by Peter Jones, CFA
Senior Vice President
Equity Research and Portfolio Management
Spooky season was in full force this week with contradictory messages from the economy versus the stock market. The week was chock-full of news with over 40% of the S&P 500 market capitalization reporting third quarter earnings, the release of third quarter economic growth, and finally, fresh data on the Fed’s preferred measure of inflation, the Personal Consumption Expenditure Index. To summarize, the inflation data wasn’t encouraging, the earnings picture looks strong, the economy even stronger and the stock market itself … not so much.
On the earnings front, we received reports from “Magnificent Seven” bellwethers Microsoft, Alphabet (Google), Meta (Facebook) and Amazon. These four companies alone make up 16% of the S&P 500 Index. For Microsoft, earnings grew an incredible 27% compared to the prior year with broad-based strength, especially in its AI-enabled cloud business. Alphabet (Google) earnings grew even faster, up 46% with the digital advertising “winter” coming to an end. However, a deceleration in their own cloud business pushed the stock price lower. Meta (Facebook) grew even faster at 168% and Amazon the fastest at 236%. While these numbers are staggeringly impressive, it must be mentioned that they come in part due to easy comparisons from weaker demand and high one-off costs the year before. Nonetheless, overall S&P 500 earnings have grown 9% so far this quarter and have come in 8% better than expectations. By all measures, this has been a very robust earnings season with growth accelerating from the first half of the year, which can be interpreted as a strong economy.
Continuing on the theme of a solid economy, third quarter GDP came in at 4.9%. This represents the best growth since the fourth quarter of 2021 when the economy was still recovering from the pandemic (chart below). Even more, 4.9% is more than double the average economic growth rate in the U.S. over the last ten years. While inventory adjustments drove a portion of the strong growth, the primary contribution came from consumer spending. As we always remind our clients, the U.S. is a consumer economy and so long as the consumer is healthy and spending, the economy will remain in good shape. By all measures, the GDP report suggests a very strong economy.
Undoubtedly, corporate earnings and GDP growth point to an economy far from recession … but the message from inflation is that interest rates are likely to stay higher for longer. The Federal Reserve’s preferred measure of inflation, Personal Consumption Expenditure (PCE), came in hotter than expected, increasing 0.4% compared to the prior month and 3.7% compared to the prior year. The monthly increase was the highest since April. While the surge in inflation has subsided from 40-year highs a year ago, it remains persistently above the Fed’s 2% target. The read-through from the inflation data is that investors hoping for a reversal in Fed policy and lower interest rates are likely to be disappointed. Moreover, this isn’t good news for those looking to originate a new mortgage. While the inflation data is not supportive of lower rates, it does coincide with GDP growth and corporate earnings to suggest an economy that is very strong. So much for the most anticipated recession ever by Wall Street economists in 2022.
Conversely, the message from the stock market has been much darker. Since corporates began reporting earnings a couple of weeks ago, the S&P 500 has declined 5.5%. Even more, the market has declined 10% from the 2023 high reached in late July. It may seem counterintuitive that the market is coming under pressure when the economy is strengthening and earnings are accelerating. This juxtaposition suggests that investors are looking at economic data and earnings as “old news” and pricing in an economy that is set to weaken in 2024. This rationale, unfortunately, does make sense. The Fed has raised interest rates at the fastest clip in decades and main street has yet to fully feel the impact of this tightened policy. Similarly, inflation remains too high and therefore it is unlikely we will see an easing of policy anytime soon. Lastly, these higher interest rates are clearly creating competition for funds in the stock market. After all, to some, it is an appealing proposition to earn a nearly risk-free 5% in short-term Treasuries versus taking risk in the stock market. Altogether, we agree that the economy is set to slow. However, the strength in the labor market and the workhorse consumer should keep the economy afloat in the coming months.
Takeaways for the Week
• The economy and corporate earnings are sending a much different signal than the stock market
• It is unlikely we will see a reversal in Fed policy any time soon and therefore interest rates should stay higher for longer
• Higher interest rates are creating competition for funds with the stock market