Before we start this week, we want to wish former President Trump a speedy and full recovery. Our political institutions require passion and even partisanship by design, but are peaceful by design as well. Our hearts go out to all the victims and especially the family of Corey Comperatore.
- Carson Investment Research released its Midyear Outlook last week.
- We continue to see low odds of a recession over the rest of the year and the prospect of stock gains supported by earnings growth.
- We expect core bonds to outperform short Treasuries over the rest of the year.
- With the most recent CPI report it’s clear—inflation was last year’s story (and stocks love it).
- The Federal Reserve should be shifting their focus increasingly to supporting employment.
- We believe a rate cut at this point is justified but likely won’t come until September.
Carson Investment Research has released its Midyear Outlook 2024: Eyes on the Prize. It’s been quite a year so far, with continued job market strength (with some recent slowing), strong earnings growth, and stock gains that surprised many to the upside, outpacing even our out-of-consensus views for continued market strength.
Our most important calls for the year were that the economy would avoid a recession and equity markets would see solid gains supported by continued earnings growth. So far so good. Here’s a quick look at what we said in our Outlook 2024, penned back in November 2023, what’s actually happened, and what we’re expecting over the rest of the year here at midyear.
The Economy
Our Outlook 2024 forecast: “Overall, in 2024, we see productivity growth compensating for slower job gains in the U.S., which together form the foundation of continued economic growth … All told, the economy looks nicely positioned as we head into 2024, with continued consumer strength providing the foundation and the massive headwind of Fed policy potentially turning into a tailwind. Much of the economic uncertainty from late 2022 / early 2023 has receded, and we believe the probability of a recession in 2024 is low.”
What happened: Most importantly, we are not in a recession and see little sign of one around the corner even with the on-going normalization of the labor market. Unexpected strength in the labor market has played a stronger role in extending the expansion than productivity growth so far this year, but we think the potential for productivity growth to play a meaningful role is still there. Consumer spending has played the role expected well, supported by job gains.
Our Midyear Outlook 2024 update: “The economy remains resilient supported by job gains, income growth, and strong consumer balance sheets as well as productivity gains on the business side.” Our basic view of the economy hasn’t changed, although seeing the Fed start to cut rates before the end of the year has become a more important factor in sustaining the expansion. We still see strong potential for productivity gains to help sustain the expansion and will be watching the numbers carefully in the second half.
The Federal Reserve
Our Outlook 2024 Forecast: “All signs point to inflation easing back to the Fed’s target in 2024. As a result, the Fed is unlikely to raise rates again, and in fact, by Spring of 2024, they could even start thinking about rate cuts. If inflation is on a sustainable path lower, there’s no need to keep policy rates as restrictive as they are now, especially when there’s a risk of breaking the economy. At the same time, we don’t think the Fed will cut more than 3-4 times in 2024, since our base case is for no recession.”
What happened: The Fed ended its hikes. Inflation remained more stubborn than expected in the first half of the year pushing back rate cuts, but there has been meaningful progress more recently. We were out of consensus and quite conservative in the number of expected rate hikes heading into 2024 compared to the market, but with the more recent inflation progress, we may still see three hikes in 2024.
Our Midyear Outlook 2024 update: “Inflation will continue to fall and the Fed will begin cutting rates in the second half of the year, with a base case of two cuts in 2024.” Some of this has already come to pass since we wrote the Outlook. At this point, we think that a rate cut in September is not only likely but called for as inflation continues to subside.
Stocks
Our Outlook 2024 forecast: “What could help drive stocks higher, and likely even to new all-time highs during the first half of next year? At the end of the day, it’s earnings … When companies are posting record profits, stocks tend to follow, something we expect to see in 2024. Potentially even more surprising than expected record profits are improving profit margins … Average election year gains of 12.2% for the past 10 first-term presidents provides a strong script for 2024 and gives us more confidence in our fundamentally driven forecast of potential low double-digit return in 2024.”
