June 2024 Update on the Economy and Investment Markets

Key Updates

• The Federal Reserve kept rates unchanged at their May meeting.  The timing of the first rate cut remains unknown, but it is becoming increasingly possible that the first rate cut won’t come until the fall. The Fed remains focused on inflation and labor data trends, all of which will ultimately drive their decision.
• U.S. equities reached new all-time highs during May. Following a pullback during April, U.S. equities rallied during May with the Dow Jones Industrial Average topping 40,000 for the first time. The S&P 500 was up over 10% this year as of May 30.
• U.S. headline inflation remains stuck above 3%.  April inflation data reported during May was in-line with market expectations with headline inflation (CPI) increasing 3.4% year-over-year (YoY) while core inflation (excluding volatile items such as food and energy) rose 3.6%. The Core Personal Consumption Expenditure (PCE) Price Index, the Fed’s preferred measure for inflation, came in at 2.8% YoY. The Fed continues to target a 2% inflation rate.
• U.S. home prices grew at the fastest rate since October 2022 in March reaching new all-time highs. The Case-Shiller 20-city home price index rose 7.4% (YoY) in March driven in part by the scarcity of homes on the market. Homeowners are reluctant to leave their current homes due to the higher mortgage rate environment.
• U.S. Retail sales grew 0% month-over-month (MoM) in April compared to market expectations of 0.6%.  Also, March’s number was revised down.
• University of Michigan Survey of Consumer Sentiment Index – The initial May reading for the Michigan Consumer Sentiment Index came in at 67.4 vs. market expectations of 76. This was the largest miss on record and the lowest reading in six months. The drop from 77.2 last month was driven in part by increased inflation expectations from consumers with year-ahead inflation expectations rising to 3.5%. Other concerns for consumers included unemployment and high interest rates. The final reading, released on May 24, did improve slightly to 69.1, but this was still a deterioration from recent months.
• TSA announced that Friday, May 24, was the busiest travel day in their history with almost three million passengers screened.  Five of the ten busiest travel days in TSA’s history took place during May (data through May 25). Below data does not even account for travelers driving to their destinations.

Despite persistently sticky inflation and hawkish commentary from Fed officials, U.S. equity markets pushed higher in May with the S&P rising over 4% through May 30. Investor sentiment and better-than-expected corporate earnings supported the move higher. According to the weekly survey results from the American Association of Individual Investors (AAII), bullish sentiment rose during May. The current bullish sentiment reading of 47% is well above the historical average of 37.5% but below the recent high reading of 52.9% which occurred during the week ending December 20, 2023.

With corporate earnings season essentially wrapped up for the first quarter of 2024, YoY earnings growth results came in above expectations. According to FactSet, earnings growth for Q1 for the S&P 500 was 6% (calculated using actual results for the 96% of companies that have reported combined with projected earnings for the remaining companies).

Coming into the quarter, expectations were that earnings had grown 3.4% during Q1. If 6% becomes the final reading of Q1 earnings growth, it would reflect the fastest growth since Q1 2022. Q1 earnings growth was driven by Communication Services, Utilities, Information Technology and Consumer Discretionary, all of which produced earnings growth of more than 20% year over year. Materials, Healthcare, and Energy offset some of this growth with 20% or more declines in each sector. While not surprising, it should be noted that artificial intelligence (AI) was cited during a record number of earnings calls, with FactSet citing 199 companies that discussed the use of AI. It is expected that this trend will continue as AI evolves and affects more companies.

The current rally that began at the end of October 2023 has pushed valuations higher. As of May 24, the forward price-to-earnings ratio (P/E ratio) for the S&P 500 was 20.6x compared to a 30-year average of 16.7x. The below chart shows that the market is expensive relative to history, but stretched valuations can endure for longer periods of time than investors anticipate, especially if corporate earnings growth accelerates. Perhaps this is best summarized in the following quote that has been ascribed to economist John Maynard Keynes – “markets can stay irrational longer than you can stay solvent.”

