Three Key Thoughts:

1.     Earnings Growth Supports Stocks
2.     Growing Economy AND Lower Inflation?
3.     Geopolitical Risks Stay High

Earnings Growth Supports Stocks
Buoyed by the expectation that the Federal Reserve would cut interest rates in 2024 and by reports of stronger than expected corporate earnings, the US stock market continued the rally that started in November of last year. The rally continues to be led by large technology companies, the most prominent of which have been dubbed the “Magnificent Seven.” The rally kicked off late last year when inflation dropped more than expected, making it highly likely that the Federal Reserve was done raising rates. But the rally was supercharged by the expectation that newly launched artificial intelligence capabilities would drive productivity and, more importantly perhaps, earnings growth for companies well positioned to take advantage of the AI boom. Several of the Magnificent Seven fit this profile but a couple did not, at least in the short term. In the first quarter, those two – Apple and Tesla – fell by the wayside.

So investors’ focus shifted to earnings growth, which continued at a surprisingly strong pace through the quarter. With the labor market remaining reasonably strong, consumer spending held up well. Companies in a broad range of industries from capital equipment to manufacturing to finance posted solid earnings too. Correspondingly, participation in the stock market rally expanded from the tech sector to many other areas of the market, including value and small cap stocks which had been left in the dustbin for some time.

Interestingly, the stock market rally has held up even as hopes of Federal Reserve rate cuts have faded. Recent inflation reports, including today’s CPI, have come in slightly higher than expected, likely pushing rate cuts further into the future. The rent component of inflation continues to stay particularly strong, contrary to anecdotal evidence of weakening prices, leading many commentators to pick apart the methodology used to report the statistics. Energy prices remain a wild card, as continued instability in the Middle East threatens the stable backdrop for oil and gas prices. For now, bond investors are adjusting back to a “higher for longer” rate regime and stock markets will focus more intently on the outlook for corporate earnings, making the next few weeks of announcements more important than usual.

Growing Economy AND Lower Inflation?
Many investors, including us, have been waiting for the Federal Reserve’s aggressive rate hikes to reverberate through the economy, slowing growth and weakening the labor market. We are still waiting. We believe that massive fiscal stimulus (budget deficits in excess of $1.5 trillion, roughly 7% of GDP) is largely offsetting the impact of the Fed’s tightening. There is no appetite in Washington DC, on either side of the aisle, to address this spending issue, which is destined to grow, using CBO projections, to 10% of GDP over the next decade. Viewed in this context, it’s not surprising to see the economy growing and the labor picture staying solid.

So how can we get this growth without re-igniting inflation? The answer is productivity. If we take the productivity improvements that the pandemic spawned along with the prospect of improvements with the broader implementation of artificial intelligence, we could well be starting a period of higher productivity growth, which gives us solid economic growth and low inflation. While this would be a very positive environment for financial assets, the biggest risk is that productivity doesn’t improve as much as expected and inflation spikes once again.

Coming back to what this means for interest rates, it is sensible for the Federal Reserve to take its time in cutting interest rates, while it observes what is going on in the economy. In particular, the Fed is very attuned to the risk of reflation, preferring to make sure that lower inflation is here to stay for a while before reducing interest rates. As other major central banks start to cut rates, we expect the dollar to stay relatively strong until our rates are reduced too.

Geopolitical Risks Stay High
The hot spots just seem to keep piling up: Russia/Ukraine, Israel/Hamas/Iran, Houthis/Red Sea, China/Taiwan and, lest we forget, North Korea. There are undoubtedly more, lurking below the surface. With this many major areas of potential conflict, the risks of more catastrophic violence are greatly increased. Adding even more risk is the fact that several of the major powers – Russia, China, Iran and North Korea -- are ruled by dictators who cannot be counted on to act rationally or even in the best interests of their own countries.

In this environment, a strong voice for peace and freedom is important. Unfortunately, that is lacking. The nature of the European Union makes it difficult for them to act in a unified fashion. Indeed, the Union was conceived to link the members economically to make conflict among its own members less likely. And here in the US, both Democrats and Republicans are leaning toward a more isolationist approach to US foreign policy. We believe this makes the world a more dangerous place, not less dangerous. We are in need of positive, transformational leadership in Washington but we won’t get it for at least another four years.

Investment Implications
As long as the economy keeps growing and inflation stays low, both stocks and bonds are likely to fare reasonably well. That said, the risks to both the economic and geopolitical environment can’t be ignored. We believe that well-diversified portfolios with substantial amounts of liquidity are best for this environment.