QQQM - S&P 500: CPI Uptick May Create Opportunities To Buy The Dips

2024-01-12 08:30:38 ET

Summary

• Not only has the S&P 500 become increasingly more expensive relative to historical valuations, but prices seem to have also factored in more rate cuts than the Fed is communicating.
• Although the higher-than-expected December inflation reading did not result in an immediate selloff, we suspect there may be ramifications in the coming weeks.
• We foresee Fed officials taking the opportunity to start talking down expectations on rates. Hawkish comments by the Fed are likely to weigh on the S&P 500.
• Although we are flagging risks of a potential correction, we remain bullish on equities. We are targeting a more moderate return of 5% to 10% for the S&P 500 this year, with an end-2024 target of 5,200 points.
• We maintain our "Buy" rating on the S&P 500 for now, with a view to accumulate on potential dips in the coming weeks.

The S&P 500 Index ([[SP500]], [[SPX]]) has been struggling to break above its all-time high of 4,818 points recorded on January 4, 2022. Although the index surpassed our 2023 target of 4,600 points to close at 4,769 on the last trading day of the year, there were already signs that the rally was running out of steam.

Not only has the S&P 500 become increasingly more expensive relative to historical valuations based on price-earnings ratios, but prices seem to have also factored in more rate cuts than the Federal Reserve ("the Fed") has been communicating. Some may argue that the expectation for rate cuts is a signal that the market is worried about a recession. But that would be inconsistent with a surging equity market that is attempting to make new highs.

An increasing number of analysts on Wall Street are arriving at the same conclusion: that investors must be optimistic that the disinflationary trend will continue, but they are also expecting a mild recession.

That interpretation of current market sentiment seems logical. Equity investors should not be overly concerned about a mild recession, especially if such a recession is expected to be short and markets can count on the Fed to come to the rescue by cutting interest rates.

Perhaps rate cuts were simply out of the equation when inflation was running too hot at 9% back in 2022. But now that inflation is just a whisker away from the Fed's 2% target, rate cuts are becoming an increasingly feasible option for the Fed.

The road to disinflation, however, is likely to be bumpy rather than smooth.

CPI Surprise A Risk But Also An Opportunity

The latest CPI data published by the U.S. Bureau of Labor Statistics showed that the consumer price index increased by 0.3% in December (3.4% year-on-year), above consensus estimates of 0.2%.

Although the higher-than-expected December inflation reading did not result in an immediate selloff in equities (the S&P 500 was only down -0.07% for the session), we suspect there may be potential ramifications in the coming weeks.

First of all, the December CPI reading presents a rather ambiguous outcome for the FOMC. This comes at a crucial time when the FOMC will be looking for more convincing evidence that inflation has been contained. Should inflation continue to cool, then the FOMC can be more confident that the job is done and that monetary easing can once again serve as a tool to support full employment if needed. But should inflationary pressures resurface, the FOMC will be forced to keep its hawkish stance and further delay rate cuts. In the worst-case scenario more hikes may be needed, ultimately resulting in a hard landing.

Secondly, the unexpected uptick in December CPI is likely to dampen market expectations for rate cuts in the near term. According to the CME FedWatch Tool , Fed Funds futures indicate that traders are already pricing a 39% probability of six rate cuts (150 basis points) by the end of the year.

This is much higher compared to the Fed's "Dot-Plot", which shows a median forecast of four rate cuts (100 basis points) by the end of the year.

We suspect that market sentiment may be getting ahead of itself and potentially bordering on extreme greed by pricing in more rate cuts than the Fed is communicating. With the latest uptick in December CPI, we see increasing risks that market sentiment may begin to moderate somewhat in the coming weeks.

Finally, even if market sentiment for rate cuts remains unfazed by the uptick in December CPI right now, we foresee Fed officials taking the opportunity to start talking down expectations. Any hawkish comments by the Fed in the coming days are likely to weigh on the S&P 500.

Will The Fed Overreact Or Play Along?

We discussed in a recent article that we think the Fed has reached a critical make-or-break moment to decide if it will nail that soft landing this time, or live up to its reputation of falling behind the curve.

The Fed risks throwing the economy into an unnecessary recession in our opinion if it chooses to overreact to the latest blip in inflation data. But the good news is that financial conditions have been easing meaningfully in recent weeks with Treasury yields declining quite sharply in anticipation of rate cuts (see chart below). This decline in bond yields is monetary easing itself: lower yields are already reducing borrowing costs for companies and mortgage rates have also declined from as high as 8.0% in October 2023 to 6.76% this month.

This is why we remain optimistic towards a soft landing for the U.S. economy. Should the Fed play along with market expectations of rate cuts, we see a rather benign economic environment that should be constructive for the S&P 500 and bullish for fixed income.

The latest uptick in December CPI has nonetheless given the Fed an opportunity to rein in that optimism in the market by reiterating its cautious stance on monetary policy. With the S&P 500 looking increasingly exhausted from its extended rally since late October 2023, any hawkish comment from the Fed is also more likely to trigger a correction.

S&P 500 To Finish 2024 At Around 5,200 Points

Although we are flagging risks of a potential correction, we remain bullish on equities. We are targeting a more moderate return of 5% to 10% for the S&P 500 this year, with an end-2024 target of 5,200 points.

Our 2024 target for the S&P 500 is in line with our core view that the U.S. economy is headed for a soft landing with the possibility of a short and mild recession. Current valuations and technicals on the S&P 500, however, suggest to us that the market is adequately priced for our base case scenario. Therefore, we expect a more moderate year for the S&P 500.

This does not necessarily mean that equity investors will have to accept moderate returns. We recently outlined our strategy in a separate article discussing how we are positioning for alpha by investing in laggard themes including residential REITs, biotechnology, and healthcare. A correction on the S&P 500 would thus provide an even greater opportunity to accumulate into these themes.

This means we would be looking for opportunities to buy into dips, and a 5%-10% correction on the S&P 500 from current levels would present attractive levels for us to accumulate more aggressively and to generate alpha.

We maintain our "Buy" rating on the S&P 500 for now, with a view to accumulate on potential dips in the coming weeks.

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