US Equities Keep Rolling: Could It Really Be This Easy?
So far in 2024, hotter-than-expected economic data and record S&P 500 closing levels have left many consensus views from the end of last year in tatters. Investors expected equities to reel from a long list of potential pitfalls, but instead, US large cap has continued the resilience it has shown in recent years. As investors take a beat to reassess, we consider what could slow down the US large cap train in the near term and what trends could help determine whether we are entering an expansionary cycle.
From Soft Landing to No Landing?
At the start of the year, investor concerns included tightening liquidity, a weaker consumer due to the prolonged effect of higher interest rates, and the knock-on effects of diminishing corporate earnings. Instead, the impact of rising rates was only evident in small pockets (such as lower-income households), and US equities surged despite delayed expectations for the first Federal Reserve rate hike. The S&P 500 Index is off to a roaring start this year with a first quarter return of 10.56% (Figure 1).
With inflation normalizing in the 2%-3% range, and economic growth reaccelerating faster than predicted, investors are left wondering if the overused phrase “soft landing” should be substituted for “no landing,” as low levels of volatility remain and the labor market is still very healthy. Despite our strong start, we believe markets will have to deal with bouts of uncertainty due to several risks that have not been priced in:
- Uncertain Monetary Policy. The market has had to grapple with rapidly changing expectations around the size and speed of rate cuts in 2024. At the beginning of the year, markets were pricing in 100+ bps of cuts. Today, the market is only pricing 50 bps of cuts. The dispersion around the data has also moved frequently. While it was previously just a fat-tail view, feasibility has increased that strong economic data could disallow the Fed from making cuts this year. This lack of cuts could result in a fracture to some of the (few) shakier areas in the economy, such as commercial real estate or unseen leverage in the market. Our Chief Economist Simona Mocuta’s base case remains 100 bps in cuts, but there is uncertainty to digest.
- Risks to Corporate Earnings. The S&P 500 reported Q4 2023 earnings growth of 4.17%, a solid showing given expectations. (Some market participants were concerned that falling inflation would mean diminished corporate margins.) That said, results were mixed. Communication Services, Consumer Discretionary, and IT contributed 10.35% of the total result, while several other sectors reported negative growth. Not all of the Magnificent 7 names met expectations, while several companies outside of that group performed well (such as Disney, Chipotle, and Marriott). With EPS growth estimates of 10.8% in 2024, and recent revision estimates upward of 0.58%, any misstep to US earnings should result in a pullback. The rest of the world has recently guided downward.
- Complacency. The VIX Index has remained low this year, averaging 13.65. This is just short of the average of 16.86 for 2023, a year in which the S&P 500 had a total return of 26.29%. The market seems to be underpricing volatility at the moment, which could create outsized risk if short volatility positioning turns. In addition, flow data1 show that investors are overweight in equities in some concentrated parts of the market such as IT.
While our comments so far are aimed broadly at US large caps, it should be noted that the so-called Magnificent 7 powered much of the S&P 500’s gains last year. Since the start of the year, three of the seven (Apple, Tesla, and Alphabet) have experienced far weaker returns (negative in the case of Apple and Tesla), signaling a possible end or, at the very least, a repositioning of how investors view these tech titans. We believe it might be time for attention to revert to the other 493 stocks, where some overlooked segments are favorably positioned across the quality/valuation continuum. For a more in-depth look at this, please see Unlocking Opportunities in the Forgotten 493 Stocks.
The Bottom Line
Markets have become used to the resilience of equities despite a wide range of shocks, and the previous concerns of a recession have largely been quieted. However, we note that despite a slew of healthy economic data prints, there is still relatively below-trend growth. We continue to evaluate whether we are entering an expansionary cycle. Before making that call, we will closely assess the risks above and may even want to see a bit of a pullback (as evidence that these risks are priced in) before constructively moving forward. In the meantime, we remain cautiously optimistic with domestic equities, especially after a healthy return in the first quarter of 2024.