Wall Street Gets Its Groove Back
The S&P 500 and tech-heavy NASDAQ finished last week at record highs, as investor exuberance grows.
Several factors are fueling the bullishness, including sustained economic growth, falling inflation, strong corporate earnings, a moderate Federal Reserve, and normalizing interest rates. A “soft landing” appears to be in the cards after all. Wall Street is back in its groove.
Last week’s economic highlights centered on the June Federal Open Market Committee (FOMC) meeting and the latest U.S. inflation data, both delivering encouraging signals for investors.
The May consumer price index (CPI) revealed a year-over-year increase of 3.3%, slightly below the previous month’s 3.4% and lower than forecasts.
The Fed, as anticipated, maintained its federal funds rate within the 5.25% to 5.5% range during the June meeting. Notably, the Fed’s updated projections suggest a single rate cut in 2024, contrasting with the three cuts predicted in March. In January, Wall Street had predicted six cuts this year, but those hopes are out the window.
May’s inflation figures were bolstered by stable food prices and a decline in energy costs, as well as reductions in new car prices and airline fares.
The headline CPI’s 3.3% increase and core inflation’s 3.4% rise, both below expectations, marked a significant cooling from earlier months. This deceleration provided reassurance that inflation pressures are easing, though the Fed is likely to seek several more favorable readings before considering rate cuts.
Potential Drivers of Continued Disinflation
At his customary post-meeting press conference, Fed Chair Jerome Powell highlighted potential factors that could further reduce inflation towards the Fed’s 2% target. These include the stabilization of shelter and rent costs, supported by real-time data, and a potential slowdown in services inflation as the labor market cools and wage growth decelerates.
While a straightforward decline in inflation is unlikely, the disinflationary trend appears set to persist. The Fed’s moderate stance last week kept the rally aloft and boosted the rate-sensitive tech sector (see chart).
The eagerly awaited “dot plot” from the June FOMC meeting outlined the projected path of the fed funds rate. While the updated plot indicates only one rate cut in 2024, the terminal rate target of 3.1% by 2026 remains steady. This consistency suggests that despite uncertainties about the pace of rate cuts, the Fed’s long-term goal of normalizing interest rates remains intact.
This trajectory implies gradually improving borrowing costs for both households and businesses, alongside declines in savings rates. Historically, lower interest rates have been conducive to higher market valuations and growth in cyclical sectors. As the prospect of rate cuts looms closer, these sectors should experience renewed momentum.
Anticipating a Soft Landing
The Fed’s latest economic projections reinforce a “soft landing” scenario for the U.S. economy. Predictions indicate steady U.S. gross domestic product (GDP) growth at or above 2% through 2026 and an unemployment rate stabilizing between 4% and 4.2%.
Despite prolonged high interest rates, the Fed foresees no significant economic downturn or severe labor market weakening. Inflation also is expected to hit the 2% target by 2026, amid sustained economic growth.
This soft landing is considered a base-case scenario, underpinned by recent productivity trends driven by labor shortages and advancements in artificial intelligence (AI) across various sectors.
Any slowdown in consumption and the labor market might signal a normalization rather than a deterioration of economic conditions. If inflation continues to moderate and the Fed commences a rate-cutting cycle, economic momentum should strengthen in the coming years.
Potential risks to this outlook include a failure of inflation to moderate as expected or an unforeseen deterioration in the economy or labor market. However, current data and leading economic indicators do not support these adverse scenarios.
Consumption patterns remain robust, the labor market shows relative strength, and recent inflation data have exceeded expectations in terms of moderation.
The Fed’s cautious 2024 outlook leaves room for additional rate cuts if inflation moderates further or if labor market conditions soften more than anticipated.
In a broader context, with the terminal fed funds rate projected between 3% and 3.5% by 2026, interest rates and Treasury yields are expected to remain higher than in the recent past. While the 10-year Treasury yield ranged between 1.5% and 2.5% in the decade following 2008, it may stabilize around 3% to 4% in the coming years.
This environment presents appealing yield opportunities for bond investors and a favorable outlook for equities, particularly U.S. large-cap and mid-cap stocks. Within U.S. investment-grade bonds, extending duration slightly should yield positive results as the economy normalizes and rates gradually decline.
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John Persinos is the editorial director of Investing Daily.
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This article previously appeared on Investing Daily.