US stocks started the new year on a strong footing. In the first month of this year alone, the Dow Jones Industrial Average has already made multiple all-time highs while the broader market gauge, the Standard & Poor’s 500 index, has also eclipsed its previous record set in late 2021. The obvious question for investors is whether this uptrend is sustainable; and, for those still sitting on the sidelines, should they chase this rally?
Some analysts have noted that there remains substantial cash on the sidelines that could provide a tailwind to the rally. Sharply higher interest rates and widespread expectations for a recession last year significantly improved the risk-reward for cash versus stocks. As we wrote previously, cash was no longer trash. Many shifted their money into minimal-risk money market funds. With recession fears now all but banished and the US Federal Reserve poised to cut interest rates, would the flow reverse — that is, investors redeploying money into stocks for better returns — over the coming months?
To answer this question, we drew an illustration showing the prevailing key expectations that are driving this stock market rally — rapid disinflation (and big interest rate cuts), a soft landing for the economy as well as stronger-than-GDP corporate sales growth and double-digit earnings expansion. And we will explain why all these expectations are nearly impossible to achieve concurrently. In other words, they cannot all happen at the same time — therefore, something must give. Stocks, on the other hand, are priced for perfection. And that is a highly risky proposition.
Soft landing for the economy
The US economy has demonstrated remarkable resilience, thus far, against the backdrop of sharply higher interest rates. Contrary to widespread expectations for a recession at the start of 2023, GDP growth for last year is now projected at 2.5% — higher than the 1.9% in 2022 and, indeed, the average growth of 2.4% for the five years prior to the Covid-19 pandemic. What’s more, the Atlanta Fed’s GDPNow model forecasts growth of 3% in 1Q2024. The stronger-than-expected economic growth is being driven, primarily, by consumer spending.
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At the same time, inflation has fallen rapidly, after the surge in prices during the pandemic and as supply chains and demand normalised. Inflation peaked at 9.1% in June 2022 and has fallen to 3.4% in the latest December 2023 consumer price index (CPI) report.
In short, the US witnessed a painless rapid disinflation, where both economic growth and the labour market stayed strong. The economy continues to add jobs at a rate consistent with expansionary periods. The unemployment rate is hovering near historical lows.
As a result, analysts and economists have mostly capitulated. The overwhelming consensus now is for the US economy to make a soft landing in 2024. A Goldilocks economy — that is, not too hot and not too cold — is characterised by moderate GDP growth, CPI falling back to the Fed’s 2% target, and sharply lower interest rates. Futures pricing data implies the federal funds rate at 3.75% to 4% by end-2024, 1.5% lower than prevailing rates.
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Can disinflation continue with rising wages?
We wrote about wages and CPI in the US last week. To briefly recap, because of the steep rise in prices during the pandemic, CPI ran far ahead of nominal wage growth — resulting in falling real wages. In effect, that means erosion of purchasing power and living standards (see Chart 1).
Real wages, therefore, need to catch up to the steep price increases. That means nominal wages would have to grow faster than CPI for a time — for workers to restore their purchasing power. And in the current strong economy and tight job market, workers have more bargaining power than they have had in years. Case in point: We saw striking workers earn big wage increases from companies last year.
The thing is, wages are sticky and account for about half of the total costs for all S&P 500 companies. Importantly, the percentage is higher for the services sector and lower for manufacturing, and the former makes up two-thirds of the US economy. Businesses can more easily pass on higher costs in a strong economy (more on this later) by raising selling prices. Therefore, positive real wage growth (exceeding productivity gains) will drive services inflation, which is currently rising faster than its long-term trend (see Chart 2).
Goods disinflation — after the steep rise in 2021 and 2022 — had helped offset higher services inflation thus far. But goods disinflation has mostly played out (see Chart 2), with the pandemic supply disruptions largely resolved and demand normalised. In fact, the current risk is resurgent goods inflation, given rising geopolitical risks, especially in the Middle East. For instance, ocean freight rates and insurance costs have risen sharply in recent weeks (see Chart 3). Higher costs will trickle down the supply chains and are likely to be reflected soon in higher consumer prices for goods. In addition, the secular decline in goods prices of the past three decades has ended, with globalisation in reverse mode — owing to geopolitics and trade fragmentation, growing protectionism and trade barriers.
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Taken together, hot services inflation and flattish (if not higher) goods inflation mean that any further drop in the CPI from hereon will be incrementally more difficult — especially in a strong economy.
