January 9, 2024

By Kyle Rodda, Senior Market Analyst at Capital.com

“Equity valuations have been juiced by expectations for relatively aggressive interest rate cuts this year. The so-called Powell pivot, combined with a trend of softer than expected inflation data, has loosened financial conditions materially and boosted market multiples.

Despite some pushback from Fed officials – which screams, “We kicked our own goal by flagging rate cuts in 2024” – and solid labour market data, imminent and aggressive rate cuts are still baked-in and underpinning stock indices.

When it comes to stock markets, there is one big contradiction that could turn the uptrend around. While interest rate markets appear to be signalling a slowdown in economic activity, earnings estimates (at least in the United States) imply very robust growth conditions and EPS growth for the calendar year in excess of 10%.

Historically speaking, that level of earnings growth is at odds with a slowing economy and meaningful disinflation. It suggests that between rates markets and earnings expectations, something’s got to give. Either earnings estimates are revised lower, and prices move lower to reflect that, or interest rate cuts are priced out, and prices fall as multiples compress.

Of course, the markets could be on the path of immaculate disinflation to an economic soft landing. The Fed is projecting as much. However, the central bank thinks that this scenario will only require around three rate cuts, and that’s only to keep policy moving in line with reductions in annual inflation to keep “real” rates steady. Again, it looks like something needs to give, which means that the markets could hit a pocket of volatility at some point before a more sustained uptrend can be established.”