After a strong rally in global markets since October based on optimism that major central banks would cut interest rates this year, markets declined in April. Resilient economic data (particularly in the US), including sticky inflation, caused investors to reduce their expectations for interest rate cuts in 2024 – pushing both share and bond markets lower in many parts of the world. However, this resilient economic data should be seen as a positive for long-term investors.
Not so fast
After a strong performance in the first quarter, global stock markets took a breather in April. Following all-time highs at the end of last month, the US S&P 500 mostly retreated in April, shedding more than 5% in the first three weeks of the month. Although the index recaptured some of those losses towards month’s end, this still marked the toughest month for equities since September, and the first significant setback in the market rally that has lasted over five months.
Since the US Federal Reserve signalled a pivot from its aggressive monetary policy late last year, the market had taken the likelihood of imminent rate cuts as being all but certain. However, investors’ anticipation of at least six rate cuts this year at the beginning of January have since been pared back to only one, as economic data remains hot, and inflation has proven to be stubborn. This has raised concerns about the potential for a prolonged period of tight monetary policy that could adversely affect economic growth and companies' earnings prospects.
Why have expectations for rate cuts been scaled back?
Throughout the month, several economic data points came in hot. In the US, which is a major driver of global markets, retail sales significantly exceeded expectations, with consumers continuing to spend despite uncertainties around the trajectory of interest rates. This sustained consumer activity is likely bolstered by an enduring labour market accompanied by ongoing wage growth. While this economic strength would often be cheered by investors, markets have recently been viewing good economic news as bad news – given inflation has been more persistent than hoped.
Although inflation cooled rapidly in many markets throughout 2023, progress on the last mile towards long-term inflation goals (a 2% target in the case of the US Federal Reserve) has stalled in 2024. With inflation proving stubborn, there is now the prospect of limited interest rate cuts in 2024, which is seen as a negative by investors.
Will higher rates kill the market rally?
Concerns are mounting that the rising interest rate environment could dampen the market rally. As interest rates climb, there is a need to reevaluate companies' future earnings prospects and valuation levels - particularly following more than five months of valuation expansion. Some fear that this adjustment could lead to a harder market selloff.
However, taking a historical perspective offers a somewhat different view. Over the past ~30 years, higher interest rates have often coincided with strong performance in equities. This correlation typically reflects the underlying strength of the economy, which is a primary driver of increased rates. In fact, falling rates could indicate a worse situation for stocks altogether.
The chart below shows that the S&P 500 tends to deliver above-average annual returns when interest rates are on the rise, contrasting with periods of falling rates where returns have tended to be well below average. So, while higher rates present challenges, they do not necessarily signal the end of a bull market, especially when they stem from strong economic fundamentals.
Stocks rebound at month end as corporate earnings growth remains solid
After pulling back for much of April, stocks staged an earnings-driven rebound toward the end of the month. Results so far from the corporate reporting season suggest that over 80% of US companies are beating expectations. Major tech stocks, like Amazon, Microsoft and Alphabet, reported strong earnings, reinforcing that there is still strong secular growth in parts of the economy despite higher interest rates.
In the short term, a strong economy and higher interest rates can create headwinds for global share markets. Longer term, however, a thriving economy can only be good for investors. But as always, picking the right companies to own is critical and likely to have far more impact on investors than monthly fluctuations based on hot or cold economic data.
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