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The Weekly Five

All Eyes on September

July 12, 2024

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Katie Nixon, CFA, CPWA®, CIMA®

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

There will be no Weekly Five on July 19. Publication will resume on July 26. 

This has been an eventful week for markets, with global risk and risk control assets reacting significantly to U.S. inflation data. With soft U.S. Consumer Price Inflation data supporting the premise that progress toward the Fed’s 2% target is continuing, investors gained confidence in a September rate cut. This led to a rally in Treasury bonds, sending interest rates down across the yield curve, and a massive rally in equities — particularly in areas that had been lagging this year. Small cap stocks, real estate investment trusts, and the equal-weighted S&P 500 benefitted from the shift in tone as investors began to rotate out of the mega-cap tech stocks that have been so dominant. 

We held our monthly Investment Policy Committee (IPC) meeting this week and reviewed the global landscape. We discuss five key takeaways below.

1

What conclusions about the global growth outlook can be drawn from recent data?

Our IPC meetings always start with robust discussion on the macroeconomic outlook for growth, and here we have been very consistent in our outlook for the U.S. economy as a soft landing — despite significant “data volatility” and “narrative volatility” over the last six months, where we have heard everything from “no landing” to recession. Recent data has been very supportive to our soft-landing forecast, as we see slowing demand for labor and a decline in some of the economic activity diffusion indices, like PMI and ISM data. We are slowing down from an above-average trend, so this is good news and a forecast of normalization.

Also importantly, we are on the lookout for signs of weakness, such as real-time indicators of consumption and labor. Redbook, for example, provides real-time retail sales every week based on data from 9,000 large general merchandise retailers in the U.S., and the most recent data shows a 6.3% year-over-year increase in same-store sales. We also received weekly jobless claims on Thursday, and it came in below consensus estimates at 222,000, with continuing claims unchanged at 1.85 million. We expected the economy to slow, and that is what is happening. The triangulation of all the data points to slower, but not slow, growth in the U.S.

We see less clarity on the picture overseas, but I will say that the starting point — unlike the U.S. — was recession or near-recession activity, so even a little improvement is significant. Similar to the U.S., services spending is propping up growth in Europe as manufacturing PMIs remain below 50. The good news in Europe is that consumer sentiment is improving, and perhaps not surprisingly, the monetary policy transmission mechanism in Europe is much more direct to the consumer, so the recent ECB rate cut may have something to do with that. The U.K. growth outlook has improved as well. The outlook for China, meanwhile, remains complicated, with underwhelming policy support not able to drive a demand-led recovery in the property market. Despite that, we see growth expectations moving higher under the expectation that the government will have to, and will, do more. In the meantime, it is back to the old playbook of ramping up industrial production, and exports are outperforming expectations. The global growth outlook is constructive.  

2

What did we learn from the most recent CPI and PPI releases?

Also key to setting the macroeconomic framework, we reviewed our inflation forecast. In the U.S., the recent CPI data confirmed our outlook that we are heading more reliably, albeit slowly, toward that Fed target. With headline CPI falling to 3%, below the expected 3.1%, and core falling to 3.3% from 3.4%, the report was very good news. Key to our forecast has been the progress made in core services, driven by the labor market, which we expect to continue as supply/demand conditions fall into better balance, taking the heat off wage inflation.

Also reflected in recent inflation data, and consistent with our forecast, there continues to be progress made in the slow-moving shelter component of inflation. We have been saying for quite some time that this was a big lag that would start to show up this year, and the data on Thursday certainly supported that, with housing inflation rising 5.2% year-over-year, down from a peak of 8% in early 2023. This is still a full 2% higher than pre-pandemic, but progress is being made. That said, this week’s Producer Price Index data provides a cautionary tale and signals that progress may continue to be stutter-step in the U.S.

Overseas there is a similar bumpy ride with progress, with the last mile being services inflation driven by high labor costs. And in China, we are seeing a little inflation, which is a good thing after concerns of outright deflation had been growing.

While we anticipate further progress on inflation, we are not declaring victory just yet.

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3

How will recent growth and inflation data impact global monetary policy?

