Recent price action has shifted towards a much more cautious view. The U.S. Federal Open Market Committee (FOMC) has taken most of the punchbowl away and recent economic data is on the too-hot side for growth and inflation. The market has mostly priced out rate cuts in 2025 and all of the post-election rally in the S&P 500 Index was retraced on Monday morning’s lows. This voting shift now seems too extreme in the opposite direction for rate cuts over the next year.
There is no strong indication that the economy is weakening, but we do know that the tighter financial conditions operate with a lag and that markets are always about what is coming, not what is in the rearview mirror. Markets build expectations and as results come in (economic or earnings), we get a reaction. This feedback loop is the constant voting mechanism. In the longer-term, markets will move based on the underlying fundamentals and trends weigh on the outcome.This week, investors need to weigh the start of the fourth quarter earnings period against the retail sales and inflation data from the holiday period. Earnings should be OK for the fourth quarter of 2024, and we do not see any huge risk there. It’s always about forward guidance and while some sectors have been more cautious, the artificial intelligence (AI) leadership is where the focus will remain for now. Both retail sales and inflation are expected to be similar or stronger than in recent months. If data is hotter than expected, we can expect bond yields and equities to tighten financial conditions. It’s typically about how the data comes in relative to expectations that matters for how the market responds. Our first chart this week looks at the CitiBank U.S. Economic Surprise Index. It captures the trend of economic reporting relative to expectations. Recently, the data has been a bit hotter than expected. The lower charts show the S&P 500 Index (blue), the U.S. 30-year bond yield (black), and the Goldman Sachs Financial Conditions Index (pink). Stronger equity markets ease financial conditions while rising bond yields tighten them. Financial conditions were easing for most of 2024, but recently that trend has broken with weaker equities and rising bond yields.Over the past two years, expectations for 2024 earnings per share (EPS) has not changed much (blue line), with expectations for better earnings pushed into 2025 (orange) and 2026 (purple). EPS growth is expected to be very robust looking forward, which sets the forward guidance bar very high and suggests that bond yields need to remain high to balance off financial conditions and limit inflation risk, i.e.: the FOMC will have trouble easing unless the economy falters. Is that what the recent equity weakness tells us? Not until the long end of the bond curve trough and yields start to fall would the market be voting for a weaker economic outcome. Should that happen, forward based earnings will not deliver
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