Federal Reserve actions have been seen as principal drivers of stock market pricing over the past several years. Raising rates from zero to 5% over a 12-month period did have a big impact on stock market performance, at least initially, but not so much in 2023, with the S&P 500 up 16.38% through June 30.
- The Fed has raised rates by 275 basis points since last September and at the same time the S&P 500 is up nearly 20% from the October 2022 low. Small-cap stocks (Russell 2000) are also up double digits since the October low.
- An increasing number of analysts believe the Fed is finished raising interest rates, notwithstanding recurring hawkish comments by Fed leaders. Fed funds futures are showing a 75% probability for another 25-basis points increase which seems to be baked into stock prices already so a rate pause would be an upside surprise, which markets like, and a 25-basis point increase wouldn’t make a difference.
- Headline CPI inflation for May dropped to 4% (trailing one-year). It is expected to fall further when the June CPI numbers are released on July 12. The Fed’s preferred PCE inflation headline rate fell to 3.8% in May. The PCE core inflation rate also dropped back to 4.6% after rising to 4.7% in April. This is good news for financial markets.
What matters most to stock prices going forward is earnings growth, which is affected more by economic growth than by marginally higher interest rates.
- The outlook continues to be broadly positive for economic growth, declining inflation, and positive earnings per share growth, most recently forecast to grow 3% over the next 12 months.
- The Atlanta Fed is still estimating 2023-Q2 GDP growth at 2% (annualized), and the range between the top 10 and bottom 10 economic forecasts is from +2% to -1/2%. This is positive for earnings growth.
- A better-than-expected growth scenario in the second half of 2023 would allow stock markets to continue to rally. Conversely, a recession that is deeper and longer than currently believed could drive markets back to October 2022 lows.
- The in-between result of a shallow recession and modest increases in the unemployment rate is what financial markets are already expecting, so no downside surprise here.
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