Markets have been pricing in a U.S. Fed interest rate cut by as early as March. Will the latest stronger-than-expected CPI data alter those expectations? David Sekera, Chief U.S. Market Strategist with Morningstar Research, looks at the likely scenarios and the implications for markets with MoneyTalk’s Greg Bonnell.
Let's talk about the markets. They had a strong run into the end of last year. Investors considered the potential for interest rate cuts from the Fed. Today's US inflation report came in a little hotter than expected. So where might the markets go from here? Joining us now to discuss, David Sekera, Chief US Market Strategist with Morningstar Research. David, always great to see you.
Oh, good to see you, Greg, and happy new year.
Happy new year, indeed. It was interesting near the end of last year, of course, we had a bit of a market rally on the expectation that, as we entered 2024, where we are now, we would see rate cuts from the Fed. We got some fresh inflation. Where does the market stand right now in terms of valuation after that run?
Well, we still think the market overall is really very close to our fair value. And when we think about fair value for the market, we do take a bottoms-up approach. We compare where the market is trading, so the composite of the fair values of all of the stocks that we cover that trade on US exchanges-- over 700 stocks-- and then compare that where they actually are in the marketplace today. And that's why we think that the market is trading pretty close to fair value.
A lot of other strategists take much more of a top-down approach. They start off with some sort of algorithm or model to come up with S&P 500 earnings for the end of the year and apply some forward multiple to it. But the way that we look at it is what we think the market is actually worth today. And what we mean by fair value is that, for long-term investors, going forward, I expect that you should be able to earn, essentially, the market's cost of equity on a blended basis. So we're looking for much more normalized returns going forward, probably in that 8% to 9% area.
So in a market that you say is pretty much fairly valued right now, as we dig in beyond the broader market, where might we be seeing some value?
Yeah. So even though the broad market is pretty close to fair value, there are still some dislocations that we do think investors can take advantage of. So when we break it down the valuation into the Morningstar style box, by category, I'd note that the value category is trading at about a 10% discount to fair value.
Whereas, core stocks-- those are the ones that have some attributes of value, some attributes of growth-- they are trading at a slight premium to our fair values. And then the growth category, after the huge run that we've had last year, is now trading up at fair value. And then, when we look at it by capitalization, small cap stocks, in our view, are still very attractive-- trades at about a 16% discount to that blended fair value average.
And I think 2024 is really set up to be probably a pretty good year for value stocks, and especially small cap stocks. I think a lot of the reasons that we saw value in small caps lag the past couple years-- I think a lot of the reasons are behind us at this point. So I do think those are going to be two good areas for investors to look at going forward.
So the setup seems, perhaps, promising for value and small caps. What could be the risk to these parts of the market? What could get in their way?
Well, for the overall market, inflation is certainly going to be a risk. We did see CPI numbers come out this morning. Yeah, I would note-- and, actually, I talked to our economist early this morning. And he's still of the opinion that he thinks that the Fed will cut, and potentially cut as soon as the March meeting.
When we look at those numbers and really dig into them, a couple of the different areas that caused the numbers to be higher than what the market expected, such as used vehicle prices and shelter prices-- we still project those will moderate over the next couple months. And, specifically, we're very focused on core inflation.
And he notes that PCE, the Personal Consumption Expenditure, index for inflation, which is the Fed's real targeted number that they're focused on-- for the six months ending in November, was at 1.9%. So, in his view, given that core CPI was relatively steady on a year over year basis, and we still have that same correlation between CPI and PCE, that allows PCE to come in still below or right at the Fed's target. So it'll give them the room to potentially cut here in March.
Interesting. So, if we did see that come to pass, let's talk about the shift to easing from the Fed and what it could mean for the markets.
Yeah. So I think, with nothing else, what that's going to do is provide a good floor if we do have some downturns later this year. I am a little concerned with earnings season coming up here that it might be an opportunity that management teams maybe try to look to set the bar lower for their earnings expectations for the year.
We do expect that the rate of economic growth will slow here for the next three quarters. So if management teams have those same kind of projections in their own models, they may try and lower the bar on guidance. And, of course, that could drive some negative sentiment.
However, with the Fed cutting-- easing-- in fact, we're looking for six rate cuts this year. That would actually put the Fed funds rate in that 3 and 3/4% to 4% area by the end of the year. I do think that that will end up bolstering the economy later this year and going into 2025. So if we do have some sell-offs, that actually would probably be a better opportunity for investors to maybe go back into more overweight positions in equities.
I guess the wild card here, just like when we were speaking earlier in terms of risk, would just be in the end that inflation doesn't come down the way we hoped it did.
Yeah, that is really the big risk-- that, if inflation doesn't come down and the Fed decides that they need to keep rates higher for longer, yeah, I think that would have a lot of negative implications, not just in the equity market, but also in the fixed income market.
Yeah, we do think that interest rates also should subside this year, even in the longer end of the curve. So if interest rates stay high, and, in fact, if the 10 year were to start actually moving back up again, I do think that would pressure both equity and fixed income very significantly.
Well, let's talk about 2024 in terms of something very interesting in talking the significance of it. I have found in my work-- and it's been gradual over the past year and a half-- I say the word "pandemic" less and less. You're saying that 2024 might be the year we can actually put all that really behind us for good?
I do think so. And so, in my opinion, I think this is really the first year after the pandemic that it's not only those initial disruptions that are behind us, but all the dislocations that were then caused by those disruptions. So when we think about initially during the pandemic, we had a huge shift in consumer behavior, a big shift in consumer spending. We're starting to see that revert back to pre-pandemic norms. The amount of spending on goods and services going back to more normally historical levels.
We had the office workers, such as myself, all working from home. People are now returning back to office. But, even thinking about monetary policy and fiscal policy, we had some of the largest stimulus programs in history. Those are all moving back towards more normal type of spending going forward. We had zero interest rate policy for the first couple years. And then inflation ramped up too high. The Fed had to catch back up.
So we've had some restrictive monetary policy for the past six to nine months, which we do think that the Fed will take the foot off the brake and get back to more of a neutral policy. So, again, looking at the market, I think this year is really going to be back to basics, back to looking at individual company fundamentals, looking back at individual sector fundamentals. And I think stock picking and selection is going to be increasingly much more idiosyncratic this year going forward. [AUDIO LOGO]