Growth in the U.S. economy strengthened during the second quarter of 2024, and it looks set to continue into the third quarter despite many economists predicting a recession by now. Indeed, earlier this year the data did appear to be signaling a recession was coming soon. Capital spending by businesses was showing signs of slowing. Excess savings among consumers, which had been built up during the pandemic, had been depleted. Defaults were rising on office mortgages, and delinquency rates were beginning to rise across a wide range of consumer debt, including credit cards. The Conference Board’s Leading Economic Indicators had fallen for 20 straight months, and in December of last year the Conference Board said a recession “is likely in 2024 due to high interest rates, tighter lending standards and a slowdown in consumer spending.”
However, consumer spending has remained robust, and strong consumer demand has been the primary driver of economic growth in the United States. Consumers continue to spend, although there has been a split in the spending abilities of the three income levels of consumers. Higher- income households are in great shape and can continue to spend. Lower-income households are struggling with higher prices, rising debt balances and delinquent credit cards and auto loans. Their excess savings remain depleted. Middle-income households, which had been in good shape, are increasingly hurt by the same forces impacting lower-income households.
Higher-income households’ savings are on the rise thanks to solid returns from a booming stock market and higher yields on their bond portfolios. This has created a powerful wealth effect within high-income consumers, which has allowed them to continue to spend freely. Lower- and middle-income consumers are increasingly using loans and credit cards to continue to spend.
Many consumers are also benefiting from an unusually low sensitivity to higher interest rates, a trend that was not fully appreciated coming into this year. Many consumers, as well as many businesses, are locked into low interest rates on their mortgages and other loans. Most homeowners are in 30-year fixed rate mortgages substantially below current rates, and many firms termed out their debt at very low interest rates. Also, a growing share of businesses’ capital spending is on intangibles such as Research and Development, which is not as dependent on the level of interest rates because of the tax breaks provided to spur innovation.
So, the substantial rise in interest rates isn’t significantly impacting monthly expenditures. The expectation that the Fed will cut rates this year, possibly in September, is also a factor because the current level of rates can be largely ignored if people believe they will be coming down soon.
For these reasons, today’s economy is much less sensitive to a rise in interest rates than it was in the past. This is why consumers, and businesses, have continued to spend, providing a strong tailwind to economic growth.
While economic growth has continued to grow beyond what was previously expected, it is very uncertain how much longer it will continue. Most of the economic data released during the past few months show a U.S. economy that is slowing, but still solid. U.S. Durable Goods Orders growth slowed slightly in May but has remained constant over the past year. In June there were signs the labor market was gradually cooling down with the unemployment rate rising to 4.1 percent and average hourly earnings gaining the smallest amount since 2021. More people are entering the labor market, but that makes it more difficult for job seekers to find a job. Housing stats are contracting amid signs that supply is now outstripping demand in several southern states but remain at the 10-year median. Consumer prices, according to the Fed’s preferred measure, were unchanged from April to May, the mildest reading in more than four years.
A Diffusion Index that measures whether economic data points are revised higher or lower shows that many more data points are being revised lower than higher for the past year. At the same time, data on inflation has been holding steady, although more recent data show more softening. It remains to be seen if the softer inflation data continues.
Source: Morgan Stanley
The U.S. Federal Reserve has been successful in cooling the economy without causing a recession, but inflation is not improving as rapidly and remains above its 2 percent target. Fed Chair Jerome Powell said inflation in the U.S. is slowing again after higher readings earlier this year, although he still wants to see annual inflation slow further toward their 2 percent target before cutting interest rates. The Fed chair also said the job market is “cooling off appropriately,” meaning rapid wage gains won’t heighten inflationary pressures and the Fed can take its time in cutting rates. But can high income consumers continue to drive growth until the Fed cuts rates, which will alleviate some pressure on lower-end consumers?
The Fed is in a tight spot as they try to cut inflation, but still be accommodative enough for growth to continue. If they begin to cut rates too soon, Inflation could remain elevated, or even spike higher again, as the economy grows. However, if they keep rates higher for a longer period, it could hurt growth enough to cause the long-anticipated recession, or if inflation does not fall, stagflation. Either way, there is plenty of uncertainty which makes it likely that the stock market will be a lot more volatile over the next twelve months.
