The Wile E. Coyote-conomy

Equity indices are once again trading at all-time highs as prospects for multiple rate cuts by the Federal Reserve within the remainder of 2024 are gradually creeping back onto the scene. Stocks have largely looked through elevated rates and toward an expected easing for more than seven months now, largely buying into the plan for a “soft landing” illustrated by the Fed. Though the latest GDP and labor market figures, as well as underlying data in consumer spending and industrial output, would seem to inspire dovishness among monetary policymakers, inflation looks like it may be stickier than anticipated at levels still well-above the Fed’s 2.0% target. Cuts may certainly be coming, but the context matters. If easing is induced by unemployment continuing to rise without a further reduction in inflation, rate cuts may be employed to help the US avoid a stagflationary scenario or recession. Such outcomes carry the potential to derail optimistic corporate earnings projections and poke a hole in swollen stock market valuations.

Despite an aggressive run-up in interest rates at the US Federal Reserve, as well as some degree of temporary contraction in monetary aggregates, there had been few signs of any material deterioration in economic growth until the GDP print for the first quarter arrived. An initial read of 1.6%, significantly undershooting economist projections for a 2.4% expansion, felt like a signal that something had shifted in an unexpected way. A subsequent downgrade to just 1.3% in the second read should spark even greater concerns in a US equities market that is trading near all-time highs on strong earnings growth forecasts throughout the next several quarters.

Though S&P Indices’ latest figures project 12-month earnings growth of 12.8% by Q4 of this year, as well as a further jump of 14.7% by the end of 2025, it would be hard to imagine corporate earnings reaching such lofty estimates if quarterly increases in GDP were to continue shrinking. Based on the latest GDPNow from the Atlanta Fed, which provides a “nowcast” of real GDP growth based on available economic data and expectations for the current measured quarter, Q2’s expansion is indeed showing signs of further weakness. Between May 8 and June 3, the GDPNow model’s running appraisal was cut down by more than half, skidding from 4.2% to just 1.8%. Further downward revisions may lie ahead throughout the remainder of the quarter if macro data points continue to disappoint as they have thus far.

Such a scenario conjures up images of the classic Looney Toons cartoon character known as Wile E. Coyote; in constant pursuit of an elusive roadrunner that would somehow find a way to bait Coyote into chasing him over the edge of a cliff. As Coyote would look down, the realization would strike that he was standing on nothing but thin air, whereafter he would tumble into the ravine below.

Lacking Action in Long-Term Rates Keeps Stocks Buoyant

As recently as March, the US Fed’s dot plot showed policymakers expected three cuts to the upper limit on its benchmark Federal Funds rate this year, which currently sits at a multi-decade high. Not long before that, a meaningful number of more optimistic traders in the futures market had an even more dovish view of their own – looking for as many as six cuts before year-end. However, that optimism has gradually evaporated throughout the first few months of the year. Sticky inflation readings and a persistently stalwart economy has brought traders expectations more in line with the Fed. The most recent data has likely inspired a bit of dovishness, beginning to…