Q2 Update: 2024 Outlook for the Stock Market and Economy

Susan Dziubinski: Hello, and welcome to Morningstar’s second-quarter 2024 US Stock Market Outlook. My name is Susan Dziubinski and I’m an investment specialist with Morningstar.com. The US stock market enjoyed a strong first quarter in 2024, advancing 10%. But inflation was stickier than some expected. In fact, the March CPI number that came out this morning was hotter than expected, too. And that’s leading many to question when the Federal Reserve will begin cutting interest rates. What should investors have on their radars as we head into the second quarter? Here today to share their outlooks for the markets and the economy are Dave Sekera, chief US market strategist for Morningstar Research Services, and Preston Caldwell, chief US economist with Morningstar Research Services. So, let’s begin.

Dave, over to you.

Dave Sekera: All right. Well, thank you very much, Susan, and welcome everybody to our outlook call here. I’m going to start today off talking about the US equity market valuation as compared to our fair value estimates as determined by our equity research team. I’m going to then roll into our sector valuations and identify some top picks. We’ll then talk about valuation by economic moat. I’ll then turn the presentation over to Preston. Preston will then provide his economic outlook. And then I’ll take the presentation back, talk about the mega-caps and our valuations there, and then roll it up with an outlook on fixed income. And then we’ll be happy to take as many questions as we can at that point.

First, let’s talk about the US equity market valuation overall. So, right now the U.S. equity market is trading at about a 3% premium to a composite of our fair values. And as a reminder, the way that we compile that is we take the intrinsic valuation of all the companies that we cover. That’s over about 700 companies that trade on US exchanges. And then we compare that to where they’re exactly trading in the marketplace based on their market cap.

So again, it’s a much different way of looking at valuation, I think, than what you’re going to hear from a lot of other strategists. So at 3%, I would say the market is not yet in overvalued territory, but it is starting to feel stretched here. In fact, since the end of March, I think we’ve been running out of momentum. And in fact today we did see a big drawdown in the market after today’s CPI print. And that really doesn’t surprise me when you start getting into these kind of areas when valuation is getting stretched like that. Specifically, if we look back at our valuations, the market has only traded at this much of a premium or more, only 14% of the time. And as what we saw in 2023, gains have remained pretty concentrated among some of the largest mega-cap stocks. And we’ll review that in a couple more slides.

But what we do see still today is that value stocks remain the most attractive category, whereas growth stocks are getting to be pretty well overvalued as compared to our valuations. And then I’d also note too that small-cap stocks still remain the most attractive part of the capitalization stack today, whereas large-cap stocks are starting to move into that overvalued territory. So, the rally thus far this year really supported by a couple of things. So one, earnings growth as the earnings came out last quarter. Generally, I’d say they were better than expected, but even more positively than that, we really didn’t see any wholesale decrease in management, reducing their guidance for the next quarter or for the full year. I think that gave the market a lot of confidence as well. But really at the end of the day, it was a surge in kind of all the obvious AI stock plays that really registered the greatest gains.

When I think about our valuations today, and I think about what’s worked over the past one and a half years, I don’t think that what’s worked over the past one and a half years is what’s going to work going forward. When I look at the “Magnificent Seven” stocks coming into the year last year at the beginning of 2023, six of those seven Magnificent Seven stocks were either undervalued or significantly undervalued coming into the year last year rated 4 and 5 stars. At this point, most of them are all rated 3 stars, meaning they trade within that fair value territory. In fact, Meta META has actually gone too far to the upside and is now rated 2 stars.

So, my view, I think now is a really good time to start looking for more contrarian types of plays. Specifically, we’re looking at what we’re calling the three U’s. Looking for those stocks that have underperformed, are unloved, and undervalued. Just taking a quick look at how the market has performed year to date through March 22. We’re up well over 9%. I think by the end of the quarter, we’re up over a little bit over 10%. The greatest of the gains came in the core sector but that was skewed by two stocks, skewed by Meta and Broadcom AVGO, two stocks that are a pretty decent percentage of the overall core portion of the market and both of those rising well into the double digits.

