The S&P 500 fell moderately and erased the entire week’s gains on Friday, and that begs the question: Did something bad happen?
The short answer is “no,” it didn’t.
Instead, Friday’s performance reveals this current market dynamic. Around 4,500, the S&P 500 is largely priced for perfection, meaning the “Three Pillars of the Rally” are real and indisputable. Yet in reality, that simply isn’t the case, as all three of the pillars of the rally remain under threat, andabove 4,500 the fundamentals do not support a sustainable rally.
In the near term (specifically this week) the most vulnerable pillar is Fed expectations. Yes, the Fed will confirm it’s likely done with rate hikes, but it could also signal rate cuts are not coming anytime soon (barring a collapse in growth, which would be negative) and probably the most-important Fed metric right now is the December 2024 fed fund futures expectation. The closer that gets to 5.00% the more of a headwind it’ll become on stocks (it ended last week at 4.60%).
Beyond the near term, the “easy” part of resilient growth and declining inflation are behind us, as the impact of higher rates on the economy gets stronger the longer they stay elevated, while rising commodity prices could make inflation more buoyant.Here’s the point: There was nothing “wrong” with stocks on Friday.
Instead, it’s that above 4,500, the S&P 500 reflects the certainty of: 1) No growth slowdown, 2) Inflation under control and 3) The Fed not keeping rates higher for longer. And that is simply not a reality at this time, and that’s why the market was vulnerable to a decline on relatively minor news. Think of it this way: The 2023 rally has been fueled by the economy and inflation both being “not as bad as feared.” But at this point, neither is feared anymore and as such the market has lost the power of positive surprises.
The good news is that the three pillars of the rally remain intact and as such the downside in this market is limited. At the same time, all the good news is priced in, and this market needs a new catalyst to fuel another leg higher. The next possible candidate is the Fed endorsing the idea of rate cuts in mid 2024, but with inflation still elevated, that’s very unlikely to happen near term. If it does, the S&P 500 can move higher. Absent that, expect a continued rangebound trade generally between 4,350ish and 4,550-ish until either we get a new catalyst or one of the pillars gets seriously damaged.
The key report last week was the August CPI, and it was a bit of a Rorschach test as the bulls saw evidence of continued disinflation (core CPI fell to 4.3% y/y from 4.7% y/y) while the bears saw reasons to believe a bounce back in inflation is coming (core CPI rose 0.3% m/m vs. (E) 0.2%). In the end, the CPI report didn’t change the narrative on inflation: We cannot dismiss a bounce back in inflation and if that occurs, it will be a new and significant negative for stocks. But based on the economic data we have, that bounce back is not yet occurring and while there are hints it might occur, it’s not conclusive enough to warrant any changes in strategy.
The key event this week is Wednesday’s Fed meeting, and while markets do not expect a rate hike (it’d be a pretty big surprise if the Fed hiked) the decision could easily be hawkish given the 2024 “dots” as that could damage the “Fed almost done” pillar of the rally.
Should we be worried about a government shutdown?
Note that unlike some other budget confrontations in the past, this one does not involve paying the federal debt. For better or worse the debt limit has been suspended until January 2025. This means that even if the government is shut all the debt will get paid on time; there will be no default.
Social Security checks and other benefit payments will still go out. The mail still gets delivered. Essential government workers keep working, including those needed for national defense. The government is not the economy, even though many in DC (and many voters) think it is. But, those that produce wealth are the ones who have to pay for it. And that cost keeps going up. In 1930, the federal government (without defense) was about 2% of GDP. Today that percentage is 22%. The government has grown about 10 times more than the economy as a whole. Debt is at a record high and, with higher interest rates and rapidly rising entitlement costs, we are on an unsustainable path.
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