x forward earnings. The S&P 500 index could appreciate to 5,300 to 5,750 by YE 2024 (8%-17% total return).
Scenario B: Base Case
Fed holds rates steady until September 2024 and then cuts by 50bps-75bps over the remainder of the year. Economic growth slows but the US avoids a recession. Real GDP growth approximates 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 $235-$243 in 2024 and $255-$265 in 2025. Equity multiples range between 18.5x-19.5x forward earnings with the S&P ending 2024 between 4,750 and 5,150 (total return of -3.3% to +5.0%).
Scenario C: Pessimistic Case
Consumers exhaust remaining excess savings and the economy slows faster than expected leading to intensified layoffs. European weakness may exacerbate the swiftness 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 an eventual sharp rebound once Fed policy pivots.
Under this scenario, the resultant recession is likely to be deeper. S&P 500 earnings may be $225-$235 with relatively similar levels in 2025. In these scenarios, the S&P 500 could decline by 15%-20% from current levels over the next 6-9 months as investors grapple with where corporate earnings will trough. However, such events also increase the chance for an ultimate swift Fed pivot with declining interest rates which would ultimately lead to sharp equity rallies.
At this stage, while Scenarios A or B are looking more likely than Scenario C, there are several uncertainties and external variables that are difficult to predict.
Given the significant increase in equity valuations over the last 18 months coupled with significant remaining macroeconomic risk factors, we would recommend that investors not add substantially to equities at these levels.
7-year expected returns of 6.0%-8.0% are lower than historical averages.
