Weekly Recap:

With inflation and monetary policy still in focus, last week’s FOMC meeting and some soft macro data pushed rates lower and allowed stocks to rise.

As expected, there was no change to overnight interest rates, and Jerome Powell continued to preach patience, noting that in recent months there has been a lack of progress towards the committee’s 2% target. However, the committee did announce a significant reduction in the pace of Quantitative Tightening (“QT”), which could be viewed as a precursor to rate cuts. The committee reduced the monthly redemption cap on Treasuries from $60 billion to $25 billion, a move that appears to be aimed at arresting further upward movement in Treasury yields.

The rates market interpreted this as a mildly dovish outcome. In the ensuing sessions, the odds of a second rate cut in 2024 rose from roughly 15% pre-FOMC to 80% by the end of the week (one cut has remained priced in throughout). Yields fell by 10+ basis points across the curve, with greater declines in the front end.

Soft macro data also played a role last week. First, the monthly jobs report from the BLS saw just +175k net nonfarm payrolls which was well below consensus, while U-3 Unemployment and U-6 Underemployment both ticked higher by 10 basis points, to 3.9% and 7.4%, respectively. And a bit later on Friday morning, the ISM Services Index unexpectedly dropped into contraction territory at 49.4, the lowest reading since December of 2022. The services sector has largely kept the US economy afloat during the post-pandemic period even as manufacturing has slumped, so any protracted softness in services could be a significant challenge to growth.

Albion’s “Four Pillars”:

Economy & Earnings

The US economy has been resilient despite the higher interest rate environment. Analysts are forecasting low double digit EPS growth in 2024; growth of that magnitude will depend on the economy avoiding recession.

Valuation

The S&P 500’s forward P/E of 20x is above the long run average, so valuation could be a headwind to future returns. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Eq Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the mid single digits.

Interest Rates

Futures markets imply that the Fed will cut overnight interest rates once or possibly twice in 2024, most likely at some point in the 2nd half of the year. Rate cut expectations have been tempered recently due to sticky inflation prints.

Inflation

After falling rapidly in late 2022 and all of 2023, inflation has become sticky in the 3-4% range in early 2024. Services inflation remains somewhat elevated, in part due to heavily lagged shelter costs. Rising oil prices driven by armed conflicts in Ukraine and the middle east are also a risk to the inflation outlook.