Growth also performed pretty well. When we look at the growth sector, I would just note that the technology sector contributed about 440 basis points of that overall gain. Then within the value index, financials registered 251 basis points of gains within the value index. The energy sector was a little bit over 100 basis points of that as well. Then when we look at the outperformance, by the large-cap sector, I would just note that the main contributor there was it is heavily overweighted in the technology sector.

Moving on here, just taking a look at how our valuations have played out over the course of the quarter since the end of last year. The market becoming a little bit more overvalued, going from fairly valued at the end of last year to that 3% premium. Again, not yet the area that I would call overvalued but starting to feel pretty stretched here. It was really those growth stocks that have become further overvalued, in our mind. I’m thinking about investment strategy today. I still think that being overweight value stocks is probably the right position to be. I think you can be market-weight core stocks as they’re pretty much trading in line with the broad market average. I do think that in order to pay for that overweight in the value category, I would look to underweight the growth sector.

Similarly, I do like small-cap stocks here. I think you can overweight the small-cap part of the market. In order to be able to do that, I would look to underweight the large-cap stocks. Depending on your portfolio, maybe a small overweight in the mid-cap space as well.

Year to date, returns have been very broad-based. Everything rose throughout the quarter except real estate. Again, real estate is probably one of the most hated asset classes on the Street today. It’s just those stocks and those sectors that were tied to artificial intelligence that really performed the best, both the communications as well as the technology sectors. Then I’d also note, too, that energy, we’ve been very constructive on energy for a number of months now. That definitely caught a bit in the last couple of weeks, last month or so. We are starting to see the energy sector perform very well. Real estate, the only sector with a loss. I’d also note, too, that the utility sector was the second-worst-performing. Really a couple of reasons, one of the reasons both of those sectors were either down or lagged this quarter is that they are negatively correlated with interest rates. As longer-term interest rates went up over the course of the quarter, that put a lot of pressure on the stocks in that area as well.

Just taking a look at market performance, just noting here, 10 stocks, a lot of these still include the Magnificent Seven stocks, although stocks like Tesla TSLA are no longer some of the larger contributors to the market return. But these 10 stocks alone contributed 62% of the total market return through March 22. Even within that, you have to highlight Nvidia NVDA due to its 90%-some gain and it’s high weighting within the index. That in and of itself provided almost 25% of the market return thus far this year.

But when I look at our evaluations today, I just have to note a lot of these stocks are trading at fair value. A number of these stocks now trading a little bit more into the overvalued territory. Some of the stocks like Meta going from 3 stars to 2 stars, stocks like Lilly LLY that we thought were already overvalued coming into the quarter based on just excitement about the total addressable market size for the weight-loss drugs that they provide, now going even further into overvalued territory. A lot of these stocks that are becoming even further overstretched and overvalued. We do think these are probably some pretty good times to start at least peeling off and taking some profits in those stocks, even if you don’t necessarily want to sell out of them altogether.

I’m going to skip over the next couple of slides here. I wanted to give a lot of extra time this quarter to Preston, just noting that we have seen inflation thus far this year probably coming in a little bit hotter than what the market has expected. I’ll let Preston really dig into not necessarily just the headline numbers but get into a lot of the underlying dynamics as far as why we’ve seen that and then what his expectations are for the remainder of the year.

Having said that, we still remain in the soft-landing camp. We’re still looking for the rate of economic growth to slow, but we still don’t expect to see a recession this year. I just note, too, I think what we’ve seen over the course of the past year and a half is that while we’ve been in that soft-landing camp the entire time, the market was definitely expecting and pricing into pretty high probability last year of a recession, which of course didn’t come. Now I think the market is probably even starting to go a little bit too much the other way.

A lot of people are now starting to talk about a “no landing” meaning that we’re not even going to be slowing down but that the economy is going to stay better than expected going forward. I think the market pendulum is probably swinging a little bit too much to the upside in that case. I’d just note again, a lot of these trends that we’ve seen, the artificial intelligence stocks, the better-than-expected earnings, I do think that some of these trends may revert. We do expect that we’re going to see slowing economic growth. That of course could pressure earnings growth over the next couple of quarters, but that may be then moderated by moderating inflation and our expectation that interest rates will probably start to decline later this year.

