by John Lynch, CIO, & Team, Comerica Wealth Management
Executive Summary
The S&P 500® Index had its best week since November, buoyed by strong earnings reports from Big Tech, despite lackluster economic data. The latest GDP report, which showed economic expansion surprise to the downside and inflation surprise to the upside gave off a whiff of stagflation. However, deeper analysis suggests the underlying factors are likely temporary in nature.
- U.S. economic growth fell short of expectations in the first quarter, with real GDP growth slowing to 1.6%, below the consensus forecast of 2.5%. However, the labor market and consumer spending remain robust, alleviating concerns of a significant slowdown.
- Inflation, as measured by Personal Consumption Expenditures (PCE) index, surprised to the upside following upward revisions in January and February. Due to the seasonality effects at the beginning of a new year, drawing conclusions on the disinflationary trend becomes more complicated.
- In equity markets, expectations of robust earnings growth have fostered a risk-on environment as evidenced by Equity Risk Premium (ERP). ERP is currently at its lowest level in more than two decades, potentially limiting future gains. Any revisions to economic growth forecasts may portend increased volatility due to the downstream impacts on corporate profits.
Since much of projected earnings growth is predicated on a strong economy, any material slowdown in economic growth could pressure equities, making the relative safety of fixed income look more appealing. This week’s news on employment, monetary policy and Treasury refunding should help provide clarity for investors.
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1Q GDP
U.S. economic growth fell short of expectations in the first quarter, with real GDP growth slowing to 1.6%, below the consensus forecast of 2.5%—marking the slowest quarterly expansion since the second quarter of 2022. Although disappointing, the reasons behind the slowdown are somewhat mitigated. The main drivers of the slowdown include slower inventory accumulation, a widened trade deficit due to a strong U.S. dollar, and stagnant federal government expenditures. On the bright side, consumer spending, especially on services, continued to expand in the first quarter. See chart: U.S. Real GDP QoQ Annualized Growth.
Overall, the first-quarter economic data presents challenges for the U.S. economy but does not necessarily predict an imminent recession. Trade and inventories often swing inversely, so having both negative at the same time is a significant drag – but likely temporary. Undoubtedly, higher policy rates are impacting certain areas of the economy, particularly those reliant on short-term borrowing like credit card borrowers, small businesses and auto loans. Nonetheless, the labor market and consumer spending remain robust, alleviating fears of a significant slowdown.
Inflation
A notable concern highlighted in the GDP report is the Personal Consumption Expenditures (PCE) inflation reading. The data revealed the Fed's preferred inflation gauge, core PCE, surged by an annualized 3.7% quarter-over-quarter, representing a significant upside surprise. However, March core inflation met expectations with a 0.3% month-over-month increase. The surprise stemmed from upward revisions to January and February figures. Because of the seasonal nature of inflation, drawing conclusions about the latest data becomes more complicated. Inflation at the beginning of the year is often higher as many firms traditionally raise prices at the year's outset. See chart: Core PCE Inflation-Month-over-Month.
Indeed, the price increases at the beginning of the year could be dismissed as seasonal fluctuations. In 2022, there was another surge in the summer, while in 2023, core PCE inflation moderated.
Following this week's FOMC meeting, we look for the Fed to adopt a more hawkish stance as it awaits further data to ascertain inflation's trajectory in 2024.
Equity Risk Premium
Thus far, equities have largely weathered rising bond yields as investors recalibrate their expectations for rate cuts this year. Expectations of robust earnings growth have fostered a risk-on environment, evident in the equity risk premium (ERP).
The equity risk premium (ERP) measures the attractiveness of equities, in this case the S&P 500®, in relation to interest rates, represented by the yield on the 10-year Treasury note. The ERP aims to capture the additional return that an investor can potentially gain by taking on the risk of holding stocks relative to Treasury bonds.
For instance, given the current S&P 500® P/E ratio of around 21X, the earnings yield for stocks calculates as 1 divided by 21, resulting in approximately 4.75%. When we deduct the yield of the 10-year Treasury note (approximately 4.60%), the equity risk premium comes out to roughly 15 basis points. This value is notably lower than the 20-year average of nearly 340 basis points. See chart: Equity Risk Premium.
Currently, the ERP is at its lowest level in more than two decades, posing a valuation challenge for equity markets. Since much of projected earnings growth is predicated on a strong economy, any material slowdown in economic growth could pressure equities, making the relative safety of fixed income look more appealing.
Conclusion
First quarter economic data presents both challenges and bright spots for the U.S. economy.
While GDP growth fell short of expectations, consumer spending remained resilient. The surge in core PCE continues to be concerning, but seasonal fluctuations make it difficult to tell whether these concerns are overstated. Despite these challenges, equities have demonstrated resilience amid rising bond yields, fueled by expectations of robust earnings growth. Historically low ERP signals a valuation challenge for equity markets, especially if economic growth falters.
We will be closely monitoring developments this week as the April Jobs report, Treasury Refunding and the FOMC meeting all carry significant market implications.
Be well and stay safe!
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