The market in general is anticipating 2-3 interest rate cuts beginning in June, which is important because the stock market has been reaching new highs – not based on earnings growth but rather on valuations which depend on the rate reductions.
Recall that in March of 2022 the Federal Reserve began raising interest rates 11 times to a 23-year high in an attempt to slow inflation from its highest rate in nearly four decades.
Two days ago, one of the Federal Reserve governors made a speech at the Economic Club of New York explaining why he believes the Federal Reserve has no reason to cut interest rates over the next several months.1 We are in that camp.
Why do we think interest rates will remain high?
A. The rate of inflation is not coming down. Yes, it’s lower than two years ago but the key rate (the one the Federal Reserve focuses on) remains uncomfortably high given the Fed’s goal of 2%. In today’s report, the core Personal Consumption Expenditures index of inflation was 0.3% or 3.6% annualized for February. It’s down from January’s figure but remains elevated from each of the last three months of last year.2 Similarly, the core Consumer Price Index has shown the same trend.
B. Job growth remains strong. Usually we would cheer the news, but with growing wage income comes fuel for further inflation. The number of new jobs needs to go down, not up.
C. Economic growth estimates are coming down. With high inflation and interest rates we are seeing fewer purchases of homes and durable goods as well as restaurant meals and low end (i.e., dollar store) items. Inflation has been most severe to people with low end jobs and those on fixed incomes. They simply cannot afford to pay the inflated prices of everyday items. Since the consumer accounts for about two-thirds of the economy, forecasts are coming down to about 2.1% in the first quarter of 2024 from the actual growth of 3.4% in the last quarter of 2023.3
D. Earnings growth estimates for the 500 companies tracked by Standard & Poor’s are also coming down, from 5.8% three months ago to now 3.6%.4
Stock valuations have expanded to 20.9 times estimated earnings per share. This price to earnings (or P/E) ratio is above the five-year average (19.1) and above the ten-year average (17.7).4 Investors have been using the assumption of lower interest rates and higher economic growth to fuel that expansion in P/E ratios.
We believe that is no longer a base case scenario. With the combination of lower growth comes the outlook for lower valuations in both stocks and bonds in the coming weeks and months.
Mariann Montagne, CFA
Sources:
1 Federal Reserve: Transcript of Waller Speech to the Economic Club of New York 3-27-24
2 Bureau of Economic Analysis February Personal Consumption Expenditures 3-29-24