The S&P 500 Index was up more than 15 percent this year through June 30th, but the big story continues to be the performance domination of the handful of stocks dubbed “the Magnificent Seven”. The Mag 7 stocks drove the S&P 500 and Nasdaq indices to new record highs on June 18th and show no signs of slowing down. One way to illustrate how narrow the leadership is in the S&P 500 index’s performance is to look at the percentage of stocks outperforming the index. A record low number of stocks are outperforming the S&P 500 index, which historically is an unhealthy sign for the market going forward.
Source: Bloomberg, Apollo Chief Economist. Note: Annual data is from January 1 to December 31 for each year. The 2024 data is as of July 2, 2024 (year-to-date).
Another way to see the impact these stocks had on the performance of the S&P 500 Index is to look at the return of the S&P 500 Index, which is weighted by each company’s market capitalization, versus the equal-weight variant of the S&P 500 Index, a good representation of what the average stock in the index has returned.
Source: FactSet
The performance differential between the market capitalization weighted S&P 500 index and the equal-weighted S&P 500 index over the twelve months ending June 30, 2024, is nearly 13 percent. Still, while most stocks have underperformed the Mag 7 stocks by a lot during those twelve months, many have performed well in absolute terms. The average stock as measured by the equal-weighted S&P 500 Index returned almost 10 percent, not bad compared to historical averages.
Together, the Mag 7 stocks account for more than 30 percent of the S&P 500 Index’s market capitalization. While they have lifted the index higher, they also have the power to drag the index lower if their earnings are disappointing.
Source: Bespoke Investment Group
While a market that is deriving its gains from such a small handful of stocks is a reason to be worried, there is no disputing that the current environment is healthy for stocks; the economy is growing, earnings are rising, and inflation appears to be falling again, clearing the way for the Fed to lower interest rates soon.
Overall, corporate earnings remained resilient, but if the Mag 7 companies are excluded corporate earnings growth has been negative. According to data from Bank of America’s U.S. equity strategy team, combined earnings for the remaining 493 companies in the S&P 500 haven’t registered yearly growth since the fourth quarter of 2022.
Bank of America’s U.S. equity strategy team says this “hidden” earnings recession for many of the companies in the S&P 500 index should come to an end with the reporting of second quarter earnings. The 493 non-Mag 7 stocks are expected to show annual earnings growth of 6%, then 7% in the third quarter and 13% in the fourth quarter of 2024.
When 2024 began, one of the consensus views on Wall Street was that the market rally would broaden beyond the Mag 7 stocks. As already discussed, this has not happened. Could the second quarter be the turning point? Possibly, but even if most of the 493 “other” stocks begin to churn out positive earnings growth, it is more likely that the Mag 7 companies will continue to drive the markets for better or worse.
The S&P 500 index is richly valued again, mostly because of the steep valuations of these 7 stocks. As long as the earnings of these companies continue to be strong, the market is likely to continue moving higher. However, while the group may continue to lift the market higher, they also have the power to drag the index lower if their earnings are disappointing, no matter what the rest of the companies in the index do.
The optimistic case for stocks the rest of this year is based on a continuation of moderating inflation, which would spur the Fed to rate cuts by September. That would allow the positive earnings results to come to fruition, in addition to ongoing optimism on Artificial Intelligence.
However, pessimists point to worries about the health of the consumer, the potential for rising unemployment, and the possibility that sticky inflation delays the Fed’s rate cut. Combined with expensive valuations and extremely narrow market leadership, stocks could begin to struggle.
With so much uncertainty, it seems prudent to have a healthy skepticism at this point in the equity market cycle. Core fixed income, on the other hand, offers an attractive risk/return profile. Longer-term yields have moved higher in 2024 due to solid economic data as well as stalled progress on inflation. The Fed has revised its forecast for its policy rate to only a modest decrease occurring in the second half of 2024 and has increased its projection for the longer-term “terminal” rate to 2.8 percent. The possibilities of a slowdown in economic growth and further progress on inflation also provide the opportunity for capital appreciation in bond portfolios.
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