Sustainability of Q1’s bullish rally
The market momentum of February extended to March and the S&P 500 index ended the month at 5254 as bullish bets on tech companies continued. Although the benign inflation and strong consumer spending helped, the remarkable performance cannot be explained just by the positive sentiment about the economic backdrop, nor by the expectation of the rate cuts.
The S&P 500 index’s Q1 average recorded a whopping 11.7 percent growth over the last quarter of 2023. This was the largest first-quarter advance since the 13.1% increase in the first quarter of 2019. As large tech companies announced downsizing and layoffs, investors became more bullish on tech earnings. Both the cost-cutting and the AI revolution contributed to the positive sentiment. Alphabet, Meta, and Microsoft have reached all-time highs, lifting both the Nasdaq and the S&P 500 indices. The combined share of Microsoft, Alphabet, Amazon, Apple, Meta, and Nvidia is about 25 percent of the S&P 500 index.
Benign US inflation, strong consumer spending, and 2023 Q4 GDP were other reasons for the market optimism besides the tech rally. Going forward, it remains to be seen if future tech earnings will justify the lofty price-earnings ratio of the S&P 500 index. Currently, this ratio is above 20, which appears to be high by historical standards. We predict the market to settle down toward a fairer value later in the second quarter.
U.S. GDP growth in 2023 Q4 is revised up
The US real GDP growth for the fourth quarter was 3.4 percent according to the third and final estimate (Source: the Bureau of Economic Analysis (BEA)). This was a slight upward revision from the second estimate (3.2 percent), the overall GDP growth for 2023 stands at a respectable 2.5 percent.
The increase in the fourth quarter reflected increases in consumer spending, government spending, exports, nonresidential fixed investment, and residential fixed investment which were partly offset by a decrease in private inventory investment.
The latest data confirm that the US economy is expanding at a healthy pace, unlike its European counterparts, thanks to robust consumer spending. Consumer spending was revised higher (3.3% vs 3% in the second estimate), As we reiterated many times, so long as consumer spending which accounts for more than two-thirds of U.S. economic activity, stays healthy, the US economy is not likely to contract severely.
Both retail and home sales slightly recover
Starting with the economic data, retail sales and home sales showed some recovery in February after falling in January:
The advance estimate of U.S. retail and food services sales for February was up 0.6 percent from the previous month. The sales were also up 1.5 percent above February 2023 (both seasonally and inflation-adjusted). The modest monthly increase was below market forecasts of a 0.8% increase.
The National Association of Realtors index of pending home sales grew 1.6 percent in February after the massive drop of January (-4.9%). The Pending Home Sales Index leads existing home Sales by a month or two. The latest figure shows a slight recovery in the US housing market. Although US home buyers are getting more optimistic about financing, it is becoming clear that the rate cuts may be delayed and higher mortgage rates may linger longer.
The US labor market shows signs of cooling down
In the week ending March 23, the advance figure for seasonally adjusted initial claims was 210,000, a decrease of 2,000 from the previous week’s revised level. The 4-week moving average was 211,000, a decrease of 750 from the previous week’s revised average (Source: US Department of Labor).
The advance seasonally adjusted insured unemployment rate was 1.2 percent for the week ending March 16.
The US unemployment ticked up to 3.9 percent from 3.7 % last month. The layoffs in the tech sector seem to have coincided with the cooling in the labor market. The initial jobless claims remain still below the 250,000 mark. To speed up the Fed’s rate cuts in 2024, an unemployment rate above 4 percent may be necessary. The latest increase in unemployment rate indicates a step in the right direction for lower rates.
Pessimistic PMI and consumer outlook
The Chicago Purchasing Managers’ Index (PMI) fell further to 41.4 in March from 44 in February. This was well below the market anticipation of 45.9. The index’s long-term average from 1967 to 2024 is 54.7. Hence its current value indicates a contraction in business activity.
The Conference Board’s consumer confidence index slightly fell in March to 104.7 (1985=100), from a revised 104.8 in February, The Present Situation Index—based on consumers’ assessment of current business and labor market conditions—increased to 151.0 (1985=100) from 147.6 in February. Based on consumers’ short-term outlook for income, business, and labor market conditions, the Expectations Index fell to 73.8 (1985=100) in March, down from 76.3 in February.
A reading below 80 for the Expectations Index indicates that consumers are still concerned about a recession this year. The dip in consumer confidence indices is a reflection of consumers facing the fact that rate cuts may be delayed. Amid the improving economic conditions, consumers remain anxious with no clear improvement in their confidence.
Inflation edges up in February
The annual inflation rate in the US slightly increased to 3.2 percent in February, from 3.1 percent in January. This was slightly above analysts’ expectations of 3.1 percent.