May’s positive stock market performance overcame persistent inflation data. April inflation data was in line with market expectations, with headline inflation (CPI) increasing 3.4% year-over-year (YoY) while core inflation (excluding volatile items such as food and energy) rose 3.6%. Shelter inflation continues to trend down but is still elevated at 5.5% YoY.

As noted previously, shelter inflation is a lagging indicator which continues to contribute to persistently elevated inflation readings. We expect shelter inflation to continue trending down during the coming months, which is almost certainly going to be a requirement for inflation to make it down to the Fed’s 2% target. The Core Personal Consumption Expenditure (PCE) Price Index, another inflation data point that was released last week and the Fed’s preferred measure for inflation, came in at 0.2% MoM and 2.8% YoY. The MoM number was slightly lower than market expectations.

With inflation remaining elevated, it is no surprise the Fed continued to keep rates steady at their May meeting. Following this meeting, the Fed’s tone has been relatively hawkish compared to the rhetoric of recent months. In remarks that Chairman Powell gave during a panel in Amsterdam, he stated: “We did not expect this to be a smooth road, but these [inflation readings] were higher than I think anybody expected. What that has told us is that we’ll need to be patient and let restrictive policy do its work.” This language was consistent with comments by Fed Vice Chair Jefferson that, “we continue to look for additional evidence that inflation is going to return to our 2% target. And until we have that, I think it is appropriate to keep the policy rate in restrictive territory.”

This rhetoric clearly does not portend a Fed that is ready to cut rates in the near future. Therefore, investors are relying on the possibility of weaker economic data, especially in the labor markets, to force a rate cut, as a 2% inflation rate is unlikely this year. The Fed has previously stated that they do not need to see inflation decline all the way back to 2% before beginning cuts. Fed Fund expectations have changed drastically since the beginning of the year (as evidenced by the data below) with the Fed continuing to adjust on the fly. Further, policies among major global central banks are diverging, with cuts potentially beginning in June for the European Central Bank (ECB), Bank of Canada (BOC) and Bank of England (BOE), while the Bank of Japan (BOJ) recently began increasing rates for the first time in 17 years.

Source: Charles Schwab, Bloomberg and the Federal Reserve.

Source: Charles Schwab, Bloomberg data as of 5/9/2024.

Bond yields will continue to take cues from the Fed and continue to trade near the highs of the past 15 years. The 10-year treasury yield began and ended the month of May right around 4.5% while trading in a range of 0.15% on each side. Yields took a brief dip in the middle of the month on hope that the Fed rate cuts were coming this summer but have now risen towards 4.6% (as of May 29) following comments from Fed President Kashkari last Tuesday. Kashkari commented that he needs to see “many more months of positive inflation data, I think, to give me confidence that it’s appropriate to dial back… I’m not seeing the need to hurry and do rate cuts. I think we should take our time and get it right.” With short-term rates remaining above 5%, money market funds and short-term treasuries continue to offer attractive yields. When the Fed does eventually begin cutting rates, it is expected that short-term rates will track the Fed moves.

On the geopolitical front, a number of events occurred this month alongside the continuation of wars in Ukraine and Gaza. Russia’s current offensive against Kharkiv continues (Ukraine’s second largest city that effectively fended off Russian forces earlier in the war) and has become more intense with the bombing of civilian targets. At the same time, reports have come out of Russia, confirmed by Putin, that Russia is open to peace talks. Specific points of any peace treaty at this time would likely involve Russia retaining the current territory in Ukraine that it occupies (estimated at about 20%). The question is what Ukraine would require (NATO and/or EU admission? – countries such as Hungary and Turkey could be roadblocks)?

