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At times, the financial markets exhibit an interesting dynamic where positive economic developments may not necessarily be welcomed by investors. In the current context, keen observers of the Federal Reserve’s actions have been monitoring incoming economic data for indications of a potential slowdown. Following a series of unprecedented monetary tightening measures, which encompass over 500 basis points of interest rate hikes by the Federal Reserve, it appears that the overall growth of the American economy is displaying signs of softening at the margins. Counterintuitively, this is perceived as good news for the markets, as any alleviation of the ongoing restrictive policies may augur well for the beleaguered financial markets.
However, a twist in the narrative emerged last week, as the seemingly robust Q3 GDP report appeared to contradict the prevailing notion of economic deceleration. A government report released last Thursday revealed that the US economy expanded at its fastest pace in nearly two years during the last quarter, driven by unexpectedly strong consumer spending. Gross Domestic Product (GDP) surged at an annualized rate of 4.9%, more than double the pace observed in the previous quarter. This growth was primarily spurred by a 4% increase in personal spending, even in the face of one of the most rapid interest rate hiking campaigns in history, showcasing the resilience of the labor market.
During this week’s Federal Open Market Committee (FOMC) meeting, it is widely anticipated that policymakers will opt to maintain the benchmark interest rate at its current level, given the substantial monetary tightening measures already in place and the historical lag time required for these measures to fully manifest within the system. Notably, the ten-year Treasury yield breached the five percent mark last week for the first time in 16 years.
Thus far, data suggests that, by all metrics, inflation has exhibited a downward trajectory this year, although recent readings have exceeded the Federal Reserve’s 2% target. The most recent Consumer Price Index (CPI) stands at 3.7% on a year-over-year basis, while the Personal Consumption Expenditures (PCE) index, the Fed’s preferred gauge of inflation, registers at 3.9%. Service-sector inflation, excluding housing and energy, a narrower measure closely monitored by Fed officials, has experienced a slight uptick, rising at a rate of 3.6% from the preceding quarter.
Despite the apparent resilience of the US consumer, numerous headwinds loom on the horizon. Notably, US mortgage rates, which have surged to nearly 8%, are poised to exert a significant drag in the coming months. However, it’s worth noting that only approximately three percent of houses are transacted annually. Given that the majority of American mortgages are locked in for 30 years, the segment of the population in need of borrowing at these elevated rates remains relatively small.
Furthermore, the recent weeks have witnessed a continuation of the downturn in major technology stocks, which have been correcting since this summer. This sell-off can be attributed to a combination of slightly less favorable forward guidance than initially expected and the adverse effects of rising interest rates, which diminish the intrinsic value of longer-duration securities, including high-valuation technology stocks.
Last week, the technology-heavy Nasdaq 100 index declined by approximately 2.62% as several of the so-called “Magnificent 7” stocks reported their earnings. These mega-cap stocks, including Alphabet (Google), Meta, Amazon, and Microsoft, have witnessed capricious investor sentiment. For instance, Meta Platforms’ stock price experienced a sharp decline last week, despite surpassing both revenue and profit estimates. Following an initial uptick, the stock plummeted due to cautious forward guidance.
Although the S&P 500 index has delivered returns exceeding 10% and the Nasdaq Index has yielded over 20% year-to-date, these gains are highly concentrated within a handful of stocks. Excluding the “Magnificent 7” from the S&P index, the remaining 493 companies have essentially shown flat performance this year.
The outperformance of technology companies in 2023 can be attributed to the belief that interest rates have reached their zenith and their robust underlying earnings trends. While the current Price-to-Earnings (P/E) ratio for technology firms modestly exceeds historical levels, it’s noteworthy that the P/E, excluding cash, would be lower. These companies, sitting on substantial cash reserves, could generate returns exceeding 5% from money market instruments. Moreover, when compared to smaller-cap enterprises, mega-cap companies require significantly less external funding at these higher interest rates.
Though technology stocks could experience a correction if market volatility escalates, the sector is expected to maintain strength in the medium term, spanning two to five years. Furthermore, assuming eventual stabilization of the bond markets, we may anticipate a broadening of the market beyond the mega caps as investors turn their attention to the next phase of the economic cycle.
The information contained in this article is for information purposes only, and represent the views of the author. It is not intended as specific investment or financial advice, or a recommendation or solicitation to buy or sell any security. Any investments or strategies listed in this article may not be suitable for all investors. Past performance is not indicative of future performance, and as with any investment, prices may fluctuate. It is recommended that advice is sought from a qualified investment professional prior to implementing any financial plan. LOM has made every effort to ensure that the contents herein have been compiled from sources believed reliable, however LOM does not warrant the accuracy, adequacy, timeliness, or completeness of this information expressly disclaims liability for errors or omissions in this information.
