By Ellen Hazen, CFA®, Chief Market Strategist

November Takeaways:

• US labor market cools; still solid. October jobs were reported in early November; the US added 150,000 to non-farm payrolls in October, missing economists’ estimate of 180,000. This continues the deceleration we’ve seen since the peak of 800,000 jobs in early 2022. The unemployment rate increased by a tenth of a percentage point, to 3.9%. Average hourly earnings increased by 4.1% in October, increasing slightly more than inflation for the second straight month. The labor market is softening from red-hot levels but remains solidly in expansionary territory.
• Inflation has continued to wane. The October Consumer Price Index (CPI) was 3.2%, down from 3.7% in the prior month and slightly lower than expectations of 3.3%. October Personal Consumer Expenditures (PCE), (another measure of inflation) also declined, to 3.0% from 3.4% in September.
• The Federal Reserve held interest rates steady at the November meeting and noted that tighter financial conditions have contributed to economic slowing. Before the meeting, the markets had been pricing in one more interest rate increase in late 2023 or early 2024. After the softer inflation data, the markets are instead pricing in cuts—starting at the March 2024 meeting—with a total of 4 cuts priced in by the end of 2024.
• Rates dropped sharply in the month, as evidence accumulates that the Fed will not raise rates any longer. The 10-year Treasury rate declined by nearly 0.6%, ending the month at 4.34%. The yield curve inversion – when short rates are higher than long rates – softened, from 100 bps earlier this year to only 36 bps by month’s end.
• It was a “risk-on” month across markets. Just-right economic data provided comfort to market participants that the Fed will stop raising interest rates. Equities had their highest monthly return all year, with the S&P500 appreciating by 9.1%. Small- and mid-sized stock indices were only marginally behind, appreciating by 8.2% and 8.5% respectively. Corporate bonds appreciated by 6.0% and high-yield bonds appreciated by 4.9%. Both investment grade and high yield spreads tightened.
• Corporate bond performance rebounded, reflecting both lower rates and tighter spreads. Both high grade and high yield spreads tightened notably in the month.
• The US equity market further narrowed, with the largest stocks outperforming the rest of the market. Growth outperformed Value by 3.4%, returning 10.9% versus 7.5%. The Magnificent 7 stocks (Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia, and Tesla) returned an average of 11.9%, nearly 3 percentage points better than the benchmark return of 9.1%.
• Earnings were solid. The companies in the S&P500 index reported earnings growth of 4.5% for the third quarter of 2023, on revenue growth of 1.9%. Analysts had estimated that earnings would be flat-to-down in Q3, so this was a positive surprise. Small cap companies did not fare so well on the earnings front. Companies in the S&P600 Small-Capitalization Index reported revenue declines of 4%, and earnings declines of 12.9%.

What We Are Watching in December

• Jobs will be reported on December 8. We expect the labor market to continue to moderate, but we expect a modest decline in the number of new jobs added, not a sharp decline.
• CPI/PCE will be reported on December 12 and 22, respectively. We expect continued moderation in inflation due to a softer labor market and lower rents making their way into the calculation.
• Fed meeting December 13. The Fed is widely expected to hold rates steady. The Committee will release its Statement of Economic Projections at this meeting, which includes participants’ forecasts for inflation, unemployment, economic growth, and interest rates. Earlier this year, Fed staff were forecasting a recession, then that forecast was removed in recent meetings. It will be interesting to see whether Fed staff re-inserts a recession into their forecast.

Looking ahead to 2024

Equity markets tend to follow earnings. Sometimes they anticipate earnings, sometimes they are more coincident with earnings, but they generally stay anchored to earnings. While price-to-earnings multiples fluctuate (primarily due to sentiment), getting earnings at least directionally correct can help inform where the best opportunities lie.

Currently, Wall Street analysts expect S&P500 earnings per share to grow 12% in 2024, increasing from an estimated $217 per share in 2023 to $243 per share in 2024. This would appear reasonable on the surface; earnings have grown at an 11% compound annual growth rate over both the last decade (which includes the COVID era) and the last two decades (which also includes the Global Financial Crisis). There are at least a couple reasons to be cautious about a 12% earnings growth expectation, though: chronic analyst optimism and the slowing economy.

Historically, analysts are too optimistic when initially forecasting earnings. The average decline in estimates between initial forecasts (typically two years prior) and actual earnings reports is 8%. Estimates for 2024 earnings have already come down over the past 12 months by 4%, so perhaps we could expect a further 4% decline in 2024 estimates, if history is a gauge. That would put 2024 earnings growth at something closer to 8% rather than the 12% currently expected.

Another reason earnings growth may come in lower than the current 12% expectation is that the $243 per share earnings estimate for 2024 assumes a record-high operating margin of 15.7%, a 130-basis-point increase over the 14.4% expected to be reported in 2023. However, with a slowing economy, engineered in part by the Fed, operating margins are more likely to stay flat or increase modestly. You can see from the nearby chart that 15.7% would match the previous record set in 2022.

Meanwhile, evidence that the US economy is slowing continues to accumulate:

• The labor market, while remaining healthy, is slowing, as evidenced by the declining number of new nonfarm payrolls added each month as well as the low-but-increasing unemployment rate.
• Real GDP growth for Q3 2023 was reported as 5.2%, but GDP for Q4 2023 is currently estimated to be only 1.2% (Atlanta Fed’s GDPNow indicator). 2024 is estimated by economists to be 1.2%, well below 2023 at 2.4%.
• Consumer spending is running a bit ahead of a sustainable level. Consumers continue to spend, as evidenced by the strong Black Friday through Cyber Monday sales growth of 7.8%. However, that’s on a nominal basis, and includes likely inflation of 3-4%. Moreover, consumers continue to increase credit card balances rather than pay them down. According to Fed data, card balances grew by over 10% year-over-year in the most recent period, faster than spending growth. Delinquencies are increasing for both cards overdue by 30 or more days and 90 or more days. Collectively, these point to a consumer that may weaken a bit in coming quarters.
• The Citigroup Economic Surprise Index continues to steadily soften after peaking in August of 2023.

Most economic indicators suggest that the US is in the latter stages of an economic expansion. The pandemic interrupted this expansion, and the US experienced a recession in mid-2020. However, because that recession was induced by a deliberate economic shutdown rather than typical credit excesses, the economy has more or less resumed its pre-COVID trajectory. The current economic slowing is being driven not only by internal dynamics but also by the cumulative impact of eighteen months of monetary policy tightening. The Federal Funds rate is still at 5.5%, and the balance sheet is still running off at a pace of $95 billion per month. If the economy continues to slow again, 2024 earnings estimates may be a bit too high.

How to invest in such an environment? At FLP, we turn to individual company earnings and evaluate them by sector. Examining 2024 earnings, some sectors look more appealing than others. One example is the healthcare sector, which has the highest expected earnings growth in 2024 of any other. The average healthcare company is trading just above its 10-year median valuation, and is cheaper than the overall market, while exhibiting faster growth – an appealing combination in a slowing economic environment.

Zooming out, we combine bottom-up analysis with historical precedent. Late in an economic cycle, the asset classes that perform the best tend to be the more conservative ones: bonds perform well, and within equities, large-cap stocks and stable sectors perform well. Layered on top of this, high quality tends to outperform low quality across multiple asset classes. Thus, as we look to 2024, we are investing client assets in high-quality areas across both fixed income and equities, while seeking stocks whose individual earnings trajectories are attractively valued and are less likely to be economically sensitive.

Disclosures