US markets grapple with mysterious contradictions
Something is amiss in American financial markets. US stocks hit new highs last week, propelled in part by the belief the country will vanquish inflation and avoid a recession.
At the same time, though, derivatives traders are betting that the Federal Reserve will slash interest rates. That will not happen unless the central bank is seriously worried about growth. One of the two camps is destined to be wrong.
The S&P 500 Index has started 2024 with a bang, notching up new records and closing above the symbolic 5,000 mark for the first time last week. The US equity benchmark’s 5.4% advance since New Year’s Day means it has already surpassed the year-end forecasts by strategists at banks such as Morgan Stanley, Jpmorgan, and Société Générale.
And this comes after US stocks crushed most other asset classes in 2023, with total returns of more than 26%.
Sceptics may grumble that this stunning ascent has been largely down to just seven technology giants – Meta Platforms, Amazon. com, Apple, Alphabet , Microsoft, Tesla and Nvidia.
The “Magnificent Seven” last year returned 76% as investors bet that they would be the main beneficiaries of a boom in artificial intelligence. The other 493 members of the S&P 500 returned just 14%, according to Goldman Sachs analysts. So far this year, the seven are up 8%, versus 3% for the rest. But that’s all right for investors in the index funds that dominate US equities.
Besides, the S&P 500 now collectively trades at around 20 times its components’ expected earnings for 2024. That compares to an average multiple of around 16 over the past decade.
The question is whether economic fundamentals, developments in monetary policy and companies’ future earnings justify such a rally. And here’s where different markets have widely diverging views. Investors betting on interest rates have a bleaker view of the economic trajectory. They think the Fed will cut borrowing costs aggressively by the end of the year.
Derivatives prices collected by LSEG imply an 80% probability that the Fed will lower rates four times by December, and a near-50% chance it will cut five times. Looking further out, derivatives markets are pricing in nearly 175 basis points of rate cuts between May this year and June 2025.
Since 1955, a monetary policy easing of that magnitude has only ever occurred because of a recession, according to Jim Reid at Deutsche Bank. The exception came in 19841985 when Fed Chair Paul Volcker reversed previous steep rate hikes as inflation eased. This gloomy outlook is entirely missing from equity markets. In fact, Wall Street analysts forecast that earnings per share at S&P 500 companies will grow 10% this year and 13% in 2025.
Economic data also point to a “soft landing”, with inflation abating and the economy avoiding a contraction. GDP is on track to rise at an annual rate of 3.4% in the first quarter of the year, according to the Atlanta Fed, while unemployment has been below 4% for two years – the longest such stretch in more than half a century.
Fed Chair Jerome Powell will not be easing monetary policy so quickly if the economy remains resilient, not least because every Fed decision until November’s US presidential election will come under heavy scrutiny from both Democrats and Republicans. Powell recently stressed the Fed would be “prudent” in lowering rates even though inflation is converging towards its 2% target.
How to explain the discrepancy? One possibility is a glitch in the Fed funds futures market, which anticipate the central bank’s moves.
The contracts, traded on the Chicago Mercantile Exchange, are used by banks and companies to hedge interest rate risk and by speculators to bet on rate movements. As such, they are an expression of market participants’ views, not a perfect crystal ball.
Torsten Slok, chief economist at Apollo Global Management, has noted, that derivatives tend to overestimate the central bank’s willingness to cut when rates are high, and vice-versa.
And a 2002 study by the Atlanta Fed found that, before interest rates came down in 1990-1991, these markets had expected much deeper cuts than actually happened.
Even so, other asset classes also seem to be pricing in higher borrowing costs. Yields on 2-year US Treasury bonds have risen from 4.19% on Feb 1 to 4.49% on Feb 12, as strong data and Powell’s cautious words convinced traders that rates would remain high.
That matters for the equity market because bonds compete with shares for investors’ affections.
High stock valuations and rising yields have pushed the equity risk premium – the excess return that stock market investors expect over risk-free US government debt – to its lowest level since at least 2006, according to Michael Hunstad, deputy chief investment officer at Northern Trust Asset Management. —