April 2024 Stonemark Market Commentary

Anticipation among investors and market participants was high, with many expecting at least one rate cut by this point. This sentiment fueled a robust rally in equity markets as last year ended. However, the landscape has shifted due to the formidable showing of economic data throughout the first quarter of 2024. What was initially perceived as a countdown to the end of Fed tightening and high interest rates has evolved into a question mark regarding the possibility of any rate cut this year. This shift reflects a notable decline in expectations, with the number of anticipated rate cuts dwindling over the past few weeks.

In the past month, investors and markets have navigated through turbulent waters, grappling with a confluence of factors. Geopolitical events have added an element of uncertainty, contributing to market volatility and investor unease. Moreover, the surprisingly robust economic data, while seemingly positive, has been interpreted as "bad news" by some, particularly in terms of its implications for potential rate cuts. Additionally, the first-quarter earnings season has kicked off with a lukewarm start, prompting many to question the sustainability of the strong rally that began in late 2023. There's a palpable sense of skepticism lingering in the air, with some speculating whether the current market exuberance is a bubble on the verge of bursting. We will delve into the major data releases that have driven these discussions and explore their implications for the market outlook.

Throughout the year, contrary to anticipated rate cuts, the remarkable resilience of job creation has remained steadfast, surpassing expectations, and signaling a robust and enduring labor market acceleration. March saw U.S. job growth exceed forecasts significantly, with wages also rising steadily, indicating a strong close to the first quarter for the economy. The Labor Department reported a notable increase of 303,000 jobs in March, up from 270,000 in February and well above the anticipated 200,000. Notably, sectors such as healthcare and government, along with cyclically sensitive areas like construction, retail trade, and hospitality and leisure, contributed to this growth.

The latest employment report from the Labor Department revealed a drop in the unemployment rate to 3.8% in the previous month, down from 3.9% in February. This decrease in the jobless rate was fueled by a robust resurgence in household employment, which more than offset the influx of 469,000 individuals entering the labor force. While these strong figures may not provide immediate support for the Federal Reserve to consider interest rate reductions, the report also offered elements to assuage inflation concerns. Notably, the growth rate of average hourly earnings moderated to 4.1% year-over-year in March from 4.3% in February, marking the slowest pace since June 2021. Two years ago, this rate stood at 5.9%. This trend suggests that employers can continue hiring at a brisk pace without overheating the labor market, potentially allowing inflation to continue its downward trajectory while the economy maintains its strength.

A growing consensus is emerging regarding the disconnect between robust employment growth and a non-overheating labor market, indicating the possibility of ongoing inflation mitigation. This trend is attributed to a surge in immigration, as highlighted by recent data from the Congressional Budget Office, which revised previous immigration estimates for 2023. Initially pegged at an increase of 800,000 migrants, the actual figure turned out to be 3.3 million. Moreover, current immigration flows suggest a similar, if not slightly higher, influx of newcomers this year. This signals a positive supply-side shock, wherein supply may outpace demand, resulting in a larger economy without the corresponding tightening as described by Chairman Powell.

Economic theory offers insights, but the realities of the data often paint a different picture. In March, U.S. consumer prices surged beyond expectations, driven by continued hikes in gasoline and rental housing costs. This unexpected uptick prompted financial markets to anticipate a delay in Federal Reserve interest rate cuts until September.

The latest report from the Labor Department's Bureau of Labor Statistics revealed a third consecutive month of robust consumer price increases, challenging economists' assertions that the earlier inflation spikes in January and February were solely due to businesses adjusting prices at the year's outset. According to the report, the Consumer Price Index (CPI) rose by 0.4% last month, mirroring February's gains. Gasoline prices climbed by 1.7%, following a 3.8% surge in February, while shelter costs, including rents, also increased by 0.4%, matching the previous month's rise. Excluding the volatile food and energy sectors, the core CPI also rose by 0.4% last month, consistent with the increases seen in January and February. Economists noted that the unrounded core CPI increase of 0.359% suggested inflation was not spiraling out of control. Over the twelve months leading up to March, the core CPI increased by 3.8%, matching February's rise, and accelerated to a 4.2% annualized rate in the first quarter, up from the previous quarter's 3.4% pace.

Adding to the existing challenges, the minutes from March's Federal Open Market Committee (FOMC) meeting were released, revealing Fed officials' uncertainty regarding the persistence of high inflation. They expressed concerns that recent data did not bolster their confidence in inflation gradually returning to the targeted 2%. While some officials maintained optimism that key factors such as housing inflation would eventually slow down, "several" suggested that improvements in productivity could sustain robust growth while facilitating a decline in inflation.

However, the overall tone of the minutes underscored a growing apprehension regarding the inflationary landscape, which appeared more manageable at the beginning of the year. Discussions among Fed policymakers revolved around the timing of potential reductions in the central bank's benchmark overnight interest rate, currently held within the 5.25%-5.50% range since last July. Their next meeting is scheduled for May, with rates expected to remain unchanged.