Moving on, sorry, we’re missing a couple of slides here. Here we go. Just showing our price/fair value and breaking it down by the individual market capitalizations. I would note here, it’s interesting to see over time, back in 2013, 2014, and 2015, how much those price/fair values were within a relatively small range of one another, but now we’re starting to see since the advent of the pandemic a big discrepancy in how those small-cap stocks have traded versus the large-cap stocks. I do expect that over time we’ll start seeing some more normalization as small-cap stocks and their valuations being as low as they are should start moving back up over time.

I do think we actually have a pretty good setup for small-cap stocks looking forward with interest rates coming down, with the Fed expected to start easing later this year and with the economy in that slower-growth mode but not recessionary mode. I think all of those factors, which really impacted small caps over the past couple of years should start getting eased in traders’ minds. I do think that we’re going to start seeing a lot more focus in that small-cap space going forward. And then similarly looking at value stocks versus growth and core stocks over time. Again, it’s interesting looking and seeing over time how much more closely those stocks traded on a price/fair value basis among one another but then seeing the dislocations caused here by the pandemic and as we get further and further away from those dislocations caused by the pandemic that we do expect to see value stocks continue to outperform based on their valuations going forward.

Let’s just turn really quickly to our sector valuations. The thing I would note here is that when we look at our star ratings throughout the entire coverage that we have, there are fewer and fewer 4- and 5-star stocks to pick. As the market is becoming stretched here, getting not in overvalued territory but above fair value, it is definitely harder finding some of these stocks that we think are undervalued. Just taking a look here at our individual sector picks, I would note that real estate is by far the most undervalued sector, trading at about an 11% discount from fair value.

When I think about our contrarian opportunities, I think real estate is probably first and foremost one of those areas that not, has only underperformed but a lot of negative market sentiment and a lot of areas that are undervalued, and we’ll talk a little bit more about some real estate picks going forward. The utilities sector, again, that got hit pretty hard last year, especially as interest rates were going up. People oftentimes use utilities as a fixed-income substitute. As they saw better rates as treasuries backed up and the corporate bonds looked more attractive, a lot of people rotated out of utilities into fixed income.

We think the market pushed them down just way too far last year. In fact, when I talk to our utilities team, I just note that fundamentally they still think that the utility sector, the outlook is as strong as they’ve ever seen, specifically thinking about the growth that they’re expecting over the next couple of years as we see more and more investment in renewables as well as more government investment into the infrastructure and the electric grid. Then lastly, just highlighting the energy sector, that was a sector that up until a month, a month and a half ago, there was a lot of negative sentiment there. We have seen a pretty good rally in the energy sector. In fact, if I look at our valuations today, we’re probably at fair value if not even maybe a touch above fair value. But I still see a number of stocks there. I really like having that energy in your portfolio, really to act as a natural hedge against potential inflation as well as geopolitical risks going forward.

Taking a look through our best ideas here, I do bold here, the new ones. This quarter from last quarter, so we do have Dow DOW. Dow is probably our new pick on trying to play a rebound in the commodity chemical sector. I think that’s an interesting one. We’re looking at Under Armor UA as really being a turnaround story here with new management coming in, making some changes to their product lines that we think will benefit that company over time. MarketAxess MKTX, a little bit of a turnaround story as well. MarketAxess is an online platform for trading bonds for institutional investors. Of course, with corporate bonds last year, seeing a very modest amount of new corporate bond issuance that really weighed on the amount of volume on their trading platforms. We do expect to see a more normalized amount of corporate bond issuance this year and next year, so that should be a good tailwind for that company.

Then U.S. Bank USB makes a return appearance to our list here, but that has probably been our go-to pick for the regional bank sector for at least the past year now at this point. A lot of new picks here in the economically sensitive sectors. Crown Castle CCI. So, for those of you that don’t know Crown Castle, it’s essentially a REIT that owns all of the wireless towers. We do think the investment in 5G will help provide a tailwind for that company. Warner Bros. Discovery WBD , probably one of our top picks in that more traditional media sector. We do expect to see some pickup in their streaming business.

