Equities and bonds retreat ahead of Fed decision

Mark's monthly letter: That butterfly effect (3:12)
Our CIO Mark Haefele on investing through new complexities in global markets.

The S&P 500 Index declined 1.6% on Tuesday, after US macro data added to investor concerns about sticky inflation and slowing economic momentum. In April, the S&P 500 fell 4.2%, bringing an end to a run of five consecutive monthly gains. Yields on 10-year US Treasuries stood at 4.68% at the time of writing, rising around 7 basis points on Tuesday and posting their largest monthly increase in April since September 2022.

Tuesday’s sell-off was sparked by a higher-than-expected reading for the employment cost index (ECI), one of the Fed’s preferred measures of labor cost inflation. The index rose 1.2% quarter-over-quarter, versus expectations for a 1% increase and faster than the fourth-quarter's 0.9% q/q growth. Sentiment took a further hit with the subsequent release of the Conference Board’s consumer confidence indicator, which dropped to 97 in April, the weakest level since July 2022 and lower than expectations for a reading of 104.

The data came ahead of the Fed’s latest interest rate decision on Wednesday fueling concerns that the central bank could adopt a more hawkish tone. But, while Fed commentary may reflect recent sticky inflation data, our base case remains a soft landing, with economic growth and inflation cooling off, and the Fed starting to cut rates before the end of the year.

A clear hawkish Fed pivot is unlikely. Fed officials started sounding more hawkish prior to the blackout period, consistently saying that rate cuts are unlikely anytime soon. While there won’t be an update to the Fed's economic projections or the “dot plot,” Chair Jerome Powell may say that most members now expect fewer than three cuts. But with the market pricing just 28bps of easing this year, it’s unlikely the Fed would deliver a sufficiently more hawkish message that leads to even fewer rate cuts being priced. What’s more, the Fed has only one additional month of data since the last FOMC meeting, suggesting it’s likely too soon for a clear hawkish pivot.

The overall inflation trend is better than individual headlines suggest. Inflation remains too strong to permit an early cut in rates, and we expect the Fed to leave rates unchanged. But, despite the rise in the ECI, most measures of US wage growth have shown moderation in recent months (including average hourly earnings, Atlanta Fed wage tracker, and NFIB compensation plans). Similarly, last week’s first-quarter PCE inflation data surpassed expectations, but the monthly data were less alarming. Core PCE inflation climbed 0.5% in January, slowed to 0.27% in February, and then climbed to 0.32% in March—while inflation is still high, it isn’t obviously accelerating.

Consumption is likely to slow, not collapse. Consumer spending is continuing to rise faster than income, and as a result the US savings rate fell to 3.6% in the first quarter, around half its pre-pandemic level. This situation can’t continue indefinitely. Interest rates remain elevated, giving consumers an incentive to save rather than spend, and we do not see much room for savings rates to fall further. But rising labor income should provide a floor on spending. We expect consumption growth to slow over the remainder of the year, in line with our base case. In our view, nothing in the data suggests that a hard landing is likely over the next 12 months.

So, we maintain our base case for two 25-basis-point Fed rate cuts in 2024, likely starting in September. In our view, current economic conditions are consistent with a soft landing this year, even if this outcome isn’t without an occasional speed bump, as has occurred in April. As this outcome becomes more apparent in the data, we expect fixed income markets to recover and forecast 10-year US Treasury yields to decline to 3.85% by year-end compared with 4.68% currently. We also expect further modest gains for equities at the index level and forecast the S&P 500 to end the year at 5,200. This supports our most preferred view on quality stocks and fixed income and our focus on finding equity opportunities both within and beyond the technology sector.