What happened: The S&P 500 had a total return of over 15% in the first half of the year, supported by a continued expansion, profit growth, and improving margins. Our forecast was too conservative despite being above consensus, although the basis for the forecast was right on target. Toward the final months of the first half we did see the market starting to narrow but we see no reason to despair. As Ryan highlighted in a recent blog on first half returns, “According to Howard Silverblatt at S&P, if you removed NVIDIA’s gains the S&P 500 would be up 10.7% and if you removed all of the Magnificent 7, it would still be up 6.3%.” That 6.3%, which excludes the Magnificent 7, was right in line with our target. And the election year script? Still working.
Our Midyear Outlook 2024 update: “We are targeting a total return for the S&P 500 of 17-20% in 2024 … This young bull market will continue, supported primarily by earnings growth. Economic strength will support more cyclical stocks, while catch-up for undervalued areas of the market may contribute to a broadening rally. Stocks outperform bonds.” Our midyear update now looks conservative. But our fundamental story remains the same: As long as the economy and profits continue to grow, we will view risks to our equity forecast as predominantly to the upside.
Bonds
Our Outlook 2024 forecast: “Our recommended maturity profile for bond holdings was quite short at the beginning of 2023. We slowly faded rising rates over the course of the year and moved just short of the Agg toward the end of the year. This final move was based on the historical pattern that intermediate maturity bonds start to outperform ultra-short maturity bonds in the six months before the first rate cut after a hiking cycle. This isn’t surprising, as markets are forward-looking. We believe the effect in 2024 may be consistent with the past but somewhat weaker, since many initial cuts historically are in response to an economy entering a recession following Fed overtightening, which is not what we expect to see next year.”
What happened: Stubborn inflation pushed back rate cut expectations, with the 10-year Treasury yield rising from 3.88% to 4.36% over the first half of the year. But much higher starting yields compared with 2022 and some additional compression in credit spreads limited losses for the Bloomberg US Aggregate Bond Index to 0.7% in the first half. That still lagged quite a bit behind the Bloomberg 1-3 Month Treasury Bill Index’s 2.7% return.
Our Midyear Outlook 2024 update: “Bonds will be more resilient in the second half of the year as the Fed begins to cut rates. Historically this has been a good time to shift short term holdings towards more traditional bond allocations…The Bloomberg US Aggregate Bond Index outperforms short-term Treasuries in the second half of the year.” The tendency of intermediate-term bonds to outperform short-term bonds in the six months prior to the first rate cut may still hold true, but we had the timing wrong. Nevertheless, we still think it’s important to keep this piece of market history in mind over the second half of the year. A rate cut in September would put the start of the six-month clock in March, just a little earlier than the current 2024 rate peak in April.
Midyear Outlook 2024: Eyes on the Prize
The costliest investing mistakes are often not missed opportunities but straying from a long-term plan at the worst possible time because of emotionally driven decisions. We chose “eyes on the prize” as our Midyear Outlook theme because recently some of those lessons have been hitting home.
Many investors received some hard knocks due to missed opportunities after the bear market low in October 2022, in part because so many financial industry pundits remained sour on the economy and equity markets. We also saw a recent example of overconfidence, starting back in 2020 following a strong bond rally that led some to believe that bonds would always have a low risk profile. Not surprisingly, there were heavy inflows into bonds at the time.
That long-term focus is so important because a good investment plan is in the service of the real prize, the chance to discover and live our best lives and to support and spend time with the people we care most about. That’s a prize worth always keeping an eye on. We hope you find our Midyear Outlook a useful guide to what may lie ahead this year. We will continue to communicate our views throughout the year as we monitor the markets and the economy and share what we see ahead.
Inflation Is Last Year’s Problem and Stocks Love It
The June inflation report was picture perfect. The Consumer Price index (CPI) fell 0.1% in June, which was below expectations. Core CPI, which strips out the volatile food and energy components, rose just 0.1%. These were below expectations, and combined with April and May data, reverses the “heat” we saw in the first quarter inflation data.
CPI ran at a 1.1% annualized pace in the second quarter (Q2), bringing its six-month pace to 2.8%. That’s still elevated relative to the Federal Reserve’s (Fed) target of 2%. But here’s the thing: 35% of CPI is shelter, and official shelter inflation runs with significant l ags to what we see in actual rental markets. Strip out shelter and here’s what we have:
- CPI ex shelter ran at a -0.5% annualized pace over the last 3 months (Q2). The negative sign is not a typo.
