In This Article:
Stocks have continued last year’s positive momentum into the New Year, pushing the major indexes into record territory. Driving this sentiment appears to be optimism about the Trump administration’s policy agenda, expectations of easier Fed policy and a corporate earnings picture that continues to defy the skeptics.
Plenty of progress has been made on the inflation front over the past year, though more recent readings have not been consistently heading in the right direction. These uneven inflation gains have delayed further Fed easing for now, but market bulls remain sanguine about the Fed and inflation and see nothing egregious with valuations.
Market bears see this market optimism in the market as without a fundamental basis. This line of thinking sees inflation as ‘stickier’, leaving the Fed no room to loosen policy any time soon. Valuation worries also figure prominently in the bearish view of the market.
The interplay of these competing views will determine how the market performs in the coming months and quarters. To that end, let’s examine the landscape of bullish and bearish arguments to help you make up your own mind.
Let's talk about the Bull case first.
The Fed’s Easing Cycle: The Trump administration’s trade agenda has added an element of uncertainty to the market’s inflation and what that means for Fed policy. The bulls see the inflation issue as headed towards a resolution to the central bank’s satisfaction, allowing the Fed to continue with easing policy.
This view doesn’t see tariffs as inherently inflationary, but acknowledges that the issue will likely prompt the Fed to adopt a wait-and-see approach and implement fewer rate cuts this year than would otherwise be the case.
The Fed did not announce a rate cut after its January meeting, which followed three consecutive rate cuts since September 2024. This was no surprise for the market as expectations of the number of rate cuts in 2025 had come down following the December Fed meeting. While inflation has declined significantly over the past year and now remains within striking distance of their target, they would like to see continued progress as they cut rates further.
Market bulls would prefer to have more rate cuts rather than fewer, but they can appreciate the central bank’s logic. The wait-and-see approach has the added benefit of giving the Fed time to size up the effects of the Trump administration’s policies, particularly on the tariffs front. With the overall policy bias firmly in the easing mode, the expectation is that the next rate cut will arrive at the May Fed meeting.
Continued . . .
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The Economy’s Strong Foundation: The U.S. economy remains in solid shape as was reconfirmed by Thursday’s Q4 GDP report. But if we step back from the quarterly GDP reading and compare the economy’s growth pace in the first half of 2024 relative to the second half of 2023, it becomes clear that the growth trajectory moderated in response to tighter Fed policy.
This is beneficial to the central bank’s inflation fight, particularly the demand-driven part of pricing pressures, as the GDP report’s price deflator reading was confirmed. The Fed started easing in September, but many in the market believe that the overall level of interest rates remains restrictive to economic activities.
Bears still remain worried about recession risks, but the U.S. economy’s resilient performance in the face of extraordinary Fed tightening has significantly increased the soft-landing odds. Underpinning this view is the rock-solid labor market characterized by strong hiring, an unemployment rate that is still low by historical standards, and steady wage gains. It is hard to envision a recession without joblessness.
The purchasing power of lower-income households has been eroded by inflationary pressures, as companies confirm on their earnings calls. But household balance sheets in the aggregate are in excellent shape, even though most of the Covid savings have largely been used up by now. This combination of labor market strength and steady wage gains should help keep consumer spending in positive territory in the coming quarters.
While estimates for the coming periods have been coming down, the Zacks economic team is projecting below-trend but nevertheless positive GDP growth in 2025.
All in all, the strong pillars of the U.S. economic foundation run contrary to what are typically signs of trouble ahead on the horizon.
Valuation & Earnings: Tied to the economic and interest rate outlook is the question of stock market valuations that still look reasonable given the expected interest rate trajectory.
The S&P 500 index is currently trading at 22.5X forward 12-month earnings estimates, up from 15.6X at the end of September 2022, but below the peak multiple of 24.2X in August 2020. It is hard to consider this valuation level as excessive or stretched, particularly given the ongoing Fed easing cycle.
The appropriateness or otherwise of valuation multiples has to be seen in the context of the interest rate outlook. Valuation multiples typically expand when the Fed is easing policy, particularly when the catalyst for the loosened policy is confidence on the inflation front instead of growth fears.
Earnings outlook is a key part of the valuation discussion. Contrary to the earlier doom-and-gloom fears, the ongoing 2024 Q4 earnings season is reaffirming the resiliency and stability of the corporate profitability picture, with the growth pace expected to steadily improve in the coming quarters.
