Soft Landing On Track, With New All-Time Highs Ahead

All eleven sectors of the S&P 500 (SP500) finished higher last week to end a three-week losing streak for the index that was instigated by fears of stalled progress on inflation and a “higher-for-longer” interest rate policy from the Federal Reserve. Reigniting investor enthusiasm were earnings reports from some of our largest technology companies that are starting to monetize the explosive growth in artificial intelligence, while corporate profits in aggregate are also exceeding expectations. The earnings season has been an effective counterbalance to fears of sticky inflation and restrictive monetary policy, but I think both are unwarranted concerns. On the contrary, they set the stage for the next leg up in this bull market.

Just three months ago, the consensus of investors was confident that the Fed would reduce short-term interest rates as many as six times this year, beginning as early as March, as inflation was rapidly collapsing towards the Fed’s 2% target. Yet, the lagging impact of price increases in several components of the inflation gauges (shelter, medical care, auto insurance) lifted the monthly increase above expectations in January, February, and March, resulting in a 3.7% annualized rate for the core Personal Consumption Expenditures (PCE) price index during the first quarter. That reduced rate-cut expectations to just one before year-end while lifting short- and long-term bond yields close to last year’s highs. After we learned that growth during the quarter fell to a less-than-expected 1.6%, the bears are attempting to take control of the narrative again with forecasts for stagflation, ever-higher interest rates, and lower stock prices. I couldn’t disagree more.

The first quarter was a speed bump in a disinflationary trend that continues, but pessimists are extrapolating the first quarter into the remainder of 2024, which is like driving in the rearview mirror. The core PCE held steady at 2.8% in March on a year-over-year basis, and as real-time data catches up with the stale statistics used to compute the index, with an emphasis on rents, the monthly increases of the first quarter will abate, moving us closer to the Fed’s target.

Additionally, as the rate of economic growth continues to soften under the weight of depleted excess savings and the lagged impact of higher borrowing costs, disinflation should further entrench, especially for the service sector. At the same time, the expansion looks well-balanced given that the shortfall in growth for the first quarter was the result of lower inventory levels and trade, both of which should be sources of growth later this year. Consumer spending, capital investment, and housing remain strong contributors to the ongoing expansion, while government spending is now negligible.

Instead of using economic data from the first quarter to predict what will happen over the coming three, I prefer to rely on more real-time leading indicators like the survey of purchasing managers (PMI) conducted by S&P Global in mid-April for the service and manufacturing sectors. That report showed a significant softening in demand for services with lower levels of output and employment, which portends an ease in pricing pressures. In fact, this report showed the second-lowest overall cost increase for service providers in three-and-a-half years, which should lead to lower output price increases.

The sell-off in the bond market this year because of the uptick in inflation, has driven both short- and long-term bond yields higher to close in on their 2023 highs, which is a level that coincided with the correction lows for the S&P 500. I think the 2-year Treasury yield (US2Y), which is a proxy for where investors see the Fed’s benchmark rate a year from now, is peaking again at 5%. As the high-frequency economic data softens and disinflation in the monthly data returns, the 2-year yield should start to fall again, supporting stock prices in the months ahead. The soft landing remains on track, and this bull market has much further to go. Another bear trap has been set by the bond market, like the one set last October, for those who think that rates will keep rising and that this bull market is coming to an end.

The one caveat I see is that sector leadership in the stock market is likely to change during the next advance. According to FactSet, halfway through this earnings season, corporate profits are now increasing 3.5% in aggregate for the first quarter, which is up modestly from the outlook at the end of March. More importantly, the sources of earnings growth are expected to shift moving forward. Whereas the Magnificent 7 technology-related names did all the heavy lifting last year, as well as in the quarter just ended, their rate of growth is forecast to slow from unsustainable high levels, while the remaining 493 names are expected to see a positive rate of change in growth through year-end. Markets respond to rates of change far more than absolute numbers, and this shift suggests more of an equal weight than overweight to the tech sector.