LONDON, Feb 13 (Reuters Breakingviews) - Something is amiss in American financial markets. U.S. stocks hit new highs last week, propelled in part by the belief the country will vanquish inflation and avoid a recession. At the same time, though, derivatives traders are betting that the Federal Reserve will slash interest rates. That will not happen unless the central bank is seriously worried about growth. One of the two camps is destined to be wrong.
The S&P 500 Index (.SPX), opens new tab has started 2024 with a bang, notching up new records and closing above the symbolic 5,000 mark for the first time last week. The U.S. equity benchmark’s 5.4% advance since New Year’s Day means it has already surpassed the year-end forecasts by strategists at banks such as Morgan Stanley (MS.N), opens new tab, JPMorgan (JPM.N), opens new tab and Société Générale (SOGN.PA), opens new tab. And this comes after U.S. stocks crushed most other asset classes in 2023, with total returns of more than 26%.
Sceptics may grumble that this stunning ascent has been largely down to just seven technology giants – Meta Platforms (META.O), opens new tab, Amazon.com (AMZN.O), opens new tab, Apple (AAPL.O), opens new tab, Alphabet (GOOGL.O), opens new tab, Microsoft (MSFT.O), opens new tab, Tesla (TSLA.O), opens new tab and Nvidia (NVDA.O), opens new tab. The “Magnificent Seven” last year returned 76% as investors bet that they would be the main beneficiaries of a boom in artificial intelligence. The other 493 members of the S&P 500 returned just 14%, according to Goldman Sachs analysts. So far this year, the seven are up 8%, versus 3% for the rest. But that’s all right for investors in the index funds that dominate U.S. equities. Besides, the S&P 500 now collectively trades at around 20 times its components’ expected earnings for 2024. That compares to an average multiple of around 16 over the past decade.
The question is whether economic fundamentals, developments in monetary policy and companies’ future earnings justify such a rally. And here’s where different markets have widely diverging views. Investors betting on interest rates have a bleaker view of the economic trajectory. They think the Fed will cut borrowing costs aggressively by the end of the year. Derivatives prices collected by LSEG imply an 80% probability that the Fed will lower rates four times by December, and a near-50% chance it will cut five times. Looking further out, derivatives markets are pricing in nearly 175 basis points of rate cuts between May this year and June 2025. Since 1955, a monetary policy easing of that magnitude has only ever occurred because of a recession, according to Jim Reid at Deutsche Bank. The exception came in 1984-1985 when Fed Chair Paul Volcker reversed previous steep rate hikes as inflation eased.
This gloomy outlook is entirely missing from equity markets. In fact, Wall Street analysts forecast that earnings per share at S&P 500 companies will grow 10% this year and 13% in 2025. Economic data also point to a “soft landing”, with inflation abating and the economy avoiding a contraction. GDP is on track to rise at an annual rate of 3.4% in the first quarter of the year, according, opens new tab to the Atlanta Fed, while unemployment has been below 4% for two years – the longest such stretch in more than half a century.
Fed Chair Jerome Powell will not be easing monetary policy so quickly if the economy remains resilient, not least because every Fed decision until November’s U.S. presidential election will come under heavy scrutiny from both Democrats and Republicans. Powell recently stressed the Fed would be “prudent” in lowering rates even though inflation is converging towards its 2% target.
How to explain the discrepancy? One possibility is a glitch in the Fed funds futures market, which anticipate the central bank’s moves. The contracts, traded on the Chicago Mercantile Exchange, are used by banks and companies to hedge interest rate risk and by speculators to bet on rate movements. As such, they are an expression of market participants’ views, not a perfect crystal ball. Torsten Slok, chief economist at Apollo Global Management (APO.N), opens new tab, has noted, opens new tab that derivatives tend to overestimate the central bank’s willingness to cut when rates are high, and vice-versa. And a 2002 study by the Atlanta Fed found, opens new tab that, before interest rates came down in 1990-1991, these markets had expected much deeper cuts than actually happened.
Even so, other asset classes also seem to be pricing in higher borrowing costs. Yields on 2-year U.S. Treasury bonds have risen from 4.19% on Feb. 1 to 4.49% on Feb. 12, as strong data and Powell’s cautious words convinced traders that rates would remain high.
That matters for the equity market because bonds compete with shares for investors’ affections. High stock valuations and rising yields have pushed the equity risk premium – the excess return that stock market investors expect over risk-free U.S. government debt – to its lowest level since at least 2006, according to Michael Hunstad, deputy chief investment officer at Northern Trust Asset Management. History suggests that slow rate cuts as inflation glides back to target are better for equity investors than fast monetary easing caused by a looming recession. In cycles where the Fed has cut rates less than five times in 12 months, the S&P 500 has risen on average 24% in the first year, according to Ned Davis Research. By contrast, stocks only rose by an average of 5% in the first year of quick cuts. During the last two big recessions, in 2001 and 2007, the S&P 500 ended up losing 14% and 21%, respectively, within a year of the first rate cut.
The wild card this time is Big Tech. The seven giants make up nearly 30% of the S&P 500’s total market capitalisation and 22% of its members’ total expected net income for 2024. Continued strong performance would keep pushing up the whole market. Recent signs are positive. Five of the six that have already reported earnings for last quarter of 2023 beat Wall Street’s earnings estimates. David Kostin of Goldman Sachs reckons that if Nvidia meets consensus forecasts when it reports later this month, the Magnificent Seven will deliver a 14% year-on-year increase in revenues, way better than the 2% managed by the other S&P 500 stocks to have reported so far.
Of course, the Magnificent Seven wouldn’t be immune to a sharp economic downturn. Investors cannot be right about both the direction of U.S. interest rates and the future of U.S. stocks. If traders need a reason to be cheerful, they may have to turn away from Washington and look in the direction of Silicon Valley.
Editing by Peter Thal Larsen, Aditya Sriwatsav and Streisand Neto
