When the U.S. Federal Reserve cut its benchmark interest rate by a half-point last week, it began a rate-cutting cycle that follows one of the most aggressive rate-hiking cycles in decades. While relieved equity investors pushed the S&P 500 Index to a new all-time high, and even as the rate cut boosts the likelihood of an economic soft landing, the question remains: What’s next?
Corporate fundamentals may hold the key. Morgan Stanley’s Global Investment Committee sees economic stability as well as market growth increasingly hinging on companies’ ability to meet earnings expectations – but these are already ambitious. Consider this:
- Earnings are estimated to grow about 13-14% through the end of 2025 — roughly double the normal year-over-year pace.
- Specifically, the Magnificent 7 mega-cap tech stocks are expected to see their earnings growth decelerate, to about 15-18%, while the other 493 companies in the S&P 500 are expected to boost their profit growth rate to about 10-11%.
- Those earnings gains are expected to come from expanding margins. Estimates imply margins for the S&P 500 will increase to an all-time high of 17.8% by the end of 2025, up from 13.5% last year.
Underlying Assumptions
Is such extraordinary margin expansion realistic, and where would it come from? Investors are tying the expansion to productivity gains, rather than cost-cutting efforts.
At first glance, it may be an easy case to make. Capital spending since the pandemic remains above average and has been accompanied by government-linked investments in infrastructure, clean energy, semiconductor competitiveness, and supply-chain realignment. In addition, investors hope that integrating generative AI into business operations could boost productivity across a wide range of sectors.
In fact, economy-wide productivity has improved, with U.S. labor productivity increasing 2.5% in the second quarter, versus the annualized rate of 1.6% over this current business cycle starting in late 2019. However, it remains to be seen whether capital expenditures or new technology can unlock the additional productivity required to achieve the market’s lofty expectations for margin growth.
Similarly, even as layoffs remain benign, especially considering the continued softness in manufacturing data, job openings have now normalized to pre-pandemic levels. It’s an open question whether companies can achieve additional productivity gains without job cuts.
Limits of the Fed Rate Cut
Potentially complicating the picture for the economy moving forward is its relative lack of sensitivity to changes in interest rates during this cycle. For instance, the rate hikes of the last few years should, in theory, have had a restrictive effect on spending or incomes, but in aggregate they haven’t quite had such an effect.
Now, on the flip side, reductions in interest rates may have less of a stimulus effect on the economy than anticipated. For example, corporate debt burdens are modest and the average cost of capital for the largest borrowers remains at just about 4%. Since that is already lower than the new benchmark interest rate of 4.75-5%, it is likely to limit the effect of the initial rate cut. In addition, the housing market remains relatively frozen, as the majority of homeowners either own their homes outright or hold mortgages with rates below 4%. Rate cuts may do little to motivate homeowners to sell or new buyers to borrow when a 30-year mortgage is still pricing well above 6%.
What Should Investors Do Next?
Now that the drama surrounding the timing and amount of the Fed’s first rate cut has been resolved, the power of macro dynamics to singularly drive the market has diminished. Corporate fundamentals will now need to come into sharper focus, though expectations there are already ambitious.
Given this backdrop, investors should consider reducing ultra-short and money market positions in favor of locking in longer-dated rates. The equal-weighted S&P 500 Index may provide better risk-adjusted exposure than its market-cap-weighted counterpart. As for sectors, we continue to find compelling opportunities in financial services, industrials, energy, healthcare and materials, as well as parts of technology such as software. Look for defensive ideas in residential REITs and utilities, while also considering non-U.S. assets.
Información extraída de: https://www.morganstanley.com/ideas/fed-rate-cuts-2024-soft-landing-earnings-key