As we approach the summer months, when many large institutional traders and fund managers in New York depart for vacation, market liquidity and trade volumes tend to decrease. This trend is often summarized by the adage, "Sell in May and go away, don't come back till St. Leger's Day." Typically, a market sell-off occurs in late May, leaving junior traders to manage portfolios until September when activity typically resumes. However, lower volumes during this period can lead to increased market volatility, underscoring the importance of maintaining a steady approach.

In election years, this seasonal pattern may not hold true, particularly when considering the influence of geopolitical and macroeconomic events. However, the ongoing conflicts in Gaza and Ukraine have benefitted the US aerospace & defense and energy sectors. While the current average S&P 500 price target for 2024 suggests a stabilizing market, the growing interest in AI-related ventures continues to drive Wall Street analysts to raise targets, intensifying the scrutiny on earnings reports.

Despite a 5.6% year-over-year growth in first-quarter earnings for the S&P 500 index and an impressive 78% of reported companies surpassing expectations, companies are now expected not only to beat revenue and profit estimates but also to raise their full-year guidance. Failure to meet these heightened expectations can result in market repercussions. This trend is particularly evident in the semiconductor manufacturing sector, where expectations are high for Nvidia's upcoming earnings report on May 22.

Nvidia, known for consistently exceeding EPS estimates by double digits, is anticipated to maintain this trend. Despite a reported slowdown in orders by semiconductor rival AMD, Wall Street analysts continue to revise their estimates upwards, reflecting the sector's overall optimism. Nvidia has jumped to the third largest company by Market Cap and its performance will greatly affect investors’ outlook moving forward.

In addition to the semiconductor industry, the healthcare sector is undergoing rapid transformation. The emergence of weight loss drugs, led by Novo Nordisk and Eli Lilly, as well as newer players like Viking Therapeutics, represents the most significant wave of investment in the sector since the COVID-19 pandemic. Analysts project the industry to surpass $100 billion by 2030.

Novo Nordisk and Eli Lilly collectively spent over $1 billion on weight loss drug advertising in 2023, a 51% increase from the previous year, and are expected to more than double that figure this year. The appeal of weight loss drugs is particularly strong for pharmaceutical giants such as Johnson & Johnson, Amgen, and Pfizer, which have faced challenges in regaining momentum post-pandemic and are actively developing their own weight loss medications. The impact of having a weight loss drug in their portfolio is significant, differentiating these companies from their counterparts.

As of the end of April, the S&P 500 Health Care Sector had risen approximately 2% year-to-date. In contrast, Novo Nordisk, Eli Lilly, and Viking Therapeutics have seen substantial gains, with their stocks up by 24%, 32.57%, and an impressive 255% respectively. On the other hand, Pfizer, Johnson & Johnson, and Amgen have struggled, with their stocks down by -2.19%, -4.57%, and up by only 8.94% year-to-date, respectively. While these comparisons may not be directly equivalent, the evident premium in earnings, margins, and market interest for companies involved in weight loss drug development is undeniable. This trend is expected to intensify as more clinical trials conclude and additional competitors enter the market.

The US economy's contradictory traits present a challenge for Federal Reserve decision-makers. Despite persistently high interest rates, inflation has shown remarkable resilience, adding complexity to their policy considerations. While it has shown resilience against higher rates, inflation has proven more persistent than anticipated. This is likely to lead the Federal Open Market Committee (FOMC) to maintain the federal funds rate at its current level after its May 1 meeting.

FOMC Chairman Jerome Powell, previously confident in inflation's trajectory, now acknowledges a potentially prolonged timeline to regain that confidence, hinting at a sustained current rate level. While voices like Larry Summers suggest a potential upward shift in US interest rates, Powell has indicated no inclination to raise rates, favoring their maintenance through the year if necessary.

US companies are displaying robust growth in profits and revenues, surpassing expectations and defying pessimistic forecasts. The market is gradually accepting the Fed's cautious approach to rate cuts, given the inconsistency in jobs and CPI reports. Previous concerns about the Fed's delay in cutting rates have diminished, as the impact of higher capital costs, even on rate-sensitive sectors like utilities, has proven less severe than anticipated.

Investors are now focusing on other key factors such as the strong macroeconomic backdrop, a robust US dollar, targeted workforce reductions, and the increasing integration of AI technologies. Despite the market's advance towards year-end targets, there is a notable absence of apprehension. The anticipated rate cuts have not materialized, yet companies are reporting record profits, leading Wall Street to revise their estimates upwards. The prevailing bullish sentiment gains allure when one considers the market's impressive performance without the anticipated cuts, suggesting that when they do occur, they will likely provide a significant boost for consumers and businesses alike.

As the market enters a slower phase, pullbacks are expected. Maintaining a rational perspective and focusing on data-driven analysis will be crucial. Market reactions, particularly to strong earnings reports, may present opportunities for strategic investments.