While Israel continues its offensive into Rafah, Tel Aviv was attacked last week by rockets fired from Rafah for the first time in months. The Iron Dome was not successful in intercepting all of the rockets with multiple rockets hitting Tel Aviv, although no deaths were reported. The following day, Israel bombed a refugee camp. While the Israeli government was quick to apologize, condemnation came from around the globe including from Israeli allies. Ceasefire talks have stalled, but there is hope that they will resume in the coming days or weeks.

In other geopolitical news, the President of Iran, Ebrahim Raisi, died in a helicopter crash, reportedly due to poor weather conditions. His death may not have much of an effect in the near-term on domestic or international affairs, but he was a candidate to succeed the current Supreme Leader, Ali Khamenei. Also, there was an assassination attempt on the President of Slovakia. President Fico was shot from close range, but survived. Fico has been criticized for what appears to be a pro-Russia stance on many issues.

As we have discussed many times, most geopolitical events do not have sustained effects on investment markets. There are, however, two risks we believe could affect markets. These include a direct conflict between Israel and Iran and a direct conflict between the U.S. and China. Fortunately, it does not appear any of these countries want to engage in direct conflicts at this time, but we continue to monitor the situation closely, as a misstep could be a flashpoint for a much broader conflict.

SFG’s Take: The Fed taking a more hawkish tone did not derail markets during May. We believe at this point that interest rates will be higher for longer unless economic data, especially from the labor markets, deteriorates quickly. Economic data for the most part remains in decent shape, but there are some areas of concern that we continue to monitor closely. As we’ve said numerous times, diversification remains a pivotal strategy given where valuations sit for U.S. stocks. In addition to a potential rate cut, one key to the next leg up for stocks is the earnings growth of companies this year, along with about $6 trillion in cash sitting in money market funds.

FAQ

Q: My children along with many of their friends spend hours each week on TikTok.  What is going to happen to TikTok as a result of the recent bill that was passed in D.C.?

A: Background:  TikTok is a social media platform launched in 2017 by the Chinese technology company, ByteDance, following its 2016 founding of Douyin (Chinese version of TikTok). TikTok is essentially a short form video sharing platform. Over the past seven years, TikTok’s number of users has grown to over a billion with over 150 million in the U.S. alone. This is a staggering number of users given the U.S. population hovers around 330 million.

Beyond the usual reported negative impacts psychologically that social media apps can have on users, concerns have risen over the years regarding ByteDance’s relationship with the Chinese Communist Party (CCP) and the influence that the CCP is able to exert over the company. ByteDance, via the TikTok application, can harvest data on its users and control what videos pop-up for them based on complicated algorithms they create. This allows ByteDance, and possibly by extension the CCP, to push or repress certain narratives. Given that it is estimated by Pew Research that roughly one-third of Americas ages 18-29 regularly get their news from TikTok, it is viewed as a risk that our rival controls what a significant portion of our population consumes. Imagine a scenario where the Soviet Union controlled a portion of U.S. airwaves and what was shown on American’s TVs during the Cold War in the 1960s and 70s. The U.S. would not have allowed that to happen.

What does the current bill do to TikTok?  In April, a bill was passed by Congress and signed by President Biden that essentially requires ByteDance to sell TikTok within nine months with the option for the President to extend this to a year. This bill was a part of the broader legislation package that included aid to Ukraine, Israel and Taiwan. National security concerns with regard to TikTok were the main reason cited for passing this bill that would disassociate TikTok from the CCP. 

What’s Next?  The bill is already facing legal challenges with regard to this potentially violating the First Amendment. From here, the legal process will play out. It should be expected that the Chinese government will try to block this forced sale via negotiations, and U.S. companies may face retaliation. If legal challenges are not successful, the issue for ByteDance will become trying to find a buyer given there are only so many companies and investors with the means to acquire TikTok.    

SFG’s Take:  Given the popularity of TikTok in the U.S. and the monetary value it offers to its owner, we would expect that if legal challenges are not successful, a sale will take place. It is hard to see a complete removal of TikTok from the U.S. social media ecosystem.