Up, Not Down?

By Paul Broughton, Portfolio Manager

Earnings estimates for the S&P 500 have been moving higher which, you could say, is due to the outlook for a continued healthy economy and the belief that we’re in for the proverbial “no landing.”  We have very low unemployment, and consumers, in general, continue to spend.  The market’s first-quarter return of 10.5% was exceptionally strong.  That’s a good return for a full year rather than just a quarter.  Everything is looking bright.  Now would be a good time to step back and examine whether investors have, perhaps, been too optimistic. 

The strong equity rally through the end of March has been engendered by the belief that the Federal Reserve’s efforts—by pushing the overnight rate to 5.50%–have largely put the inflation genie back in the bottle and that we’re going to avoid a recession.  But we’re starting to see that inflation is proving itself more stubborn than originally thought.  The 10yr Treasury reflects this.  It was 3.88% at the start of the year and is now 4.60%.  This price action in the 10yr is a good insight on how the collective market sees inflation as being more persistent than thought at the start of the year, and that it looks challenged in getting back to 2% anytime soon.      

Worth noting, regarding inflation, is that strong demand is also pushing commodity prices up since the start of the year along with the move higher in the 10yr.  Crude oil is up 14% year-to-date, gold and silver are up 15% and 19%, respectively, and copper is up 14%.  Coffee, cotton, and sugar (“the softs”) are up a combined 11%.  Food-at-home prices rose by 5% year-over-year in 2023 and were up by 25% from 2019 to 2023, according to the USDA.  Gasoline for your car is up 18% this year. 

On April 1st, California introduced a new $20 minimum wage law for fast-food workers, which amounted to a 25% pay increase.  This higher wage will likely lead to fewer hours worked in the fast-food industry and higher prices for consumers.  Chipotle Mexican Grill’s average burrito bowl on March 29th in California was $9.50, but on April 3rd it was $10.27, according to KeyBanc Capital Markets.  Obviously, Chipotle wasted no time in raising prices.  Further knock-on effects mean there will likely be wage pressures on other hourly service jobs such as janitors, cafeteria, and hotel workers, etc.  Some restaurants are trying to avoid some of these higher labor costs by replacing workers with technology.  For example, many McDonalds restaurants take orders over iPads, which means fewer workers at the counter.  Machines are also being installed to produce French fries.  Not surprisingly, California’s labor market is significantly weaker than the whole country.

Over the last couple of weeks, market participants started to recognize that the higher-for-longer interest rate environment is looking more likely than the hoped-for Fed easing of rates.  Currently, investors expect fewer than two rate cuts in 2024.  And since March 28th, the S&P 500 is off by 4.6% and the VIX has jumped from about 13 to 19 as investors look to buy protection against a market drop.     

Our Chief Investment Officer, Chuck Lieberman, for the past few quarters has consistently stated that higher interest rates are going to be more persistent than the market had anticipated and that financial conditions are still relatively accommodative.  This scenario is only now being acknowledged by the collective market. 

So, what does all this mean?  Increasingly, there’s a greater chance that we won’t see any rate cuts in 2024.  And if inflation is resurgent this year, there’s an outside chance that we see a rate hike.  This possibility is now entering the collective mind of the market.  The strong equity rally in the first quarter now looks to be overly optimistic, as inflation remains stubbornly above the Fed’s target and consumers continue to spend.  There is one saving grace, however.  The solid growth we have been enjoying also means corporate profits will likely be better than anticipated.  That’s a nice tailwind for equities.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.