- CPI ex shelter is up 1.6% annualized over the last 6 months, and 1.8% over the last 12.
Official shelter data is also looking positive from the perspective of what may be coming ahead. Rent of primary residences account for 8%-points of that, while “owners’ equivalent rent” (OER) accounts for the other 27%-points. OER is the “implied rent” homeowners pay, and it’s based on market rents as opposed to home prices. In June, these ran at the slowest pace in three years, and close to the pre-pandemic trend. It’s easy to think of that as a blip, since it’s much lower than recent months. But there’s reason to believe that May data was skewed upwards for idiosyncratic reasons, which means the downtrend is smoother, and likely to continue.
We also got the producer price index data for June on Friday, which along with CPI, serves as a partial input into the Fed’s preferred inflation metric, the Personal Consumption Expenditures Index (PCE). Core PCE is expected to be on the softer side as well in June, running between 0.1-0.2% for the month, going by estimates from our friends at Employ America.
As the title of this piece says: Inflation is last year’s problem.
Time For the Fed to Focus on Risks Other Than Inflation
As our friend at Ren Mac LLC, Neil Dutta, pointed out, all the stars aligned for the June inflation report. But most importantly, it shouldn’t have been a surprise since this was always coming. We’ve been talking about a disinflationary trend (and the problems with how shelter inflation is measured) on these pages since last year.
Yes, the inflation data was hotter than expected in Q1, but our analysis had concluded this was more than likely a head fake. There was no other data, including wage growth, consumer inflation expectations, business expectations, and market expectations, that pointed to a renewed surge in inflation. And these would be the places to look if that were the case.
The good news is that the Fed is starting to acknowledge this reality. Fed Chair Powell was in front of Congress last week and said that the disinflationary trend was back on and that the risks to their “dual mandate” are double-sided. On the one hand, cutting interest rates too soon could undo the progress they made on inflation. On the other hand, cutting too late could unnecessarily undermine the expansion, and cause unemployment to continue to rise. This two-sided view of the risks is different from what he was saying a year ago, and acknowledges that there are rising risks in the labor market. We would add that risks are likely more skewed to the labor market side, rather than inflation, but follow the Fed we must. It looks like they are unlikely to cut rates at their July meeting in two weeks, but we could very well see them start the rate cutting cycle in September. Not a moment too soon.
Stocks Loved This
As soon as the June CPI report was released, Treasury yields collapsed lower. The 1-year yield fell from 5% to 4.89%, and the 2-year yield fell from 4.62% to 4.51%. These are essentially market expectations for monetary policy rates over the next one and two years. And markets are saying, the Fed will cut (the current policy rate is 5.25-5.50%).
We’ve maintained across the past year (including in our 2024 Outlook and the Midyear Outlook that was released earlier this week) that disinflation is happening, and the Fed will respond to it with rate cuts. That’s going to help the stock market rally broaden out, beyond the recent gains we’ve seen for the largest technology companies in the world.
Market action after the CPI report release underlined this. Stocks overall, at least as measured by the broad S&P 500 Index, fell almost 1% on the day. Even the Dow rose under 0.1%. But it was a different story under the hood, with over 400 stocks gaining. The ones that lost the most ground were the big technology names that have been surging recently. That’s why the headline S&P 500 index fell (since large technology makes up over 30% of the index).
The Russell 2000 Index, a basket of small cap stocks, rose 3.6% on Thursday. It beat the S&P 500 by 4.5%-points, the most since March 2020. This is extreme and not something we expect to see replicated going forward. However, we think it’s likely that we see the general theme of rotation – from large cap stocks to midcap and small cap stocks, and from technology stocks to other sectors – to play out over the reminder of the year. A broader rally amongst stocks is one reason to have a diversified portfolio, even within your equity allocation, where you’re not betting on just one theme to play out.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly-traded companies from most sectors in the global economy, the major exception being financial services.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
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