US economics, inflation, and the Fed

The Federal Reserve seems to be successful in keeping pressure on inflation while the labor market still adds jobs. The inflation situation continues to improve, with consumer and, more so, producer prices easing further in September. This continued the steady downward movement in the pace of price growth over the summer months. Importantly, the central bank has been able to accomplish this without putting too much pressure on the labor market. The consensus is that the Fed will cut the federal funds rate by a quarter point, to 4.50%-4.75%, at the next Federal Open Market Committee (FOMC) meeting, which commences on November 6th.

Professor Siegel notes:

“The Fed’s path for future rate adjustments has evolved significantly. At one point, the market was pricing in as many as eight rate cuts through mid-2025, but that figure has dwindled to around three or four. The 10-year Treasury yield is up to around 4.20%, and I expect it could rise further as the economy stays strong. This is driven by the Fed’s commitment to maintaining a cautious stance in light of persistent strength in economic fundamentals.”

With prices and the jobs market coming into a better balance of late, the previous calls to cut rates by a half point have dissipated according to Value Line. The labor market has held up well despite the restrictive policies in place since early 2022. Although job creation has been erratic on a month-to-month basis (with the meager 12,000 new jobs in October), on average the nation has added an estimated 200,000 jobs per month this year as revised, a pace indicative of a healthy labor market.

Global economy

According to JP Morgan, the past three years have delivered unprecedented synchronization in inflation swings and central bank rate moves, despite wide growth divergences. The US stands alone in having exceeded its pre-pandemic potential pace while GDP shortfalls now exceed 2%-pts in Western Europe and China. Performance is more mixed elsewhere in emerging markets, but the overall group has yet to return to its pre-pandemic path. Several factors explain these gaps with the US having benefited from sustained fiscal support. Indeed, the US federal government deficit remains high and is tracking 6.6% this year despite generating a 3% annual rate average GDP gains over the past eight quarters.

Gauging the importance of “global common” influences relative to widening performance gaps is a central challenge to forecasting 2025 outcomes. The IMF October World Economic Outlook reflects a bias that is pervasive among economic forecasters: an emphasis on the global common. While recognizing widening performance gaps, these forecasts see the continued unwinding of global supply shocks along with anchored inflation expectations generating a slide toward 2% inflation across the developed markets, which facilitates broad policy easing.

JP Morgan still forecasts global GDP expansion to reach 2.7% this year and 2.5% in 2025.

Stock and bond markets

A successful start to third-quarter earnings season was headlined by strong results from the financial services sector. The big banks exceeded profit expectations, and their prognostications for the remainder of 2024 were favorable. This was likely needed to justify the stock market’s elevated price-to-earnings multiple entering the season.

As Professor Siegel puts it: “corporate America is performing well, with most companies exceeding earnings expectations. The tech sector remains the biggest mover, led by companies like Tesla, which continues to defy gravity thanks to its strong positioning in EVs and autonomous driving technology. However, it’s important to note that much of Tesla’s valuation is tied to the promise and optionality of future developments like self-driving technology. Still, good earnings across the board provides underlying support for equities, even if bond rates remain high.”

We agree with Professor Siegel that a lot of valuation of tech companies is predicated on their future and when they revise the expectations down they can see their stocks go down as well, Microsoft and Apple’s case in hand! However, as long-term investors, we understand that a company’s valuation is based on all its predicted future cash flow. Per Empirical Research a lot of Growth companies do not live up to high expectations, so we need to be very selective in this group. We also need to be diversified to capitalize on the broader market to take on the leadership. That is our plan!

Goldman Sachs in their recent paper long-term return forecast for US equities state exactly that:

• “We estimate the S&P 500 will deliver an annualized nominal total return of 3% during the next 10 years (7th percentile since 1930) and roughly 1% on a real basis. Annualized nominal returns between -1% and +7% represent a range of likely outcomes around our baseline forecast and reflect the uncertainty inherent in forecasting the future. During the past decade, the S&P 500 posted a 13% annualized total return (58th percentile).
• We model prospective long-term equity returns as a function of five variables: (1) starting absolute valuation, (2) stock market concentration, (3) economic contraction frequency, (4) corporate profitability, and (5) interest rates.
• Our forecast would be 4 pp greater than our baseline if we exclude a variable for market concentration that currently ranks near the highest level in 100 years. The 7% return would rank in the 22nd historical percentile.
• The intuition for why concentration matters for long-term returns relates to growth in addition to valuation. Our historical analyses show that it is extremely difficult for any firm to maintain high levels of sales growth and profit margins over sustained periods. The same issue plagues a highly concentrated index. Furthermore, the risk embedded in high-concentration markets is not always reflected in valuation.
• We expect the return structure of the stock market will broaden in the future. Today’s extremely high market concentration suggests that the S&P 500 equal-weight benchmark (SPW) is likely to outperform the cap-weighted aggregate index (SPX) during the next decade by an annualized 200 bp-800 bp.
• Our forecast suggests equities will face stiff competition from other assets during the next decade. Our 3% annualized equity return forecast combined with a current ten-year US Treasury yield of 4% and ten-year breakeven inflation of 2.2% suggests the S&P 500 has roughly a 72% probability of trailing bonds and a 33% likelihood of lagging inflation through 2034. Excluding concentration, the probabilities of underperforming would be 7% and 1%, respectively.
• Our S&P 500 baseline 10-year return forecast is lower than the estimates of other market participants. Buy- and sell-side projections of the long-term return of US stocks averages 6% (range of 4% to 7%).”

Obviously, we have to take these forecasts cautiously and they very seldom turn out to be 100% accurate. However, we, at Signet, are very serious about combating great market concentration (especially in our actively managed strategies) and are adamant about adding new asset classes, like alternatives, into our asset allocations to address the lower expected passive US equity indexes returns over the next decade.

The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are: WSJ.com, Jeremy Siegel, Ph.D. (Jeremysiegel.com), Goldman Sachs, J.P. Morgan, Empirical Research Partners, Value Line, BlackRock, Ned Davis Research, First Trust, Citi research, HSBC, and Nuveen.

IMPORTANT DISCLOSURE

Past performance may not be indicative of future results.

Different types of investments and investment strategies involve varying degrees of risk, and there can be no assurance that their future performance will be profitable, equal to any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.

The statements made in this newsletter are, to the best of our ability and knowledge, accurate as of the date they were originally made. But due to various factors, including changing market conditions and/or applicable laws, the content may in the future no longer be reflective of current opinions or positions.

Any forward-looking statements, information, and opinions including descriptions of anticipated market changes and expectations of future activity contained in this newsletter are based upon reasonable estimates and assumptions. However, they are inherently uncertain, and actual events or results may differ materially from those reflected in the newsletter.

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