Investors see Fed rate cuts and earnings as key to sustaining market rally

By David Randall

NEW YORK (Reuters) - After a glorious start to the year for stocks, investors are wary of a possible second-quarter shakeout as they gauge whether the Federal Reserve will honor an expected rate cut by June and turn their attention to the health of upcoming earnings.

The S&P 500 ended the first quarter with a gain of more than 10%, the biggest gain since the first quarter of 2019 when it jumped nearly 13.1%. While the so-called "Magnificent Seven" such as chipmaker Nvidia and Facebook parent Meta Platforms brought in most of the gains for the quarter, economically sensitive sectors such as energy and industrials also rebounded over the past six weeks.

Whether this uptrend continues into June will likely depend on the Fed, which has yet to indicate that inflation has declined enough to justify rate cuts. whereas at the start of January the market was expecting six to seven rate cuts over the course of 2024, it now expects three, as signs of a resilient U.S. economy have boosted investor confidence in the so-called "soft landing". The signs of resilience in the U.S. economy have boosted investor confidence in the so-called "soft landing".

"The market and the Fed's expectations are finally aligned, but that puts more pressure on every economic report that comes out because it doesn't take a lot to get everyone running the same way," said Joe Kalish, Matteo Global Macro Strategist at Ned Davis Research, "but it doesn't take a lot to get everyone running the same way. It doesn't take much." If we don't see more progress on the inflation front, we expect more volatility.

According to CME's FedWatch tool, the futures market is now suggesting a 61% chance of a 25-basis-point rate cut at the Fed's policy meeting, which ends on June 12, thereby lowering the benchmark rate to a range of 5% to 5.25%.

Continued growth in the U.S. economy is likely to extend the recent market rally into cyclical sectors and small cap stocks as investors look for more attractive valuations, said Jason Alonzo, a郃 manager in Harbor Capital's Multi-Asset Strategy team. At the end of the first quarter, the Russell 2000 Petite Granite Index was up 4.8%, while the S&P 500 Industrials were up nearly 11% over the same period.

"Right now, the only thing the market cares about is whether the Fed is still in control even if the economy re-accelerates," Alonso said." If that idea somehow breaks down and the Fed has to suggest that rate hikes are back on the negotiating table, that would be a shock to investors and �a real problem for all assets."

Next week's economic data includes ISM manufacturing data, ISM service sector data, and the closely watched non-employment report, which economists polled by Reuters expect to show a gain of 198,000 jobs in March.

Investors shouldn't be surprised if the market rally starts to slow as the Fed approaches a possible rate cut, according to Sam Stovall, CFRA Research's premier investment strategist. Since 1989, the S&P 500 has risen an average of 15.51 TP3T between the last rate hike and the first rate cut, but only 5.41 TP3T in the six months after the first rate cut, he said.

Keith Lerner, Matrix Investment Officer at Truist Advisory Services, said the strong momentum of the first quarter has historically carried over into the next quarter. Nine of the 11 times the S&P 500's first-quarter return on total assets was at or above 10%, he said, it continued to rise in the second quarter, with an average gain of 6.2%.

"The market deserves its due, and for now we think the bullish rule applies," Lerner said. The biggest risk to a continued rally, he said, is that there are signs the Fed is considering keeping interest rates where they were until the end of the year, which would lead to a "dramatic" repricing of risky assets.

The likelihood of a slowdown also depends largely on corporate earnings, which have been surprisingly strong despite the market's repricing of interest-rate policy, helping to push the S&P 500 to a series of record highs, said Emily Roland, co-head investment strategist at John Hancock Investment Management. The Standard & Poor's 500 Index has hit a series of record closing highs.

According to LSEG I/B/E/S, the S&P 500's earnings growth rate for the final quarter of 2023 is 10.11 TP3T, more than double the 4.71 TP3T expected. Analysts expect first-quarter earnings growth of 5.1%, with high interest rates likely to be a drag on consumer and business spending. companies are expected to begin announcing business results in the second week of April.

"If earnings continue to grow unexpectedly," Rowland said, "the Fed will have a hard time justifying three rate cuts this year." But if we see inflation stabilize, this re-acceleration of the economy could become more sustainable.

(David Randall reporting)