According to the metric that the Federal Reserve uses for its inflation target, personal consumption expenditures increased at an annual rate of 2.5 percent in February. Slightly ticked up from the previous month’s inflation of 2.4 percent. The core PCE, which excludes changes in food and energy prices by 0.3% on a month-to-month basis. This was slightly faster than Fed Chairman Powell’s expectation for February.
The latest uptick in inflation did not seem to be a matter of concern for Jerome Powell. He remains optimistic about the inflation rate converging to its target rate of 2 percent this year. He finds the latest numbers along the lines of Fed’s anticipation. We believe that the benign inflation rate raises the possibility of 3 rate cuts later this year.
Timing of the rate cuts
The Fed continues to anticipate a ‘soft-landing’ for the US economy where unemployment is forecast not to climb over 4.1 percent. As the US labor market loosens with more initial jobless claims with cooling inflation, market analysts priced in interest rate cuts early this year. However, this anticipation has dissipated with the stronger-than-expected GDP for Q4. The general view now is that the rate cuts will be delayed till there are clear signs of the economy slowing down.
Indeed, the Fed left interest rates unchanged in its end-of-January meeting. The Fed Chairman Jerome Powell made it clear that despite curbing inflation, there was no rush to cut rates given the robust pace of economic growth and strong job gains. There was no meeting in February. As the inflation rate of February edged slightly higher, it was no surprise that the Fed abstained from cutting rates in March. The markets do not expect a rate cut before June this year.
The 10-year U.S. Treasury Bond yield ended March at 4.20 percent. Although markets see the probability of recession as small, the inversion in the yield curve was slightly more negative (-.42) at the end of March than at the end of February (-.39).
US corporate earnings surprise on the upside
The US corporate earnings with inventory valuation and capital consumption adjustments (domestic industries) were 5.2 percent up in 2023 Q4 from the previous quarter. The earnings were also 5.5 percent higher than the last quarter of 2022. In an inflationary environment, US companies seem to have passed the price increases to consumers without big increases in their costs. The corporate earnings are nominal numbers and in an inflationary environment, they appear inflated. Recent lay-offs seem to have put a lid on the upward pressure in wage negotiations. The US company earnings increased in Q4, on the back of strong consumer spending. However, we expect the savings from the pandemic era to be depleted in the coming months, leading to lower spending and earnings.
Our consumer sentiment indicators are based on our ‘keyword’ algorithm related to ‘Google Trends’. Accordingly, these indicators are among the explanatory variables that predict US corporate profits. The Q4 earnings were much stronger than we expected. This shows that inflation continued to benefit corporates at the expense of wage earners in Q4. Our prediction of corporate earnings in 2024 Q1 is a 2.9 percent drop over the previous quarter. We expect the earnings to be 5.4 percent higher over 2023 Q1.
The historical data from March 31st, 2024
Consumer Spending, Employment, and GDP Growth
At the beginning of 2023, some market analysts were already predicting a likelihood of a recession in 2023. We have always argued that a recession this year is unlikely.
US Private Consumption expenditure is the most significant component of GDP from the expenditure side. It accounts for about 69 percent of the GDP. When we consider the US data in the last 14 years (see below), we observe that a severe drop in US GDP growth corresponds to dipping consumer spending and employment, measured with non-farm employees. We did not observe a severe fall in non-farm employees or real consumer expenditure in 2023 Q3. During the pandemic, the drop in consumption expenditure was rather abrupt. Furthermore, the ‘technical recession’ of the first two quarters of 2022, was not mirrored in consumer expenditure, or employment. Our analysis backs up the belief that as long as non-farm payrolls and US consumer spending remain healthy, a hard landing for the economy is unlikely.
Although economists generally see employment as a lagging indicator, there is academic evidence that non-farm payrolls have predictive power for economic activity.
The S&P 500 is currently overvalued
According to Factset, the forward 12-month P/E ratio was 20.9 on March 28. This P/E ratio is above the 5-year (19.1), 10-year (17.7), 15-year (16.1), 20-year (15.6), and 25-year (16.4) averages.
In terms of guidance, Factset points out that both the number and percentage of S&P 500 companies issuing negative EPS guidance for Q1 2024 are higher than their long-term average. At this point in time, 112 companies in the index have issued EPS guidance for Q1 2024. 79 of these companies have issued negative EPS guidance and 33 have issued positive EPS guidance. Thus, investors seem to be more optimistic about the US company earnings than the companies themselves.
We believe that the market optimism behind the rally will lose some steam in the second quarter as we expect the company earnings to fall.
Going forward, we anticipate the S&P 500 to trade closer to its historical average in 2024. We expect the US economy to slow down somewhat in the first quarter and the earnings to adjust accordingly.