The S&P 500 Index just finished its strongest start to a year since 2019 (and its 11th strongest since 1950), rising more than 10% in the first quarter of 2024 after a strong double-digit gain the prior quarter.
Equity investors remain highly optimistic in their outlook for the year. Many began the year expecting a “soft landing” for the U.S. economy that would bring cooling economic growth and inflation, with as many as seven Federal Reserve interest rate cuts. Since then, their expectations have shifted to a still-bullish “no landing” scenario in which a hot economy bolsters corporate profits and propels stocks higher, even if it means sticky inflation and fewer Fed rate cuts.
Indeed, after a mixed start to 2024, recent economic data does look stronger than previously expected.
- The U.S. government revised its estimate of fourth-quarter 2023 GDP growth to 3.4% year-over-year, up from 3.2%.
- Gross domestic income (GDI), a proxy for corporate profitability, rose 4.8% year-over-year, sharply higher than the tepid 1.9% increase in 2023’s third quarter.
- Personal spending was revised up to a 3.3% annual rate.
- The Institute for Supply Management (ISM) manufacturing survey in March showed expansion for the first time since October 2022.
- U.S. employers added a seasonally adjusted 303,000 jobs in March, beating expectations for 214,000.
What could a stronger economy mean for investors? While the market seems largely optimistic, Morgan Stanley’s Global Investment Committee believes more caution may be warranted.
Hotter Growth: Good News or Bad?
On one hand, investors’ confidence in double-digit corporate earnings growth—already high—could solidify in the face of stronger-than-expected data. Currently, the consensus on Wall Street is that S&P 500 earnings per share (EPS) will rise about 11% year-over-year to $241 in 2024, implying the highest company operating margins since 2021. In addition, earnings revisions breadth (i.e., the ratio of analysts raising their earnings estimates to those lowering them) has increased, while analysts’ first-quarter 2024 EPS estimates have declined by a smaller-than-average margin.
On the other hand, hot economic growth may cut the other way by fueling inflationary pressures that squeeze corporate profits. Consider that the ISM index of prices paid by manufacturers shot up to 55.8 in March, its highest level since July 2022, while the producer price index (PPI) and commodities prices are also up. These are all signs that costs are rising for many companies, even as tighter monetary policy may be cooling demand.
Additionally, a hotter-than-expected economy could spur the Fed to reconsider its latest forecast for three rate cuts in 2024. If the central bank’s rate-cutting cycle is delayed or if rates come down less than anticipated, the resulting higher-for-longer rate environment could pose risks for key sectors of the economy. It would likely weigh on spending by middle- and lower-income consumers, for instance, and put further pressure on already-vulnerable sectors like commercial real estate and regional banks. There are also unprofitable and venture-backed enterprises strapped for cash, not to mention the U.S. Treasury having to finance the nation’s record debt pile.
Portfolio Moves to Consider
Economic growth is good, but market complacency around its implications is not. Investors should stay vigilant and actively manage their exposure to such risks.
Consider reducing exposure to stocks that depend on non-essential U.S. consumer spending. Consider instead industrial cyclicals like materials, energy and infrastructure; financial companies tied to capital markets; and defensives such as utilities and real estate investment trusts (REITs).
We also suggest investing more in intermediate-duration bonds and equity-leveraged hedge funds.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from April 8, 2024, “Hot, Hot, Hot?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.