Schlumberger SLB actually just moved into that 3-star territory, but it is still trading at a discount to fair value. That’s our pick among the energy sector for the services plays. TC Energy TRP, a Canadian company that we see as being significantly undervalued. A couple of other companies, Sealed Air SEE, Stericycle SRCL, being some other ones that I think now is a good opportunity for investors to do some due diligence, do their homework. Go to Morningstar.com or whichever Morningstar platform you use and read our analysts’ commentary on some of these other names.

Adobe ADBE, I think is an interesting play right now as well. The big hit on Adobe is that last quarter when they came out with their earnings and talked about their guidance, our analysts noted that he thought the guidance that they gave was kind of confusing to the marketplace. The marketplace does not like to be confused, so that stock sold off after that guidance. At the end of the day, Dan [Romanoff, Morningstar senior analyst] noted he really didn’t see anything fundamentally any different according to his long-term view. We are holding our fair value on that stock and do see this as an opportunity today.

Then lastly, STMicroelectronics STM, probably one of the very last and few plays that we see in the technology sector in that large-cap space. Just to round these up here with the defensive sectors, Kraft Heinz KHC. Again, it’s a no-moat company. As always, I like to exercise a little bit of caution, but even for a no-moat company, when you can buy at a pretty large margin of safety, we do see the company doing a lot in order to extract some efficiency costs in order to help provide some operating margin boosts over the next couple quarters. So, that is one that we do like in the defensive sectors. Then lastly, Duke Energy DUK. At this point, we just think that the company has a very good pathway to at least be able to meet, if not beat the management’s guidance today.

Then moving on to valuations by economic moat. Again, for those of you that might be new, what is an economic moat? That’s our rating for looking for companies that we think have long-term durable competitive advantages. Those companies that we expect over the long term will be able to outearn their return on invested capital over their weighted average cost of capital. Those are just one of the ways that we look at measuring the quality of that company over time. I note thus far this year, wide-moat stocks have outperformed. The Morningstar Wide Moat Composite Index up well over 12% as compared to the market. Wide-moat stocks are trading at a 4% premium, so they are getting to be not necessarily overvalued, but it’s harder to find much more undervalued opportunities there today. Narrow-moat stocks trading in line with our valuations. And no-moat stocks only trading at a 1% discount.

Again, not necessarily a screaming buy at this point. So, I would note that if you do wade into the waters of investing in any of those lower-quality companies that don’t have an economic moat, I would say make sure that you’re investing in those that do have a pretty wide margin of safety, especially if we go into an environment where we are expecting the rate of economic growth to slow over the next couple of quarters. I’m not going to go over all of these, but I do every quarter just highlight by capitalization different investment opportunities that we see for investors today. In this case, these are large-cap stocks. So, we do a rank ordering here looking for those with a wide economic moat with a Low or Medium Uncertainty.

So, Nike NKE and Starbucks SBUX being two new to the list this quarter. You’ll notice a lot of new ones here in the mid-cap stock space. Specifically, I had to change my screening this quarter because there were just so few wide-moat mid-cap stocks that were now trading at a 4- and 5-star level. So, I did expand the screen to include those narrow-moat stocks here as well. And then lastly, in the small-cap space, a couple of new picks here. This is one where I have always included the narrow-moat names here as well, just because you don’t see naturally as many companies in that small-cap space with a wide economic moat.

With that, let me go ahead and turn it over to you, Preston, and give us your US economic outlook.

Preston Caldwell: Thank you, Dave. Good morning, everyone. The slides today won’t be updated, obviously, for this morning’s inflation release, but I’ll give you plenty of commentary as pertains to that. You might be wondering how that release affects our forecast, and we won’t make a full update to our forecast for another week. But I can say, as far as the preliminary assessment, that I think the market’s reaction to the inflation release looks like an overreaction to me. Certainly, we’ll be making some minor calibrations, but I don’t think this totally changes the story of disinflation that we’ve seen over the last two years. I think it’s more of a temporary speed bump.

