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December 18, 2023

Commentary: With mixed economic signals, perfection rarely materializes in the financial markets 

 Are the financial markets priced for perfection? The ferocious rally in both stocks and bonds since November suggest it might be.

Photo / Courtesy of NBT Bank
Kenneth J. Entenmann, NBT Bank.

But what does perfection look like?

  • It is an economy that is slowing just enough to lower inflation, but not enough to cause a recession.
  • It is inflation declining rapidly toward the Fed’s 2% target.
  • It is the Fed not only ending its rate hikes but also the pull forward of rate cuts.
  • It is 2024 S&P 500 earnings growing by 11%.

Perfection is glorious, and I hope the market is right. But perfection rarely materializes in the financial markets. 

One of the catalysts of the recent rally was a strong third quarter GDP of 5.3% (revised up from 4.9%). Broken down, approximately 1% was government spending, 1.5% was inventory build and the remaining balance, 2.8%, came from consumer spending. Business investment was 0%. Looking forward, government spending should decline. Inventory builds are not sustainable. Cautious business spending does not bode well. That leaves consumers to continue their off-the-chart spending. Indeed, the Atlanta Fed’s GDPNow forecast for fourth quarter GDP is 1.2%. While this slowing is currently being viewed as part of the perfection, the margin for error is small and the risk of recession remains.

The market is anticipating a significant reduction in inflation. Unfortunately, inflation is not cooperating. November CPI was up 0.1% month over month and 3.1% year-over-year. While the trend is positive, inflation is still over 3% and the Core CPI is 4%. Both are far from the Fed’s 2% target. Inflation has remained “sticky” and that puts the immaculate reduction in inflation in question. This latest inflation read is hardly a call to action for the Fed. 

The volatility in interest rates this year has been incredible. The Fed Funds rate has increased from 0% to 5.25% since March 2022, an unprecedented rate of change for the Fed. The 10-year Treasury note yield was 3.28% on April 5. It rose to 4.98% on October 19. Today, it is 4.20%. Wow! But the most recent rally in bond prices is based on the perfection scenario. The Fed Funds futures market has pulled the first rate cut into March. It is forecasting four cuts in 2024 totaling 115 basis points of rate decline. And, that is with the perfect “soft landing.” What if the economy and inflation remain stronger than the perfect slowdown? The market has been forecasting a slowdown/recession for 2 years and has consistently been wrong! Indeed, perfection is tough to achieve.

The 2024 S&P 500 earnings forecast calls for growth of 11%. According to Factset, the consensus estimate for 2024 S&P 500 earnings is $244, up 11% from $219 in 2023. Even by historic standards, that is a strong earnings growth expectation. And that is going to happen while the economy is slowing and a recession is still a possibility? 

The market’s 2-year call for a slowdown/recession has been based largely on the expectations that the labor market would cool and consumer spending would return to Earth.

The November employment data surprised on the upside, defying the slowdown prognosticators. Payrolls increased by 199,000 versus a 150,000 estimate in November. The unemployment rate declined from 3.9% to 3.7%. Average hourly earnings grew by 0.4% for the month and 4% year-over-year.

In addition, the consumer spending continues at a robust pace. Travel over the Thanksgiving weekend posted records. Black Friday and Cyber Monday retail sales were records as well. Amazon’s CEO, Andy Jassy, stated in a recent interview that consumer spending remains strong. How is the economy going to slowdown and inflation decline if the consumer continues to spend with reckless abandon? Again, not exactly a call for action for the Fed. Expect the Fed to continue its tough talk on rates. 

The scenario in which the economy slows just enough, inflation disappears from daily discussions, interest rates go back to their crisis-inspired low levels and earnings remain robust requires a whole lot of things to go right. Perfection is a glorious thing … that is rarely achieved in the financial markets. The labor market, consumer spending and CPI simply do not provide a reason for the Fed to change policy. The market may be getting ahead of itself. That does not mean disaster lurks around the corner. It simply means investors should manage their expectations. 

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