Managing Expectations

by: Kenneth J. Entenmann CFA®, August 2, 2024

In our last blog, we noted that the market was pricing in perfection that did not seem warranted in the risky world we live. The blog was posted on May 21st, and the market continued to rise despite my concerns. Today, the market has concluded that those concerns are legitimate. I was early!

There have been several key drivers of the equity market’s strong year-to-date performance: decent economic growth, grand expectations for Artificial Intelligence, and the Fed on the brink of lowering interest rates. Over the last two weeks, the market has been sensing some changes in the first two drivers and a market correction is getting underway. It is hoping the Fed will come to the rescue.

Economic growth has been much better than expected over the last 18 months. The recession that the entire world thought was imminent over the last 2 years never materialized. Yes, GDP growth slowed in the first quarter to 1.6%, then posted a decent 2.8% growth in the second quarter. Pretty decent growth, and far from a recession. Despite that decent growth, the market has begun to look at the economic glass as “half empty” instead of “half full.” The consumer is showing signs of fatigue. While I would describe this as a return to more “normal” spending patterns, the market is interpreting this as a sign of imminent doom. The consumer picture is far from doom. For most American consumers, their balance sheet has never been stronger. The two biggest assets for the consumer are their home and their retirement/investment accounts. In the NBT footprint, home values are up 49% over the last three years. Home equity has exploded. For the investment accounts, the S&P 500 is up 12% year-to-date and 18% in the last 12 months (even after today’s equity market sell-off.) On the liability side, by far the biggest liability is the home mortgage. The historic low COVID induced interest rates allowed the consumer to pay down and refinance their mortgage liability. Bigger assets and lower liabilities mean a strong balance sheet. This has created a powerful wealth effect that has emboldened consumers. There is no doubt that the consumer is demonstrating more discretion and does not seem to be willing to pay up any longer. I guess a $12 double mocha latte with cinnamon, or an $18 hamburger are a bridge too far for consumers. Starbucks and McDonald’s earnings certainly suggest that is the case and implies some hope for more benign inflation. Yet, airlines and cruise lines are booked well out into the future. Carnival Cruise’s CEO stated they see no sign of a consumer spending slowdown across all income levels. Mixed signals for sure. However, the idea that the consumer is on the brink of collapse and the economy is quickly heading for recession seems unlikely.

The exuberance surrounding artificial intelligence (AI) is also experiencing a reality check. Is AI the next great economic paradigm transformation? Probably, but it will take time. AI is projected to be a $1 Trillion opportunity! Given that enormous potential, investors have rewarded any company even tangentially linked to AI with high P/E multiples. The result has been a bold, disproportionate move in technology stocks. AI instant gratification! However, history tells us that previous paradigm shifters often take years and decades to realize their enormous potential. Over the last two weeks, investors have been questioning that instant gratification. Are the high P/Es for the high-flying Tech behemoths, aka “The Magnificent 7” justified? The recent earnings reports from the big tech companies demonstrate one thing for certain…the expense of AI development is huge, accelerating, and current. However, these companies are having difficulties quantifying how and when that spending will be monetized. Certain, high expense today for the promise of future, difficult to quantify earnings in the future. We are now learning that “future” may be 3 years or 10 years away. Big difference! Investment gratification is rarely instant! It helps explain why the NASDAQ is down 5% in the last two trading days and is teetering on a 10% correction.

Lastly, there are interest rates. Ask a 3-year-old if they want ice cream and the answer is always yes! Ask the market if they want an interest rate cut, the answer too is always yes! For the last two years, investors have forecast five or six rates cuts that have not come to fruition. I remain astonished that the equity markets have performed so well despite the lack of rate cuts. The recent weak economic data (particularly from the labor market) combined with encouraging inflation data, has put the probability of a September rate cut at 100%. I agree with that probability. However, like children and ice cream, two scoops are better than one!

Today’s employment report showed the unemployment rate jumped to 4.3% and non-farm payrolls grew a disappointing 114,000. A slowing economy and the new (more realistic?) outlook for AI earnings has resulted in a material sell-off in stocks. The S&P 500 is down 2.6% this week and 3.52% over the last month. The NASDAQ is down 3.69% and 7.28% respectively. The market is now demanding the Fed come to the rescue, clamoring for a 50-basis point rate cut in September! The Fed Funds future market is now projecting 5-6 rate cuts through 2025! Indeed, the benchmark 10-year Treasury note yield has dropped to 3.80%, an astonishing decline of 60 basis points in one month! Two scoops of ice cream are better than one!

Wow, what a dramatic change in market psychology in just a few weeks. Yes, the economy has slowed, but a recession is still unlikely in the near future. Consumer and corporate balance sheets remain strong and should provide ballast if the weakness persists. Yes, AI is an exciting innovative technology. But paradigm shifting technologies require massive current investment for nebulous returns in the future. Today’s big winners will not necessarily be the winners ten years from now. Paying exorbitant valuations for a highly uncertain future rarely is a good strategy. The AI rally is experiencing a reality check and that is a good thing. And yes, the Fed is finally ready to cut interest rates. Yes, a slowing economy, improving inflation trends and an equity market correction do justify a change in Fed policy. But 5-6 rate cuts?

Is this the beginning of the end, with recession on the near horizon and a full throttled bear market on hand? Possibly. But I doubt it. The economy is slowing to its long-term potential growth of roughly 2%. Slowing but not collapsing. The unemployment rate is 4.3%, still historically low. Inflation has improved, but the Fed’s favorite inflation indicator, the Core PCE, has flat-lined between 2.5% and 2.7% for the last 8 months, well above the Fed’s 2% target. Hardly an economic scenario that will compel the Fed to embark on an aggressive rate cut policy. As always, investors should manage their expectations.