We spend significant time reviewing the economic outlook because it is such a critical component to the monetary policy forecast. In the U.S., expectations for Fed policy have ebbed and flowed with inflation data — so recent progress on inflation suggests that the market is justified in anticipating the start to the monetary easing cycle. The progress on inflation indicates that what we saw earlier this year with hot 1Q prints were actually outliers and seasonal anomalies in the generally downward trend that has resumed.

This gives the Fed the ability to cut rates and start the normalization process, but importantly, because the growth outlook remains constructive, the Fed can be measured and deliberate, which is good news: The Fed will cut because it wants to, not because it must to offset weakness. We expect a September rate cut, and one in December as well. That is the market forecast, so we are aligned with the consensus. It is worth noting that Fed Chair Powell’s testimony in D.C. this week indicates that he views the growth and inflation risks being more in balance at this point, allowing the Fed to pay at least equal attention to the growth outlook — so the Fed will be tracking the employment data closely for any signs of unanticipated weakness.

Overseas, the ECB has already started the monetary policy normalization process and will continue, with two additional cuts likely this year. The BOE has been more cautious given higher and stickier inflation — again, wage driven — but recent signs of labor market softening may encourage the BOE to begin to recalibrate policy and cut rates, potentially two times this year. We will have many major central banks on the move in 2024, loosening monetary policy in an environment where the macro growth backdrop is solid — this is not like the old days of central banks reacting to an economic crisis or recession. Importantly, because this is not a growth crisis, we anticipate that the pace of normalization will be slow and steady, not the quick or mega-sized cuts we typically see in a recession.  

4

What earnings dynamics are you seeing in global equity markets?

The impact of a constructive global growth backdrop and easier global monetary policy has positive implications for global risk assets. For global equities, we continue to believe that solid corporate fundamentals and results will be supportive. In the U.S. those solid fundamentals will characterize the MAG 7, which have carried both index performance and earnings growth, and the other 493 stocks, which will begin to contribute on both fronts with a broadening of participation. In 2023, earnings growth for the S&P 500 was flat, but under the surface the MAG7 contributed 31% year-over-year growth in earnings per share (EPS), and the rest of the market -4%.

In 2024, on a year-over-year basis according to FactSet, the MAG 7 will contribute 30% earnings growth, while the rest of the market will contribute 7%. That is good news relative to last year, but when we consider the sequential pattern of quarter-over-quarter results, we see the growth rates of both the MAG7 and other 493 stocks are basically on top of each other at 17% in the 4Q, as MAG7 growth slows and the rest catch up. In aggregate, we anticipate 12-13% earnings growth in the next 12 months.

Earnings growth is expected to be supportive outside the U.S. as well, with developed ex-U.S. earnings coming out of an earnings recession to grow just under 8% over the next year, and emerging markets with an anticipated 16% EPS growth over the next year — again, coming out of a fairly steep earnings recession driven mainly by China, where earnings were down double digits in 2023.  

5

To what degree are positive macro and earnings trends reflected in current equity market valuations?

While we always remind ourselves and our clients that valuations are a very poor market-timing tool, it is worth noting that current valuations are very high in the U.S. by historical measures — particularly for large-cap growth stocks, where the P/FE for Russell 1000 growth sits around 40% higher than the long-term average.  For the broader S&P 500, valuations are distorted by those large-cap tech stocks, so one might think that the current 21.1X forward estimates for the index may not be as elevated, considering that the top 10 stocks are providing an upward bias with their collective valuation at 30.7X forward estimates. If you exclude those top 10, you see that the P/E sits at around 17.6 against an average of 15.7, so about a 12% premium to average — elevated, but not extreme. We do have a downward valuation adjustment to our one-year forecast for U.S. equities, and it offsets a bit of that very constructive earnings outlook, but still leaves us with a roughly 10% return forecast.

Overseas, we anticipate markets will also track positive earnings progress, and with relative valuations more constructive we forecast that this component of total return will be either neutral in emerging markets or additive in the case of developed ex-U.S., also leading to high single digit/low double digit potential returns.

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Disclosures

This document is a general communication being provided for informational and educational purposes only and is not meant to be taken as investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions or inflation. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein.

LEGAL, INVESTMENT AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.

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