Evening Brief – 01.04.24
Stocks Need Bonds
The stock market rally in the fourth quarter of 2023 may be difficult to replicate. But while uncertainty remains for the coming year, there is a growing consensus that the Federal Reserve will soon begin lowering interest rates, which is likely to curb any significant pullback in equities.
Although some analysts warn that the prospects of dovish policy changes aren’t as strong as some estimates suggest, the general consensus is that the Fed funds target rate will be lowered in the coming months.
Fed funds futures are currently pricing in a 65% probability of a quarter-point rate cut in March and just over 50% in May. Meanwhile, the policy-sensitive US 2-year Treasury yield is currently trading at 4.38%, which is considerably below the central bank’s current 5.25%-to-5.50% target range.
The release of the Fed minutes from the December meeting on Wednesday provided additional, albeit cautious, support for interest rate cuts. “In discussing the policy outlook, participants viewed the policy rate as likely at or near its peak for this tightening cycle, though they noted that the actual policy path will depend on how the economy evolves.”
While there’s growing confidence that the central bank’s rate hikes are a thing of the past, the timing of rate cuts remains uncertain. As The Wall Street Journal notes: “While nearly all officials anticipated policy rates would eventually be lowered before the end of this year, the written account of the Dec. 12-13 meeting underscored heightened uncertainty over how to navigate the next interval of monetary policy after the most rapid increase in interest rates in four decades.”
The Fed’s dovish pivot has boosted the forward 12-month P/E ratio for the S&P 500 to 19.3, which is slightly above the 5-year average of 18.8 and 10-year average of 17.6. Given the market is priced at the upper end of the 10-year range, accelerated growth is required to support this valuation.
According to financial data firm FactSet, this ought to be the case. “Despite concerns about a possible recession next year, analysts expect the S&P 500 to report double-digit earnings growth in CY 2024. The estimated (year-over-year) earnings growth rate for CY 2024 is 11.8%, which is above the trailing 10-year average (annual) earnings growth rate of 8.4% (2013 – 2022).”
“On a quarterly basis, analysts are expecting the highest earnings growth to occur in Q4 2024. For Q1 2024 through Q3 2024, analysts are projecting earnings growth of 6.8%, 10.8%, and 9.0%, respectively. For Q4 2024, analysts are projecting earnings growth of 18.2%.”
Despite macroeconomic and geopolitical concerns, one can argue that the market will keep its premium valuation and expand on its 2023 gains if these earnings growth predictions are even close.
That said, the current equity bull market requires a stable bond market – one in which interest rates do not rise again, principally due to a flare up in inflation.