Beginning to See Broadening and Relative Easing

By Hightower Omaha on December 5, 2023

Week of December 4, 2023

1. Broadening Stock Participation as Interest Rates and U.S. Dollar Move Lower. As often referenced in the media, the magnificent seven represent a 28% weighting in the S&P 500 index and have generated a median 72.6% year-to-date return. Year-to-date, the magnificent seven have contributed over 14% of the index’s 18.24% total return. However, there has been a notable shift since the October lows; the equal-weighted S&P 500 index is up 12.3%, compared to the cap-weighted index up 11.6%. Mega-caps rallied to pull the index off its October lows, while the rest of the market has fueled new highs. This recent outperformance from the equal-weighted index represents a broadening on the heels of some easing interest rate pressure and slowing inflation.

Price-to-earnings (P/E) multiple expansion has driven most of the returns since the October lows. The forward P/E is 18.6x, whereas without the magnificent seven, the P/E would be 16.4x. We are finding plenty of opportunities to invest in names that are not yet reflecting forward growth expectations in line with what we think the businesses can achieve.

A combination of factors, including lower inflation costs and demand inelasticity can contribute to margin expansion, while lower rates can contribute to continued broadening. Strong U.S. economic and consumer data is also good for future earnings and fundamentals. We receive employment and payroll data later this week, with expectations for stable employment and slower hourly earnings expansion – the labor market remains tight overall, and slowing payroll inflation is good for company margins.

Investor sentiment is very high heading into year-end, and volatility has been muted. Financial conditions remain restrictive, yet are loosening, but there’s a growing consensus that bonds are near or have reached a bottom, given the Fed’s dovish tilt following the recent inflation readings.

Chart 1: Equity and Bond Markets Generating Positive Returns in the Fourth Quarter[1]

2. GDP Resilience Highlighted in Commodities. Third quarter GDP was revised to +5.2% q/q, which was higher than expectations, driven by higher business and consumer spend. The long-term average GDP is around 2%. As a result of the strong labor market – higher wages and lower inflation – consumer confidence remains elevated. At the same time, core PCE, the Fed’s preferred inflation gauge, continues to fall, with the six-month annualized figures up just 2.5%. Inflation continues to improve toward the Fed’s 2% goal. Finally, the Chicago PMI in November reached 55.8 – a big surprise to the upside, highlighting continued economic strength. This was the best Chicago PMI reading since August 2022.

Other observations: copper is up +10.7% since its October lows, reflecting the strength of the macro backdrop (copper is a common input in many goods related to infrastructure, housing and industrials, which makes it a reliable proxy for the economy); gold also reached new highs against the backdrop of a weakening U.S. dollar in the fourth quarter, which is encouraging, as the U.S. dollar has been inversely correlated with the stock market all year.

Lastly, energy commodities have all weakened in the fourth quarter, and futures are pricing crude around $74 per barrel for most of 2024 – right around the current spot price. This is well-suited for energy companies to maintain shareholder programs and capital discipline, while also supporting slower inflation trends.

Chart 2: Fourth Quarter Gold and Copper Higher, U.S. Dollar and Crude Oil Lower[2]

3. Bonds Rally, Markets Pricing in 2024 Rate Cuts. U.S. bonds rallied last week after solid demand for 5-year notes at Monday’s auction. Fed Chair Jerome Powell’s comments signaled that the FOMC is moving forward carefully as the risks of under/over-tightening are becoming more balanced. However, Powell continued to push back about easing too quickly – a break from the market, which is pricing in 5 cuts by the end of 2024.

Chart 3: U.S. Treasury Yields Have Shifted Lower Since the End of the Third Quarter[3]

The 2-year Treasury rallied 41 bps with the 10-year close behind, rallying 30 bps to finish the week. High yield spreads widened by 2 bps to +420. Muni’s outperformed on the week, with yields lower by 25-37 bps across the curve. In November, Muni yields also outperformed the broader market (best one month performance since the Volker era), rallying 85-128 bps across the curve.

4. The Week Ahead.

Earnings – Tuesday: SJM; Wednesday: CPB; Thursday: DG, AVGO.

Economics – Tuesday: ISM Services (November); Wednesday: ADP Employment Survey (November), Final Unit Labor Costs and Productivity (Q3); Friday: Nonfarm Payrolls and Unemployment (November).

[1] Source: FactSet (chart). As of December 4, 2023.

[2] Source: FactSet (chart). As of December 4, 2023.

[3] Source: FactSet (chart). As of December 4, 2023.