Pressure Rising

After setting a blistering pace for much of 2023, growth stocks are finally encountering some resistance. The gravity of a surge in interest rates is beginning to work against this year's performance leaders. By extension, the S&P 500, which is heavily weighted to mega-cap growth stocks, has retreated. Three of the index's five largest-weighted companies have slipped 10% or more over the last three weeks. Market participants are left to wonder if this is a normal pullback or the start of a durable change in leadership. With earnings multiples extended, further gains likely rest on earnings growth. Of course, this depends on the economy’s trajectory in the months ahead. 

To date, the economy has held up despite 525 basis points of Fed Funds hikes due to the strength of consumer balance sheets. Simply put, consumers are working and spending. However, over time, the impact of higher interest rates will increase. Consumers have nearly exhausted their pandemic savings and are increasingly borrowing at high rates to fund their purchases. In the last year alone, the average interest rate on credit card debt increased from 14% to 21%. Rates for mortgages and auto loans have also surged. Pressure is rising and corporate earnings estimates do not currently reflect a pullback in consumer spending. 

On the other hand, inflation continues to moderate. Both headline and core CPI, which excludes volatile food and energy prices, were below expectations for the month of July. Shelter costs are still sticky, but inflation in goods and core services continues to wane. Some concerns in the inflation pipeline remain, especially with crude oil prices rising in recent months. However, we are reaching a point where the Federal Reserve can reasonably pause its hiking campaign. All else equal, this should be a tailwind for equities. Yet, it is important to remember that financial conditions can continue to tighten even if the Fed is no longer raising the Fed Funds rate. Real interest rates can still rise if inflation continues to moderate. 

It is also worth considering the growing strain of the U.S. fiscal situation. As noted in Fitch’s recent downgrade of the U.S. credit rating, interest costs are expected to rise sharply for the federal government over the coming years. As a percentage of GDP, interest costs are projected to reach a level that has historically been a headwind for economic growth. As policymakers prepare to battle over the budget in the Fall, potential spending cuts loom. Over the past three years, fiscal policy has been a key driver of market liquidity.

Taking everything into account, we believe that the macro environment is highly uncertain as is the path forward for equities. We remain highly selective about the businesses we own, preferring the security offered by strong balance sheets, essential goods and services, excellent management teams, visible growth opportunities, and pricing power. We continue to align portfolios with this thinking. 

Thanks,
Preston May, CBE®
Research Analyst