May 2024 Outlook for Financial Markets - Back and Forth

Soft-landing – Blink and you missed it

There has been a string of upside surprises to recent economic data – this includes jumps in retail sales and job growth, but also for inflation. The modest degree of economic softness that occurred in prior months seems squarely behind us. Forecasts for 2024 GDP growth continue to push higher (Exhibit 1) and our expectation of accelerating growth driven by stronger business spending is beginning to take shape in certain survey data (Exhibit 2). Undoubtedly, AI-related outlays will be part of the increase in business spending. We believe this is a durable trend and that productivity improvements from AI will become more tangible by year-end. 

Dashed Fed rate cut expectations could mean more push and pull

The goldilocks scenario that propelled the stock market from November of last year through this past March was underpinned by the pillars of falling inflation, imminent Fed rate cuts, and healthy economic growth. In recent months, however, rebounding inflation data has dramatically reduced Fed rate cut expectations and led some Fed governors to question the appropriateness of any rate cuts at all this year. The market backdrop has quickly transitioned from being supported by multiple pillars to one in which growth provides the only clear underpinning. 

Despite the stock market volatility in April, an environment of strong growth amid stable inflation and a neutral Fed is not inherently destabilizing. A measure of concern is understandable given three consecutive upside surprises to CPI inflation, but we still believe that inflation is set to decline modestly for the remainder of the year. This confidence is based on our expected moderation in “Shelter” price growth that has contributed significantly to inflation, and also based on softening wage growth that should ease cost pressures in the economy. The change in expected Fed interest rate cuts, however, is substantial, and as a result the stock market could be more sensitive to news and data relating to growth expectations. 

Looking ahead
At present, economic and earnings growth expectations for the second half of this year are favorable – even robust (Exhibit 3) – which presents a positive backdrop for equities. Given elevated valuations, however, stock market gains through year end may be somewhat below the realized earnings growth. 

In terms of interest rates, we believe that current levels of longer-term yields are in the vicinity of fair value now that the yield on the 10-year Treasury Note is above 4.5%. The risk to longer-term yields, while now decidedly two-sided, still skews toward higher yields due to potential growth surprises, heavy issuance of Treasuries to fund the fiscal deficit, and risk surrounding election outcomes and spending policies that could increase fiscal strains. A sharp increase in longer-term yields from current levels would pose a considerable headwind to both bonds and stocks.

Even absent such a jump in long-term yields, the market may experience a dose of caution ahead of the November elections. The remainder of the year may not be tranquil. Nonetheless, the pillar of expected growth is substantial and enthusiasm for AI spending and economic benefits may come in waves but is directionally higher. In sum, we continue to expect more flow than ebb, more push than pull, and more forth than back.