US Equity Market Outlook

What is happening to the US stock market in 2024? Will the magnificent seven continue to outperform or will the remaining market catch-up based on the fact that a new interest rate cycle is starting?

To start with, let’s recall some facts about the US economy and its stock market. With a nominal GDP of 26.9T, the US has the biggest economy followed by China with 19.4T. On the back of a strong GDP per capita, the US market is highly diverse, it is adding about 1 million new consumers each year, which creates a virtuous circle, and in which consumers are very responsive to new trends.

The US economic prosperity does not solely rely on a proactively managed central bank policy, human capital migrating to the States, or its currency which is used across the globe as a reference for trade. Rather, the US economy is based on four more or less equal pillars. Its industrial activity is the backbone of one of the largest, broadest, most liberal, and most liquid financial markets. The pillars are the 4 base sectors:

1. The US has a strong primary sector that involves companies that participate in the extraction and harvesting (farming) of natural products (Mining and quarrying). Remember, the US disposes of the most arable land on the globe.
2. The secondary sector contains processing, manufacturing, and construction industries. Again, the US hosts some of the world’s biggest automobile production (GM, F, etc)), chemical (DuPont), aerospace (BA, Space-X), and energy companies (XOM, CVX, etc).
3. In the tertiary sector, which consists of companies that provide services, such as retailers (WMT, COST, AMZN), entertainment firms (DIS), fast food companies (MCD), and financial services (JPM, BAC, GS, MS, etc).
4. The quaternary sector includes companies with knowledge-intensive products and services. Typically, these are based on strong research and development and result in technological advancement (NVDA, C3.ai, MU, etc), biotechnological research, and IT services such as artificial intelligence. All these services are computer power intensive, hence 48% of all semiconductor sales occur in the States.

This comprehensive and complete economic backdrop is excellent for corporate competition and ultimately, this is resulting in a highly efficient and lean market.

There is though a backside to this diversity and success. As of the beginning of 2024, according the FactSet, based on some broad-based metrics, the forward price-earnings ratio for the S&P 500 was 19.5, above the 5-year average of 18.9 and the 10-year average of 17.6, i.e., the market appears to be expensive compared to historic values. More, there is a large US government deficit – it was near 6 percent of GDP in 2023, against an average of 2.2 percent between 1945 and 2019. Thus, it will only be harder for the central bank to engineer its policy appropriately; for now, and in a nutshell, the Fed is expected to have engineered a soft landing.

But when looking at the market at a granular level, one can see that the average market ex the seven magnificent is reasonably valued, hence there is no immediate need to exit the market prematurely. With this in mind, we now can look forward to 2024:

While interest rates will stay relatively high, we don’t expect that the US will experience a recession in 2024 or 2025. On the contrary, interest rates are expected to come down, our estimate is 4 times 0.25 %, henceforth the market may experience some sector rotations.

Lower interest rates will drive profits and therefore EPS. The EPS trend is expected to be steadily upward unless there is a recession or any other kind of major event such as China invading Taiwan or the Chinese-Philippines territorial struggle to escalate further.

The general misassumption is that investors are overly optimistic about how soon and how many times the FED will be able to cut rates. Overall, we consider that the fight against inflation isn’t won yet. Therefore, rates won’t fall as low or as quickly as the market is expecting. This has two repercussions:

1. fixed-income portfolios, especially for investors seeking newly issued bonds, will benefit from higher returns for longer,
2. equity investors, especially for long-duration equity investors, capital appreciation will not take place as quickly as expected.

For investors, there’s an additional complication. Although the rate cycle is turning for most developed markets, the pace at which different central banks will be able to cut will vary. Together, these factors will lead to a greater dispersion of returns across equity and bond markets, with more volatile interest rates, and a shorter rate cycle. While in the past, the trend was your friend, in the oncoming transition period, investors will need to take a more tactical approach to managing assets and wealth because of the inflation complexity.

Inflation complexity
Across the globe and on average, inflation has fallen sharply from its highs. This does not mean that products have become cheaper, instead, prices have flattened out at a higher level. To understand the circumstances that played out over the last 3 years, it’s important to analyze the cause of inflation.

As markets entered 2020, the overall CB policies were on track to eliminate the residual excess values in balance sheets that resulted from the FC 2008. At that time, think tank organizations aired ideas on how to create inflation. And suddenly, there was COVID-19. Lockdowns and other measures designed to limit the pandemic’s impact on health had significant distorting effects on the global economy. Supply chains were disrupted, production bottlenecks appeared on the back of the just-in-time principals, and prices duly rose. Those effects were then compounded by Russia’s attack on Ukraine, and the consequent energy shock, particularly in Europe, which was heavily dependent on Russian gas.

As the global economy has returned to normal, the flow of goods, including key components like processors, returned to normal, and price rises have stabilized. But in parallel with the supply shock, there has been a smaller, but still significant demand shock. Massive flows of fiscal stimulus in response to the pandemic made their way into people’s pockets. Those demand pressures are most evident in the non-traded sector of the economy: services. At that time, the services coupled with technological advances made a quantum jump thereby creating numerous new jobs. Oftentimes, these jobs consist of activities requiring low qualifications such as delivery services, etc. In other words, while the ensemble of the service process is creating value, it does not create an extensive substance for its employees.

As developed in the past, we think that the 3rd wave of inflation has yet to come, i.e. wage inflation. Across the globe, labor markets are relatively strong. While wage increases were up to now limited, the working class has become poorer during the last 3 years. To maintain a social equilibrium, wages have to increase more and faster which, if pushed through incorrectly, will hurt EPS.

Investment ramifications

As developed above, markets are not sufficiently factoring in inflationary stickiness and loose fiscal policy. Therefore, the average portfolio is likely to be overexposed on long-duration assets.

As a result:

1. fixed-income investors will have to consider the aspects of factors such as the Modified Duration rather than the due date approach,
2. Equity investors will have to consider a well-diversified portfolio with the equity selection with a focus on:
   1. Sales growth,
   2. Profit margins,
   3. Re-investment ratio, and
   4. PEG ratio.

Based on a pure macro perspective, equity investors are also advised to combine ratio changes and economic fundamentals, i.e. the impact of lower interest rates which we expect to be softer than anticipated.

The recent spike in inflation will likely dominate investor expectations for the year to come. Furthermore, we note that the average risk premia is relatively low and pending a deteriorating fiscal deficit in the US suggests a higher level of compensation. Finally, we note that there is the 2024 presidential election which might add some unexpected volatility.

In conclusion, 2024 may not be as good as expected for equity investors, but fixed-income and credit investors might be able to lock in some opportune values.