With that said, right now, we’re forecasting GDP growth to slow gradually over the next two years. Now, it’s true that last year in 2023, GDP growth accelerated even when very few people were forecasting that. The economy was proved very resilient to the effects of the Fed’s rate hikes, which were the largest rate hikes in 40 years since the early 1980s. But there are many factors, in our view, that propped up growth in 2023 that will fade in impact over the next two years. Additionally, I think there are many delayed impacts of Fed rate hikes that have yet to fully play out. Thus, we expect growth to eventually slow to 1.4% in terms of an annual average number in 2025, before accelerating again in 2026 through 2028 on the back of eventual Fed rate cuts.

Now inflation, we do expect inflation to essentially return to normal this year. Our latest forecast is 2.2% for full-year 2024. And again, obviously that will tick up just slightly just based on today’s release, but the story will remain essentially the same. And we’re expecting inflation to fall below 2% actually next year as we continue to see relief on goods prices from supply chain relief, supply chain improvement, and also just the impact of slowing GDP growth will help to cool off prices. And so even though we’re not expecting a recession in our base case, the fact that growth will be 1.4% in 2025 will cool off the economy because right now it appears that the potential growth rate in the economy, in other words, the expansion in the economy’s productive capacity, is running a bit higher than normal, maybe 2.5% or 3.0%. Productivity growth is doing very strongly right now. And so we’re definitely, if our forecasts play out, we’ll be entering a period of below-potential GDP growth, which is really all that’s needed to slow inflation. You don’t have to have an outright recession in order to cool off prices.

So, comparing our views to consensus just briefly on the, I’m sorry, somebody else on the call if you could stop clicking your mouse, so that would be great, please. In terms of review on views on real GDP growth versus consensus, we’re a bit pessimistic in the near term but ultimately on a five-year time horizon, we’re expecting a cumulative 2% more real GDP growth than consensus, and that’s owing to our view on the supply side of the economy, namely labor supply and labor force participation, especially. On the inflation front, we are expecting inflation to normalize, a light consensus, but we’re actually expecting inflation even to dip below the Fed’s 2% target in 2025 and 2026. And that view on inflation dipping below the Fed’s 2% target ultimately is a big reason why we expect a large drop in interest rates over the next several years with the federal-funds rate falling from a target range of 5.25% to 5.50% right now to a target range of 1.75% to 2.00% by late 2026.

In the near term, the drop in the federal-funds rate will really be driven by the Fed needing to normalize rates from currently restrictive levels, restrictive as it certainly is assessed by Fed members. Once the battle against inflation is won. And then as we go into 2025, I think the Fed will continue cutting even once rates move closer to neutral territory because inflation will be, we projected to have run below the Fed’s 2% target. and we project economic growth to be slowing and the unemployment rate to tick upward. And the Fed will want to nip in the bud any kind of emerging economic weakness. If it waits until a recession, until it gets glimpses of a recession, it will be too late. It will need to cut much more quickly than that.

And we think that it will because, if you look back in 2019, the Fed cut rates by 75 basis points quite quickly, even with the faintest whiff of a scare in GDP growth rates. So, I do think the Fed will move nimbly to recalibrate its policy despite how hawkish they’ve appeared over the last six months, let’s say. Ultimately, I think there’s a variety of reasons why rates will need to come down in order to sustain a healthy normal rate of economic growth. One I could point to is in the housing market where I do think much lower mortgage rates will be needed to not only sustain a housing recovery but even to avert a much larger housing downturn. I think many homebuyers right now are buying on the hope that they can refinance a few years down the line at a much lower mortgage rate. But if that hope evaporates because rates remain high, then I do think we’re in for another leg down in the housing market.

We saw real GDP growth strengthen in the second half of 2023, deploying at 3.4% in the fourth quarter. That was driven by a variety of factors, but consumption growth was strong at 3.3% in the fourth quarter. And that’s expected to continue somewhat in the first quarter, according to the Atlanta Fed’s GDPNowcast. They’re projecting 2.5% real GDP growth in Q1, driven mainly by consumption. We ultimately think it’ll come in a bit lower than that at 1.5%, but still, the year-over-year numbers remaining strong at about 3% year-over-year growth. But we think that, over the next several quarters that sequential quarter-over-quarter real GDP growth will drop down to about 1%, persisting all the way through early 2025. And you can see on the bottom chart that the trend number in terms of the year-over-year growth starts decelerating and hits a trough by early 2025.

