Stock markets continue their rally despite dampened expectations of rate cuts

MAPFRE Gestión Patrimonial's monthly macro and markets update

The market’s strength remains steadfast. Since late October 2023, the rally in the stock markets has continued unequivocally, concluding the first quarter of the year with significant gains for risk assets. Optimism began following a sharp shift in the rhetoric used by central banks, as they moved from a hawkish tone regarding monetary policy to a more accommodative stance as inflation moderated.

As we have mentioned on several occasions, the market, behaving much like a pendulum in the short term, began the year by factoring in as many as six potential interest rate cuts, drawing heavily upon the statements of J. Powell and C. Lagarde. Yet, tempering this excessive optimism regarding interest rate expectations, in the first three months of the year, our outlook has shifted from anticipating six cuts to only three from the ECB and two from the Fed.

What is striking about this change in expectations has been that, contrary to the trends observed in 2022 and 2023, the stock markets have become “independent” of interest rate fluctuations and have charted their own course which remains bullish at present.

The reasons why equities continue to rise despite the fact that interest rates have also risen is mainly due to an improvement in growth expectations, which is very positive for investors. However, the bullish sentiment has begun to reach concerning levels, and it wouldn’t be surprising to witness some volatility in the coming weeks or months due to unexpected developments such as inflation spikes or heightened geopolitical tensions in the Middle East.

Just like in a long-distance race, it’s crucial to pace our efforts and energies to prevent stumbling at the most critical juncture.

Still soaring

In last month’s report, we mentioned the robustness of the US economy in recent months, and the macroeconomic data released over the past month further supports this trend. This increasing strength suggests a diminishing likelihood of witnessing a landing (whether soft or hard) in the US.

It is difficult to see a downturn if the labor market does not show signs of weakness, and for the moment, it has not. Unemployment remains at full employment levels, wages are growing at around 4%, and job creation is widespread in both the service and manufacturing sectors.

Hence, it comes as no surprise that expectations for earnings growth for US-listed companies in 2024 have shown improvement in recent weeks. In the case of Europe, although the outlook has not moved in recent weeks, the most recent data suggests a substantial improvement in line with the macro surprise index. This index, which rises above 0 if data comes out better than expected, was at positive levels for the first time in Europe two months ago, reflecting an improvement in sentiment about the region and fueling the belief that the worst may be behind us on the old continent.

Inflation is also revised upward (but less so)

Sudden shifts in a country’s growth expectations, as witnessed in the United States, are quite uncommon. But they are even less so if we also take into account that inflation forecasts, although revised upwards, have not done so by a proportional amount. Neither have the expected interest rates, especially considering that an increasing number of analysts are forecasting NO need for interest rate cuts.

Without going any further, the president of the Minneapolis Fed, Neel Kashkari, posed this rhetorical question at a conference: “If we have a run rate that’s very attractive, people have jobs, businesses are doing well, inflation is coming back down, why do anything?” The underlying premise of this reflection, grounded in a longer-term perspective, revolves around whether neutral interest rates—those that neither spur nor impede growth or inflation—are now higher than they have been in the past decade due to structural shifts such as population aging, endeavors to decarbonize economies, or the slowdown in globalization.

If this were the case and Central Banks had to alter their equilibrium interest rates, it would likely cause adjustment in bond prices for which the market is currently unprepared. Indeed, if the Fed refrains from implementing any interest rate cuts in 2024, the upward adjustment of the 10-year bond could amount to approximately 100 basis points.

In the case of the ECB, it seems that the macro situation is different, and a rate cut would be more justified (despite the fact that we have hardly experienced positive real interest rates). Perhaps this is why the market is pricing in a nearly 100% probability of a rate cut at the June meeting, a possibility that Lagarde herself may clarify during the April meeting.

Market liquidity is a support for assets

Although often overlooked in many market discussions or analyses, liquidity remains fundamental to the operation of financial markets and serves as one of the primary drivers of index returns, both on the upside and downside. Just look at the impact on the stock markets during the initial days of April due to the withdrawal of liquidity from deposits held by numerous US citizens and companies to fulfill their annual tax obligations.

Nevertheless, despite liquidity turning negative in recent weeks, the market has managed to augment liquidity on its own. How did they do it? Primarily by reducing the spreads at which companies can secure financing to exceedingly low levels and easing the conditions for households to acquire loans, as evident in the financial conditions index.

The positive reading of this “liquidity creation” is the market’s self-reliance in furnishing liquidity, contingent upon the maintenance of a favorable macroeconomic environment, thereby diminishing reliance on Central Bank interventions. On the downside, this liquidity tends to be less permanent and evaporates quickly if the outlook veers slightly off course.

Conclusions

The macroeconomic landscape paints an optimistic picture, marked by upward revisions to growth and inflation that remains largely untroubled. The divergence in paths between bonds and equities is advantageous for portfolio construction, as investors now have a natural hedge. Elsewhere, the imminent impact on growth improvements will become evident in the coming weeks as companies release their first-quarter earnings reports, with the potential for positive surprises serving as another catalyst for equity markets in the short term.

Another positive impact we have witnessed in recent weeks is the sector rotation in the indexes. During the month of March, technology gave way to more cyclical sectors, while sectors such as energy and materials led the rallies. As a result, the bullish rally is gaining a stronger footing as a growing number of companies are joining the upward trend.

Despite all this, we cannot ignore the fact that there are still elements of risk to be taken into account when positioning portfolios and making investment decisions. The most plausible one has to do with an upward surprise in inflation. Although under control, prices are still growing at rates above the Central Banks’ targets, while the rebound in economic activity together with the recent appreciation of energy commodities could complicate the optimistic scenario to which investors are pointing.

We assign lower probability to the remaining scenarios, but they are still within the realm of possibility, namely, increased geopolitical tensions, a worsening of growth, or increased volatility in interest rates due to high government deficits.