Equity markets have had quite the run to begin the year. The S&P 500 finished Q1 2024 up just over 10%, the best start to a year of trading since 2019. The growth has caused valuations to appear stretched, a concern weighing on investors’ minds. Firms within the S&P 500 index are currently valued at approximately 20.5 times their expected earnings for the next 12 months which exceeds the five-year average valuation of 19.1 according to FactSet. In order for equities to move higher from here, these market dynamics are crucial, and we should watch them closely.
The 10 Year U.S. Treasury Yield; A Shifting Narrative Is at Play
Markets have gone back and forth interpreting the heavily watched yield on the 10 year U.S. Treasury bond. Back in October 2023, the 10 year yield began a sharp decline from just over 5% to below 4% in late December. That large and sustained downward move in yield ignited an equity bull market. Market participants seemed to be following the narrative of declining bond yields signaling a weakening economy which would cause the Fed to cut rates sooner and more often this year. Any hint of rate cuts only reinforced this idea and drove markets higher.
Recently, the narrative seems to be changing. Remember that a lower 10 year bond yield is typically associated with declining economic sentiment which nudges investors to buy into safer bonds. As demand for those securities goes up, prices rise and yields fall. Hence, there is a link between a falling 10 year U.S. Treasury bond yield and weaker economic growth.
However, as frequent positive reports of U.S. economic growth hit the tape, market participants began to worry a bit less about interest rate cuts and focus more on a rising 10 year yield being good for equities, a more traditional economic relationship. The constant stream of positive economic reports allowed investors to let go of the idea only the Fed could drive the market higher. Instead, actual economic expansion became the growth story. At this point, investors will be looking to see if growth will continue without flaring inflation once again, the much anticipated soft landing scenario. We will get a major update on Wednesday April 10 when CPI and core inflation flation data are published before the market opens at 0830. PPI hits the tape the next day, Thursday April 11 at 0830.
Interest Rates and the Federal Reserve
Markets began the year in a bull market driven by expectations that the Fed would cut interest rates six times over the course of 2024. With hotter than expected inflation in January and February, those expectations have moderated. Market participants now expect clearly fewer cuts this year; two, one, or none are all real world options these days. FOMC members have been steadfast with their message; they will not begin to reduce interest rates until economic data show inflation is clearly cooling. In a new development on Friday of last week, the idea of interest rate increases was first mentioned as a possibility by Fed governor Michelle Bowman. That notion is a departure from Chairman Powell’s reiteration just last week that three cuts are expected. As the prospect of frequent and substantial interest rate cuts seems to be dwindling, markets will have to find other catalysts if a move higher is to be realized.
Commodity Prices Have Increased
The rapid rise in commodity prices since March 11 has threatened the ongoing rise in equities. As input costs rise, it becomes harder for companies to turn out growing profits. Oil and gold as well as copper have been standouts within the trend in commodity prices; the price of Brent crude has been rising since early December 2023. Oil has been benefiting from regional conflicts in Ukraine and the Middle East as well as from strong demand generated from U.S. economic expansion. Supply restrictions from OPEC and slowing U.S. production growth are additional drivers of oil prices. Gold is another hot commodity now due to these very same themes: two wars and strong economic growth with a side order of presedential election uncertainty.
U.S. Corporate Earnings Must Meet Expectations.
Expectations are for earnings of S&P 500 companies to have grown for a third consecutive quarter. FactSet puts expected quarterly earnings’ growth at 3.2%, slightly less than the previous two quarters but still solid for Q1 2024. With valuations extended as they are now, significant disappointments during this earnings season could easily derail a higher move in stocks. On the other hand, strong earnings could easily occupy the driver’s seat during another leg of this bull market.
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