And so, there’s a variety of factors that I think will weigh on growth over the next two years. Many of these, again, are related to the delayed effect of Fed monetary tightening. We see that credit growth is slowing rapidly right now. There’s also the depletion of excess savings among households. There’s the fact that we’ve had a huge manufacturing building boom over the last year incentivized by legislation promoting semiconductors and EV batteries. But that impact is plateauing. And also, government spending, the fiscal impact is going to run in the other direction over the next year, not only because of the federal government but also because state and local governments were spending down their surpluses over the last year.

Now state and local governments have pretty much gotten back to their prepandemic spending levels as a share of GDP, and so that further impact from higher state and local government spending will not add to growth over the next couple of years.

So, looking a little bit more detail in consumption, it’s interesting that, diving a little bit more into the data, while consumption growth has held steady, so far, if we look at the last three months and compare that to where we were in the fourth quarter, the growth rate is holding steady at 3.2% in the three months ending in February.

But we’ve nonetheless seen a large drop in goods consumption, which is reflected in the fact that retail sales have been very disappointing in the last couple of months. But that’s been more than offset, that’s been equally offset rather, by an acceleration in services spending. Now, one thing I will caution is that the source data the BEA [Bureau of Economic Analysis] uses for services data, especially in the early months, before in the preliminary release, before we get additional revisions to the data. That source data is not super high-quality, and there can be quite a bit of noise in that data. You know, certainly, in 2021 and 2022, it was understandable that services spending was going to grow at a high rate because of the fact that consumers were returning to their normal prepandemic spending patterns.

But that factor has mostly played out. So, this recent acceleration in services spending is really an anomaly. I wouldn’t expect it to persist over the course of 2024. So, if goods spending continues to remain weak, then overall consumption should slow in short order. A strong argument for this is certainly the fact that the household savings rate is very low. The personal savings rate has averaged just 3.9% in the past three months. So, that’s about 400 basis points below where we were before the pandemic in 2019. Consumers appear to still be spending down those excess savings that were accumulated during the pandemic. But depending on exactly how you estimate those excess savings they should be depleted sometime in the middle of this year, maybe early 2025 at the very latest. So, the imminent depletion of excess savings should weigh on consumption growth over the next year.

In terms of labor markets, looking at incorporating last Friday’s numbers, we’ve actually seen nonfarm payroll employment growth at 2.1% in terms of the annualized growth rate in the past three months. So, we’re running a little bit higher than the prepandemic growth rate, which averaged 1.7% in the years before the pandemic. I would say that growth is running at a brisk pace right now, but that doesn’t necessarily mean the labor market is overly tight because it appears we’re getting large additions to labor supply. That’s reflected in the fact that wage growth is continuing to trend down, which I’ll talk more about.

Now, it’s hard to break down exactly where this labor supply is coming from because most of the indicators in terms of labor force participation and so on that bear on labor supply come from the household survey. And the household survey is actually showing much weaker growth in employment recently than the headline nonfarm payroll numbers, which the nonfarm payroll numbers come from a separate survey, the establishment survey, which asks firms about their employment levels. So, there’s two different surveys that give these two different data points and they’re giving conflicting pictures right now on job growth.

Now, like most economists, we’ll tend to put most of our credence in the non-farm payroll numbers as being a higher quality data point, but we should acknowledge that the household, as you can see on the bottom chart, the household survey’s measure of employment is running much weaker. So, maybe the truth is somewhat in between those numbers, but on the other hand, what I’ll say is probably there’s a good reason to think that the household survey is undermeasuring immigration right now, and that undermeasured immigration is adding tremendously to labor supply, which is helping to keep labor markets cool, even though that hiring is continuing at a brisk pace. We are expecting, as I mentioned, the unemployment rate to tick up from an average 3.7% in 2023 to ultimately 4.4% in 2025, still remaining a bit elevated even in 2026 before coming back down as GDP growth recovers again.

