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Investment Strategy

Nerves tested. Are stocks disconnected from reality?

Nerves were tested. Spirits were lifted. All in a week.

What’s notable, though, isn’t that the market questions the risks, but how quickly it moves on. It’s a forward-looking machine.

Some might see that as a sign the market is struggling for direction, latching onto highs and lows alike. Another take is that it appreciates the risks, recalibrates and refocuses. It listens, adapts, and tunes out the noise – staying centered on what it knows.

The last week of risk whiplash – from ongoing inflation debate to questions about big tech – sparked a healthy look at our own outlook. In the end, while the headlines and top-line data can feel disconcerting, going a layer deeper gives us comfort.

Today, we unpack why we still see a constructive path ahead.

Growth versus Inflation: The balancing act

The latest GDP print showed the U.S. economy grew 1.6% in Q1, a near two-year low and short of more than 35 economists’ predictions. More unease came as the closely-watched core PCE gauge clipped a 3.7% pace, marking its first quarterly acceleration in a year. Investors now await the March monthly print (out at 8:30AM ET) to see if it echoes the same.

The worry: Slower growth and stubborn inflation has a bitter “stagflation” taste. With that data in hand, traders pared back rate cut bets. Just ~35bps of cuts are now anticipated in 2024, with the first full cut not until December. The big debate that followed: Will the Fed be forced to return to rate hikes?

The market has dramatically pared back its Fed rate cut bets

# of Fed rates cuts expected for 2024, market-implied by Fed funds futures

This chart shows market expectations for Fed rate cuts in 2024.
Source: Bloomberg Finance L.P. Data as of April 25, 2024.

Last week’s economic releases weren’t great, but the headline numbers don’t tell the whole story. To be sure, a sustained reacceleration of inflation, or stagflationary scenario that sees growth cool at the same time, could reignite a reality of rate hikes. That would be a challenging environment for the economy and markets alike. But, that’s not what we see today. Growth is solid not stagnant. Inflation is sticky not high. Consumer and corporates are strong and growing more confident, not less, in the future.

That’s a far cry from the pandemic-era extremes that prompted 2022’s aggressive rate hikes and market turmoil.

We need to go a layer deeper.

Consumer power trumps inflation

There’s more than meets the eye in last week’s GDP print. The drag on Q1 growth stemmed from volatile inventories and trade dynamics. Stripping those out and homing more in on the domestic private economy, growth actually ran at a robust 3.1% pace. Much of that was in thanks to the strength of the consumer. 

Digging deeper: The U.S. domestic economy looks very solid

U.S. final sales to private domestic purchasers, real value, q/q annualized, seasonally adjusted, %

This chart shows the U.S. Personal Consumption Expenditures (PCE), q/q % change annualized.
Sources: Bureau of Economic Analysis (BEA), Bloomberg Finance L.P. Data as of March 31, 2024.

Time will tell whether the recent uptick in inflation sticks, but even as it runs above a 3% annual pace today, both wage gains and consumer spending outpace its rate. With steady and predictable wages, consumers are more inclined to spend. Real consumer spending (adjusted for inflation) is expected to have grown at a positive 0.3% monthly pace in March in today’s print, above the average since the turn of the millennium.

Earnings from retail-linked companies echo the same: Visa, the world’s biggest payment processor, and American Express, viewed as a gauge for the more affluent consumer, both signaled spending remains in full charge.

That doesn’t mean there won’t be residual impacts of rising rates: credit card interest rates and delinquencies have been on the rise. But, that’s also not the full picture: household finances are strong overall, with interest costs as a proportion of income still low compared to history.

Interest costs have been rising, but remain historically low

U.S. household interest costs, % of disposable income

This chart shows the U.S. household interest costs and a percentage of disposable income from Q1 1978 to Q4 2023.
Sources: Bureau of Economic Analysis (BEA), Bloomberg Finance L.P. Data as of December 31, 2023.

In all, the consumer passes its health check. Considering it makes up some 70% of the U.S. economy, growth seems just fine.

Don’t underestimate earnings

With consumers still revving, corporates have more momentum behind their profits. Equally important, moderate inflation enables firms to pass higher costs onto consumers. That fuels sales, and if costs are managed effectively, boosts earnings. The Q1 reporting season is showing this in real-time. Bottom-up analysts think S&P 500 profits could grow more than 3% this quarter and culminate with a solid 10% for the entirety of 2024. That would mark a third quarter of earnings growth and the best full-year since 2021.

