A World with No Worries

by: Kenneth J. Entenmann CFA®, May 21, 2024

The equity markets continue to move higher despite plenty of worries in the world. The major indexes are trading at or near record highs! After powering through a brief 5% correction, the S&P 500 is up 11.29% year-to-date and 26.23% in the last 12 months. Even the Dow Jones Industrial Average, the much maligned “old economy” index, broke 40,000 for the first time. Break out the hats! (I still have my Dow 10,000 hat!) The current price levels are roughly 10% higher today than the major forecasters thought they would be at year-end! That is a rather good start for the year!

As discussed in the last blog, the two primary drivers of the strong equity performance have been earnings and interest rate expectations. The earnings story has held up…so far. Expectations for interest rate cuts have not. Corporate earnings grew mightily in the last two quarters of 2023. Earnings in the first quarter of 2024 posted good results, with aggregate earnings growth of roughly 5%. Not bad, but less than the previous quarters. Also, the high-flying tech sector will face difficult earnings comparisons in the second half of the year. The market has certainly digested these strong results as the Price/Earnings ratio of the S&P 500 stands at nearly twenty-one times earnings! Historically, that is a lofty multiple and leaves little room for error. Especially if interest rates remain “higher for longer.”

On the interest rate front, the April Consumer Price Index (CPI) brought some relief on inflation. The first three months of 2024 saw surprisingly strong inflation data, so much so that talk of an interest rate hike began to filter through the markets. April’s CPI was modestly weaker than expected, with both monthly and yearly data posting .01% lighter numbers. That put an end to the rate hike discussion. However, with year over year CPI running at 3.4%, inflation is still significantly higher than the Fed’s 2% target. The Fed was forced to acknowledge that inflation was indeed stickier than they hoped. This morning, Fed Board member Christopher Waller noted that while a rate hike is unlikely, it would take “several more months of improving inflation data” to convince the Fed to cut rates. Emphasis on the “several!” The market agrees, as expectations for the initial rate cut have been pushed out until September, and that assumes the inflation data cooperates!

Despite the lack of interest rate cuts, the equity markets are at record highs. What could go wrong? Well, plenty! There are other things hovering at record highs as well that provide good reason to manage our expectations.

Valuations, as noted above, are high, leaving little room for error.

Interest rates remain high and are most likely on hold until September…at best!

Copper prices are up 20% this year and are trading at record highs. It is difficult to see where the supply of many critical commodities needed to achieve green-energy initiatives is going to come from in the future. Duncan Wanbald, CEO of Anglo American, one of the world’s largest mining companies, recently stated this regarding copper: “We don’t have a lot of new supply coming online around the world. What concerns me is even when a discovery is made, it could take between seven and fifteen years before the first copper comes out.” Hmmm? High demand and low supply. I wonder if that will be inflationary.

Geo-Politic Risk is high. Russia/Ukraine, the Middle East and China/Taiwan are three major hotspots around the globe. The world economy has done a remarkable job adjusting to these conflicts. Europe survived the cut-off of Russian gas and the world more than made-up for the loss of Ukrainian agriculture production. But it does not take a wild imagination to see how any of these conflicts can expand in a dangerous way.

Debt and Deficits are at record highs. U.S. debt will shortly exceed $35 trillion. Interest expense is growing, ballooning the deficit. The debt to GDP ratio is roughly 24%. That is a record high only exceeded during World War II. The U.S. Treasury has attempted to keep long-term interest rates low by disproportionately shifting bond issuance into the T-bill market. This has helped keep long-term rates lower than they might have been. This gamesmanship on debt issuance may have worked in the short run, but interest expense on U.S. debt will continue to grow as a percent of the total Federal budget. As discussed in previous blogs, there is no easy answer to this growing problem. More importantly, there does not appear to be any political will power to do anything about it.

This blog has touched on these concerns before. They are long-term threats to a healthy economy and therefore healthy financial markets. For the most part, all of them are, or will be, inflationary and carry important implications for both fiscal and monetary policy.

The point of this blog post is not to scare investors from their long-term investment goals. Indeed, we encourage investors to stay the course, maintain appropriate asset allocations and resist the market-timing temptation. More importantly, investors should continue to manage their expectations. As noted above, there are plenty of things that can unexpectantly knock a humming stock market off track, especially when it is trading at high valuation metrics. In addition, we will now be entering the “slow,” summer trading season. With that comes reduced volatility and the potential for greater volatility. Be prepared for it, expect it.