Now, I’ll go ahead and move into inflation here. So, just diving into today’s report, we did have core CPI come in larger than expected this month, 0.36% month over month in March, that’s moderately exceeding the consensus expectations of 0.30%. Now, it’s interesting that if core inflation had come in a couple of hundredths of a percentage point lower at, let’s say, 0.34%, it would have rounded to 0.30% instead of rounding to 0.40%, and the headlines that we would have seen this morning would have been entirely different despite a statistically insignificant change in the numbers.

So, that just argues that we should be cautious about overreacting to these inflammatory headlines that we’ve seen. Certainly, the numbers did come in a bit higher than we expected, so we’ll be revising our forecast moderately, but I don’t think it’s time to panic on the inflation front. One reason why we had an upside surprise on inflation this month was shelter, which still remained fairly high at 0.4% month-over-month. I’ll talk more about that, but there’s still good reason to think that shelter inflation will come down sooner rather than later. And then in terms of core services excluding shelter, we saw a huge jump in motor vehicle insurance prices as well as motor vehicle maintenance and repair. Those two categories contributed alone about 0.1 percentage point to that month-over-month core CPI inflation.

So, with a normal rate of inflation in those two categories, it would have been a totally different number. Arguably, this increase in vehicle insurance and repair inflation represents still a delayed effect of the run-up in new vehicle prices that occurred over 2021, extending entirely to 2023. That’s obviously over now, and it does look like that, inflation in the insurance and vehicle repair categories has more than caught up to the increase in new vehicle prices. So, that would suggest that inflation in these categories shouldn’t remain high.

Also, very importantly, I would say, is that the CPI data is only important insofar as it feeds into the PCE Index. So, the PCE Price Index is the one, well, it’s an intrinsically superior index. It’s also the one that’s preferred by the Fed, crucially. So, the PCE Price Index uses different source data for motor vehicle insurance and also for the health insurance components, which health insurance also ran a bit high in March in the CPI. So, tomorrow we’ll get the Producer Price Index data, and that’s actually going to be very important for what core PCE posts for March. It’s quite likely that core PCE for March posts at about 0.20% to 0.25% month over month. So, that’s going to be much milder than core CPI. We’ll have to see what the exact number is, but it’s very likely going to be much lower. There’s been a large wedge between the CPI and the PCE because of these differences in source data recently, as well as the fact that the PCE Index has a lower weight on shelter, or housing.

In any case, I would say that, if you step back, the overall narrative on inflation hasn’t changed all that much in recent months. So, it’s still the case that core PCE inflation excluding housing is running at a 2.1% year-over-year growth rate as of February and likely as of the March data. So, core inflation, core PCE inflation excluding housing, has essentially returned to normal. Now, you can ask why is it legitimate to exclude housing? Well, just, skipping ahead here, we know that housing is giving us a rearview mirror perspective. So, in this chart here, we show the housing component of the CPI and also the PCE index compared to a composite of market rents coming from Zillow and Apartment List and CoreLogic.

And the difference here is that this purple line measures rents for tenants signing new leases. So, people going out and moving to a new apartment, whereas the teal line, which is the inflation index for housing, is a sample of all tenants, whether they sign a new lease in a given period or whether they move to a new property in a given period or not. So, the housing component of inflation is still responding with a lag with respect to the runup in market rent growth that occurred in 2021 and 2022. Now, as the gap between those two narrows, the pressure upward on the housing component of inflation will diminish. And market rent growth was just 1.7% year over year as of January 2024. So, that’s actually a little bit below normal. All of that suggests that housing inflation should fall back to normal over the next year. Exact timing has been uncertain, but even in the BLS’ own data as we tease into it, it looks like that presages a fall in housing inflation based on where market rents are going.

So, housing is really the last shoe to drop on inflation. The other big contributor, obviously, is wage growth, which is important across the board, but especially for core services excluding housing. Our composite measure of wage growth was 4.7% year-over-year in the fourth quarter of 2023. That’s still a bit higher than consistent with the Fed’s 2% inflation target. Based on our productivity growth assumptions, we believe that 3.5% wage growth would be consistent with the 2% inflation target. So, we’re still about 120 basis points above a wage growth rate that’s consistent with the inflation target. But that’s not a huge discrepancy. And combined with the fact that we’re still seeing supply chain relief and, most importantly, with the fact that the slowdown in the labor market that we anticipate over the next year should put further downward pressure on wage growth over the next year or two, that should be sufficient to help bring core inflation back to normal over the next two years.