What we are seeing this earnings season is that while companies in a number of industries are unable to have adequate visibility in their business, there are many others that continue to drive sales and earnings growth even in this environment. We are seeing many of these leaders from a variety of sectors, including Technology, come out with strong quarterly results and describe trends in their businesses in favorable terms.
Current consensus expectations for this year and next reflect strong growth that is broad-based and not driven by one or two sectors. In fact, the earnings outlook has started improving lately, with earnings estimates for this year and next starting to go up in recent months.
In the absence of a nasty economic downturn, the earnings picture can actually serve as a tailwind for the stock market in an environment of easing Fed policy.
Let's see what the Bears have to say in response.
The Market’s Fed Exuberance: The Fed kept interest rates unchanged at its January meeting. This was no surprise as the market had come around to expecting this outcome after the December meeting.
The expectation at present is for about two rate cuts this year, with the next cut most likely in May provided incoming economic data over the coming months remain supportive.
The risks to this outlook are twofold. The first is that the May rate-cut timeline may not pan out, as it will be next to impossible for the Fed to start cutting rates at that meeting if any of the monthly readings fail to show progress on the inflation front.
This is exactly how inflation behaved in the first three months of last year, forcing a reset of the market’s Fed expectations. This is hardly a far off scenario given the Trump administration’s policy agenda on the tariffs and immigration fronts. Many in the market see the ongoing elevated yields on longer-dated treasury bonds as reflective of such worries.
Tied to the first risk is the prospect that the economy’s true health may be far more fragile than the quarterly GDP readings suggest. Low-income households have been struggling for a while, but anecdotal evidence from earnings calls suggest that even better off consumers are getting more cautious in their spending plans.
In the worst case scenario, stalled progress on the inflation front may stop the Fed from easing policy even as the economy continues to weaken further. But even if that isn’t the case and the Fed starts easing in May or any of its subsequent meetings, the decelerating momentum in the economy may be hard to stop by then.
The Valuation Reality Check: Given the bears’ view that the prudent course for the Fed is to be in no hurry to start easing policy in the absence of any issues in the economy, they see no fundamental reason for valuation multiples to expand.
Higher-for-longer interest rates should have a direct impact on the prices of all asset classes, stocks included. Everything else is constant, investors will be using a higher discount rate, a function of interest rates, to value the future cash flows from the companies they want to invest in.
This means lower values for stocks in a higher interest rate environment.
The Earnings Growth Question: Current consensus earnings estimates show +13.9% growth this year and +13.4% growth in 2026, which follows the +7.8% earnings growth in 2024.
Market bears see these earnings growth expectations as inconsistent with the soft-landing outlook for the economy.
Notwithstanding the tough going in the manufacturing sector and the growth implications of the still elevated treasury yields despite Fed easing, earnings expectations for this year and next will need to come down significantly to get them in-line with the economic ground reality.
Where Do I Stand?
While I acknowledge that the next rate cut can get pushed out from the May meeting, I am skeptical of the higher-for-longer Fed policy view and see this scenario as nothing more than a low-probability event.
The current Fed Funds rate level is almost twice what central bank officials and economists see as the ‘neutral’ policy rate. At the ‘neutral’ policy rate level, Fed policy is neither ‘stimulating’ nor ‘restricting’ economic activities.
Even if further progress on the inflation front is a lot slower than what the Fed and the market is projecting at present, the central bank has plenty of cushion in its policy arsenal to start easing policy without adversely affecting its inflation fight. This doesn’t mean that the next rate cut is around the corner, but it does suggest that they don’t need to wait for an extended period to consolidate the inflation gains.
Regular readers of my earnings commentary know that the earnings picture continues to be resilient, with recent developments on the earnings front showing a favorable turn in the revisions trend. Importantly, positive estimate revisions are spreading beyond the trend’s earlier core in the Tech space.
With respect to the stock market as a whole, the major indexes are within striking distance of all-time record levels, notwithstanding some turbulence in the Technology sector as a result of new artificial intelligence models. The overall policy thrust of the Trump administration is expected to be pro-growth and pro-market, but it is nevertheless reasonable to expect some period of market tentativeness as we await full details of some of the policies. But we remain confident that investors will soon come around to our view of inflation, earnings and the much more positive times ahead after a short period of volatility.
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Sheraz Mian serves as the Director of Research and manages the entire research department. He also manages the Zacks Focus List and Zacks Top 10 Stocks portfolios. He invites you to access Zacks Investor Collection.
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