by Peter Jones, CFA
Senior Vice President
Research and Portfolio Management
On Wednesday, in a widely expected move, the Federal Reserve cut the policy interest rate by 0.25% to a new range of 4.25% - 4.50%. This brings cumulative interest rate cuts to 1% for calendar year 2024. Although the change in the policy rate was anticipated by markets, the change in forward looking commentary was perceived as a “hawkish” development, driving the S&P 500 down by 3% in the hours after Fed Chair Powell’s press conference. The 2.95% decline on December 18 marked the second worst day for investors in what has been a truly exceptional year.
Specifically, the Fed increased their inflation forecast in the year ahead by 0.3%, and implicitly acknowledged that there is little evidence inflation will reach the 2% objective in the near term. In addition, the Fed reduced their expectation for additional rate cuts in 2025. Before, the Fed expected to cut interest rates by 1% in 2025. Now, they expect just 0.5% rate reduction in the year ahead. For the past year, when it came to market expectations of interest rate cuts, we’ve been telling our clients that “we’ll take the under” as we believed that the economy was stronger and inflation stickier than most believed. With unprecedented (and likely unnecessary) government deficit spending alongside a tight labor market, we say “3% is the new 2%” when it comes to inflation.
While a more elevated level of inflation is never positive, a persistent range of 2.5%-3% is unlikely to crash the markets or economy. In fact, in the post-WWII era, the rate of inflation has averaged 3%. Given recent inflation and economic data all point to a measured approach to interest rate cuts, we are surprised that investors were caught off guard by the Fed’s more hawkish stance for the year ahead. As such, it is our view that Fed commentary is an excuse, rather than a reason, for the market’s 3% decline on Wednesday.
The market is trending towards its second consecutive year with a return >20%. Understandably, many are wondering how long this can last. We often jest that this is an easy business – “tell me where earnings are going, and I will tell you where the market is going”. If you look at the last four years, the price return of the S&P 500 is nearly identical to the growth in earnings. In other words, despite the exceptional run since October 2022, the market is no more expensive today than it was four years ago …returns have been fully justified by profit growth (chart below). While the relationship between stock prices and earnings is unpredictable in the short-term, the two have always found one another over the long-term.
Takeaways for the Week
The market had its second worst day of the year when the Fed combined an interest rate cut with a hawkish tone …but most of these losses were erased by Friday.
We expect inflation to trend between 2.5% - 3% until further notice, slightly above the Fed’s target.
Over the long term, earnings and stock prices are tightly correlated – despite the run up in stocks in the last 2+ years, the market is no more expensive than it was four years ago.