Pricing power — margins and earnings growth
Businesses will raise selling prices as long as they are confident that the market can absorb it, if the net impact on profits is positive (when the price increase more than offsets any volume drop) and doing so does not impair their longer-term competitiveness.
This was what happened at the height of the pandemic disruptions, when demand for goods far exceeded supply. Companies raised selling prices above the actual cost increases — and enjoyed abnor- mally high margins for it. Case in point: According to FactSet, margins for S&P 500 companies surged to 13% in 2Q2021 — and averaged 12.6% from 2021 to 1H2022 (when the CPI peaked), up from 10.6% in the previous five years.
Clearly, with inflation rising rapidly, it was easy for businesses to justify raising selling prices. The people already expected it, and every other company was also hiking prices. Huge government handouts during the pandemic further made it easier for consumers to accept the steep price increases — after all, they were spending free money. This greedflation — companies raising prices over and above actual cost increases — contributed to the surge in CPI from 2021 to 2022.
In a soft-landing scenario, the economy continues to grow at a solid pace, supported by consumer spending on the back of real wage gains. This will allow businesses to further raise prices — to pass on the higher wage costs and protect their margins. In fact, current consensus calls for S&P 500 companies to expand their margins — with earnings growth estimated at 11.6%, higher than the 5.4% forecast sales growth (which itself is higher than the nominal GDP growth forecast of 3.5%) for 2024. But higher selling prices will generate inflation.
Current market expectations are inherently incompatible — something must give
If the economy and consumer spending remain strong, companies will flex their pricing power and expand margins and profits. This will lead to resurgent inflation — not the continued rapid disinflation that the market currently predicts. And if the CPI becomes sticky (around current levels), there is far less reason for the Fed to aggressively cut interest rates, particularly in a resilient economy with a record-low unemployment rate. In fact, cutting rates when the economy is already growing faster than expected risks stoking inflation, which is the opposite of its objective. See the problem here?
Current bullish stock market expectations are predicated on a combination of rapid disinflation (and sharply lower interest rates), a soft landing (strong economy and job market) and double-digit earnings growth (margins expansion). As we explained above, these factors are inherently incompatible.
We suspect there will be more pushback from consumers against higher prices (making it harder for companies to raise prices) this year. The excess savings and cash handouts during the pandemic are largely depleted, by most measures. Real wages have yet to fully catch up to the previous steep price increases. Indeed, we think companies will start to give up their abnormal margins (by lowering selling prices) when they see demand falling, to maintain competitiveness. Case in point: the brewing price war among electric car makers, including Tesla, as demand growth for electric vehicles slows.
There will also be more aggressive cost cutting, including layoffs. If employment prospects dim, consumers will tighten their purse strings, further dampening demand. But cutting selling prices also means weaker margins and profit growth. On the other hand, lower selling prices will help bring down inflation. And the Fed will cut interest rates more aggressively, especially if it sees recession risks rising. In this scenario, we will get the rapid disinflation and sharply lower interest rates — but weaker-than-expected sales and earnings growth as well as recession, maybe.
Our point is current market expectations cannot all happen in the same breath. Something must give. For one, we think current earnings growth estimates are too optimistic. There are very (too) high expectations for artificial intelligence (AI) to drive productivity gains, and earnings. The reality is that most companies are still in the investing stage. Few, with the notable exception of Nvidia, have a working business model to monetise AI. Productivity will improve, but this will happen over the coming years, not right now. As such, we expect a gradual downward revision to sales and earnings growth estimates as the year progresses.
Plus, we are already seeing some paring back on interest rate expectations in recent days — as the most recent batch of data continues to indicate a hotter-than-expected economy. In its latest meeting, the Fed, too, has poured cold water on an early rate reduction. The probability of the first interest rate cut in March has fallen, and consensus is shifting to May.
The probability of 1.5% in total rate cuts, too, has fallen, though this remains the consensus, for now. If the CPI proves to be stickier than expected, yields could rise anew, and tighter-for-longer monetary conditions will eventually inflict greater damage on the economy. The reality will end up being a balancing act — with some trade-offs in expectations for economic growth, inflation, interest rates as well as corporate margins and profits. The worry is that stocks have priced in an unattainable perfection. Investors must understand their own risk-and-reward trade-off in deciding whether to chase this rally.
*The porfolio performance and table is not displayed as it is not updated due to early closing for Lunar New Year.
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