The Fed and Broadening Portfolios in 2024
What happened last week?
- The S&P 500 gained 2.49%
- The Dow Jones made a new all-time high while rising 2.92%
- The Nasdaq advanced 2.85%
The Fed surprised markets last week by acknowledging a path of rate cuts for the coming year without forecasting an economic collapse. Much of the Fed’s views and actions are consistent with our Outlook 2024.
The Fed sees a strong possibility that a recession can be avoided. Fed Chairman Powell noted that policy easing could be more aggressive if the economy surprised to the downside.
After a year in which most S&P 500 firms saw EPS declines while employment and wages grew solidly, we see a reversal in favor of corporate profits beginning in 2024. While we don’t expect another 20% surge for the S&P 500, we expect returns to broaden, with larger gains for the “average” stock.
3 Things to Know
FOMC remains on hold, Fed Funds rate left unchanged at 5.5%
The Fed surprised markets last week by acknowledging a path of rate cuts for the coming year without forecasting an economic collapse.
The Fed’s Summary of Economic Projections (SEP) shows three quarter-point rate cuts during 2024. By adding a single word to their official announcement (officials will consider the extent of “any” additional policy firming) markets implied that there would be no further rate hikes.
Compared to the last SEP release, their outlook for 2024 was a reduction in the Fed’s key policy rate by 50 basis points. The Fed’s targets suggest a more benign inflation picture even though it will remain “vigilant” and prepared to raise rates if necessary.
The Federal Open Market Committee (FOMC) participants continue to consider a 2.5% policy rate as normal for the “longer run.” Markets price in a faster decline in rates than the Fed’s most recent projections.
The six-to-seven 25 basis point easing steps priced in the US bond market seems aggressive to us.
However, this is understandable on the basis of the Fed’s history of rapid rate reductions.
In our view, the broader bond market has rallied sharply from a period of “yield overshoot.” After a 6% total return from September 2023 to now, we see current yields as still on the higher side of fair value given our benign inflation outlook.
What Makes the “Magnificent” 7?
The so-called Magnificent 7 are a diverse group of US mega cap tech firms. They are the leaders of disparate industry groups such as software, semiconductors, social media and electric vehicles.
They have collectively grown their earnings 16.3% per year for the past decade. They trade at a valuation of 31X trailing earnings, a 58% premium to the S&P 500 overall.
However, their ability to grow and exceed expectations consistently is far from guaranteed.
Their collective performance in 2022 and the strong likelihood that they will diverge in performance from each other is a major reason we see risk in concentrating portfolios and expecting a repeat of their 2023 performance.
2022 will be remembered as the “Great Fed Tightening,” with the US central bank swerving from history’s most radical easing cycle to one of history’s most radical tightening cycles. As interest rates surged, “long duration” assets plunged in price.
Long duration assets depend on distant future profits, coupon payments or bond redemptions for their value. That’s why the underperformance of tech’s growth leaders in 2022 appeared to be an interest rate problem. (The Nasdaq 100 total return was -32.4%, underperforming the S&P 500’s -18.1%.)
Yet, there was another more fundamental reason for 2022’s tech declines. EPS for the Magnificent 7 fell 22%.
Today’s largest semiconductor firm, the world’s undisputed AI beneficiary, saw EPS drop 47% in 2022 before an EPS gain in 2023 that is expected to be +529%. While there is little doubt that the long-term growth prospects for US tech leaders are attractive, our confidence in their growth pattern is less rosy.
For example, EPS have grown less than 10% in 5 of the past 10 years for Magnificent 7 firms. As a corollary, their earnings volatility has been 44% higher than for the remaining 493 S&P 500 firms.
Potential Opportunities Ahead
The unusually “narrow” performance engine driving equity markets up and down this year has been firmly grounded in fundamental earnings performance.
In 2023, when earnings per share were down for most firms, the Magnificent 7 tech firms outperformed. In 2022, when large cap tech shares were the underperformers, it was their EPS that suffered.
Why would we want to add shares that have fallen behind the “Magnificent 7” US large cap tech shares? Because the historical pattern for earnings gains and performance suggest “catch up potential” based on likely corporate earnings recovery.
Relying on a handful of companies or just a few sectors of the economy often adds idiosyncratic risk to portfolios. As importantly, our broadening ideas are consistent with potentially better risk-adjusted returns in the coming year.
We see a widening of EPS gains driving a “broadening” for equity performance in 2024.
Our Citi Global Wealth Global Investment Committee (GIC) has modified its portfolio weightings over the past few months to broaden rather than concentrate holdings within US equities.
Specifically, we added tactical over-weights in the S&P 500 Equal Weight Index and the S&P 400 and 600 Growth indices (see Wealth Outlook 2024 again for details).
See our weekly CIO Strategy Bulletin for more details