Companies are not only generating solid earnings, but they are also doing so more efficiently. Profit margins are high and stable at pre-pandemic levels. Some, and especially tech stalwarts, are even experiencing margin expansion. Take, for instance, Alphabet’s report last week: while sales climbed 15% over the last year, expenses rose just 5%. High quality companies are successfully navigating and thriving in a high rate environment.

Firms are capitalizing on this strength to return value to shareholders, using extra cash to boost dividends, engage in share buybacks, and pursue strategic investments. Notably, Meta and Alphabet both announced their first-ever dividends this year. Some Street estimates expect dividends for the broader S&P 500 to grow as much as 6% in 2024.

Finally, nerves around tech’s rally and AI hype are understandable. The reaction to Meta’s report last week seems to reflect investors working to price in the real profit-boosting potential of AI at companies leading the charge in these cutting-edge technologies. But while the debate on the scale and timing is heated, the impact and growth potential feels tangible. Meta, Alphabet, and Microsoft all announced a further increase in AI spending in the last week. More broadly, almost 40% of S&P 500 companies mentioned AI on their quarterly earnings calls in Q4 2023, a big jump from 20% a year prior in Q4 2022. 

“AI” mentions are broadening beyond just big tech

% of S&P 500 sector with “AI” mentioned on earnings call

This chart shows the percentage of S&P 500 sectors with AI mentioned on earnings calls.
Sources: S&P 500, Goldman Sachs Investment Research. Data as of December 31, 2023.

We are only scratching the surface of this transformative era, with AI-driven opportunities set to expand across the ecosystem.

Putting it together: Stay focused

When it gets down to it, stocks have shown resiliency in the face of this year’s challenges.

Despite investors aggressively paring back Fed rate cut bets (from ~160bps at its highs to ~35bps today), the S&P 500 is up 6% so far this year. That’s more than double the average return at this point in the year over the past 20 years.

We don’t think that suggests the market is disconnected from reality. Instead, it underscores that solid growth and an ongoing earnings recovery outweigh the challenges of higher interest rates. That makes stocks one of the best potential hedges against sticky inflation, especially given that investors have already recalibrated their expectations for a year with no rate cuts.

Stocks have been resilient despite fewer expected rate cuts

This chart shows the S&P 500 next 12-month price-to-earnings ratio against the December 2024 policy rate implied by fed funds futures from August 2023 to today.
Sources: Federal Reserve, Bloomberg Finance L.P. Data as of April 26, 2024. NTM = Next 12 months. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

But as our CEO Jamie Dimon wrote in his 2023 annual shareholder letter, “we look at a range of potential outcomes for which we need to be prepared.” That includes our base case for a soft landing, with modest growth and declining inflation and rates. It also includes the risks of a recession and stagflation.

So while we think stocks will likely outperform bonds this year, investors can use this recent rate reset to their advantage. Bonds may not work as well as initially hoped this year, but elevated yields mean that investors can step out of cash to lock-in high rates for longer. Other pockets of credit, like preferred equity and private credit, can enhance yield and take advantage of some of the idiosyncrasies of a “higher for longer” rate environment. As friction points surely arise, active stress and distressed managers can nimbly navigate overleveraged pockets of the market. Finally, real assets continue to be one of the only assets positively correlated with inflation, offering both diversification and access to long-term secular trends.

Above all, having a plan and sticking to it can be the most powerful tool of all. Pullbacks and periods of uncertainty are normal, but in the end, staying invested in a diversified, goals-aligned portfolio has stood the test of time. Your J.P. Morgan team is here to discuss what this means for you.

TAGS

All market and economic data as of April 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

RISK CONSIDERATIONS

  • Past performance is not indicative of future results. You may not invest directly in an index.
  • The prices and rates of return are indicative, as they may vary over time based on market conditions.
  • Additional risk considerations exist for all strategies.
  • The information provided herein is not intended as a recommendation of or an offer or solicitation to purchase or sell any investment product or service.
  • Opinions expressed herein may differ from the opinions expressed by other areas of J.P. Morgan. This material should not be regarded as investment research or a J.P. Morgan investment research report.

Index Definition

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.

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Growth is solid, not stagnant. Inflation is sticky, not high. Here’s why stocks are so resilient.
Published Apr 29, 2024

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