We've reached the halfway mark of the year, with the other half still ahead. However, it is hard to believe that there are only four Federal Open Market Committee (FOMC) meetings remaining this year with high expectations for rate cuts. The FOMC will meet on July 31, September 18, November 7, and December 18. At the beginning of the year, Fed Funds futures, or the market, was signaling that the Fed Funds rate would end 2024 at 3.62% (3.50%-3.75%), while the FOMC forecasted a year-end rate at 4.6% (4.50%-4.75%). Midway through the year, those forecasts have changed significantly, with the FOMC now suggesting that they may only lower rates once this year!
The Next Cut
The chart below highlights the forecasted changes for Fed funds rates at the end of 2024 by tracking the Fed Funds futures data for the June and December meetings. Focusing on the red line below December 18th meeting), one can see that in January, the market (as measured by Fed Funds futures) believed rates produced, and the market believes that rates will still be north of 5% at the end of 2024. Presently, December Fed Fund futures are forecasting a 43.4% chance of 4.75%-5.00% (0.25% cut) and a 30.5% chance of 5.00%-5.25% (rates unchanged).
Inflation and the Economy
Why the slow walk lowering rates? The FOMC believes that inflation is still too persistent and sticky. When looking at the inflation data at face value, one could see that inflation did drop precipitously off the peak, but over the last several months, the pace of decline has slowed and is potentially plateauing. The FOMC’s preferred measure of inflation is the PCE (Personal Consumption Expenditures), not the CPI (Consumer Price Index). Long-term, they would like to see this measure at 2.0% vs. the last reading of 2.6%.
PCE is designed to measure the cost of living changes in a typical household, and the measure has a weighting mechanism to account for the fact that certain household expenditures consume more of one’s non-discretionary spending. For instance, one might spend more on gasoline (car) than they do on milk, and this is adjusted by assigning weights to the various spending components of PCE. Digging into these components, it is apparent there are two catalysts in the underlying stickiness. They are owners’ equivalent rent and auto insurance. Auto insurance does not require a definition, but the reasoning or inflating costs can be tied back to the pandemic. Specifically, the surge in car prices that was evident years ago is now bleeding into increased costs to insure more expensive vehicles and components. But few know what the owner’s equivalent rent is, and once defined, it may leave the reader scratching their head to understand how it is causing inflation to remain higher.
Owners equivalent rent is a way to measure what households pay monthly to live in their residence. By utilizing data from rental units, the Bureau of Labor Statistics attempts to use the monthly cost of rents to extrapolate what a homeowner is spending monthly on shelter. There is a major flaw here, in that many homeowners remain handcuffed to their low-interest mortgages. According to Fortune, 58% of homeowners presently h have a mortgage with a rate below 4%. And only about 14% have a 6%, or higher, mortgage interest rate, which is reflective of the current environment. For the existing homeowner segment of the population, dwelling costs have not inflated. When housing prices went through the roof, rents increased. However, if one does not sell their home and buys into the inflated housing market, they still have not experienced any inflation in their monthly housing costs. Back to the original point, how does the owner’s equivalent rent remain one of the prevailing factors of sticky inflation when the data does not accurately reflect the real world?
The recipe of higher interest rates for longer, coupled with PCE inflation not declining in a straight line to the 2% FOMC target and GDP softening in the first quarter, began to stoke stagflation fears. The first read of GDP that was released on April 25th came in at 1.6%, vs. the 2.4% consensus estimate the Street was looking for. This was also the first reading since the 3.4% print in the 4th quarter of 2023. Put simply, it was disappointing. Of note, each quarter’s GDP data is reported three separate times as the data moves from preliminary to final. The second print, released on May 30th , was a further disappointment, at 1.3%. The final print was released on June 27th and was revised slightly higher to 1.4% for the official first quarter GDP report.
Stagflation
To coincide with the Q1 GDP print, there was a spike in Google searches for the word stagflation, as shown in the Google Trends chart below. Stagflation is the combination of slowing economic growth and high unemployment, coupled with rising prices. The preferred tool in the FOMC’s toolbox to combat stagnating growth and rising unemployment is to ease conditions with lower interest rates (the Fed Funds rate). In contrast, the solution to combat higher prices (inflation) is to raise rates. This puts the FOMC in a quandary, as adjustments in the Fed funds rate will not work if we end up with stagflation. The best outcome is to avoid getting there altogether, but the lone solution is time. Time should allow prices to cool, growth to resume, and jobs to come along with that. Historically, this has also coincided with a recession.
Source: Google Trends
The S&P 500 was down 4.16% for the month of April, and that downward move, along with the poor GDP print on April 25th , created a bearish narrative that the market was going to fall during hard times. The S&P 500 closed lower by 0.46% on April 25th , the date of the weak Q1 GDP report, only helping to add to that narrative. From April 24th (the close before the first print) through June 28th , the S&P 500 has moved higher by 7.67%. Note the market strength even as GDP continued to weaken from the initial to the final print.
The paradox where bad news is good news helped propel the market forward. Slowing GDP could mean the FOMC will move to cut rates sooner rather than later. Unemployment remained at historical lows
but is moving slightly higher (3.7% -> 4.0% YTD). And as mentioned above, inflation continues to cool, albeit slowly.
Earnings
The final component that drove the market forward this year was earnings. S&P 500 year-over-year earnings grew by 8% for the quarter and exceeded analysts’ estimates for five consecutive quarters. Estimates for Q2 earnings are forecasted to grow at 8.8% year-over-year, which will mark the highest YoY growth rate since the first quarter of 2022, if the data comes in as forecasted. For Q1, 79% of the S&P 500 beat on earnings per share, while 13% missed and 7% were in line. On the revenue side, 61% beat and 39% missed. The chipmakers and drug makers have been riding the AI and GLP-1 (think
Ozempic) waves in their respective sectors. The data in the chart below highlights how well those areas did in 2024. But not all are equal; this is not a market where a rising tide is lifting all boats. Stock and
sector selection have been critical this year.
Stay the Course
To close my quarterly note, I would like to touch on the upcoming election. I will not pretend to have any predictions or commentary about the election itself. Instead, I would like to share some market history around trying to time investment decisions with a political party. The chart below mirrors the message I always strive to convey: stay the course! The chart shows three portfolios all with a starting value of $10,000, invested in the S&P 500 in 1953. The difference between the three portfolios is whether one only invested during Republican or Democratic presidencies vs. staying invested all years. The historical data is clear, the best outcome is to stay invested for the long term, as that choice has produced exponentially higher returns throughout history. Avoid market-timing investment decisions around things we do not directly control.
Source: Goldman Sachs – Market Monitor
Thank you for your continued trust and confidence. Here is to finishing off the year as strong as we started.
If you are not presently a client and would like to discuss your personal circumstances, please do not hesitate to reach out to me.
Feel free to schedule a quick 15-minute virtual introduction meeting.
Rob Leiphart, CFP®
203-220-6474
rleiphart@rbcapitalmanagement.com