So, with that, I spent more time on inflation than I anticipated. One thing, sorry, I’ll just go ahead and add on our views on monetary policy. So, we are expecting the federal-funds rate, as I mentioned, to drop faster than the market anticipates. So, we are expecting the federal-funds rate to, by late 2026, fall to below 2%, which is almost 200 basis points below what the market is expecting. Now, as I mentioned, that’s based on our views on inflation coming down further than the market expects, as well as unemployment rate, the unemployment rate rising a bit higher and GDP growth slowing a bit more than the market expects.

Now, I do think the market has overreacted in response to today’s inflation reading. We saw the two-year Treasury yield jump by 19 basis points this morning. So, that’s essentially taking one rate cut off the table and not only delaying it, but taking it off the table entirely for the next two years. I think that’s too big of a probability shift. I would say if core PCE comes in at 0.2% month over month for March, which is still quite possible, a rate cut for June by the Fed is still more likely than not. If core PCE inflation for March comes in more like 0.25% month over month or a bit higher, then probably a rate cut will not come in June. But it’s not accurate, I think, to totally take it off the table at this stage.

So, there’s some other material I didn’t cover, just given the change in plans this morning, but we could hit it up in the Q&A. So, if there’s anything I didn’t cover that you’re curious to hear about, please ask away in the questions. Otherwise, I’ll kick it back over to Dave.

Sekera: Great, thank you Preston. I really do find it an interesting takeaway that you noted that two tenths of 1% actually could have been the difference between how the market reacted to today’s CPI print. Again, we’re running a little bit longer than I think what we were originally expecting. I’m going to run through these slides pretty quickly.

So, taking a look at mega-cap stocks specifically and how they’ve performed. So, I’d note that those stocks that we outlined at the beginning of the year that were trading at a pretty large margin of safety have generally traded pretty well over the course of this year. So, when we’re now taking a look at which mega-cap stocks—so again, those stocks that have $200 billion in market cap and higher—that are undervalued, there’s only four at this point, Adobe being the only new addition to our list. And then as far as the overvalued mega-cap stocks, a lot of these were overvalued coming into the year that we now think are even getting further overvalued. We talked about Eli Lilly a little earlier in the call, but a number of other names here that are getting further and further into that overvalued territory, and only a handful of them have pulled back in the face of the rally thus far this year.

And then taking a look at our new updated list of overvalued mega-caps, a number of new names. Meta probably being the one that’s the biggest addition to the list this quarter, and even companies like AMD, which we do think that over time AMD will be a strong number-two competitor to Nvidia in the GPU space for AI, but again, in the short term, we think the market is getting overextended at this point. And I’m just going to wrap things up with our fixed-income outlook for the second quarter.

So, what we’ve seen thus far this year is that we have had a pretty decent backup in long-term Treasury rates that has put a lot of pressure on the bond prices, as yields go up, those bond prices go down. So, the core bond index, I think if we look at it at the end of the quarter, it was actually down a little bit over 1%. Essentially what happened is that the decline in those bond prices as yields went up was more than enough to offset the amount of yield carry that you got over the first quarter. I’d also highlight, the corporate-bond market, so investment-grade bonds, also down slightly here in the first quarter.

And a lot of that was just due to the long duration of the corporate-bond index because if you look at the high-yield bond index, much lower duration, less sensitive to interest rates, actually was still able to post a gain thus far this year. Thinking about what we expect for interest rates, going forward, looking at the US 10-year to average 4% over the course of this year, continuing to come down in 2025, averaging 3% next year. I do think that as interest rates are going up here in the short term, it’s a good time to continually to lengthen out the duration of your bond portfolio. I’d say pick your spots and as rates back up, continue to add from the shorter-duration to the longer-duration part of your portfolio. And depending on the type of investor you are, either you can lock in those higher rates or conversely when interest rates do start coming back down and those bond prices start moving back up, then you have the ability when you move back to a shorter duration to lock in some of those profits.

And then lastly, I would just say this is probably my biggest change in my outlook for the corporate-bond market in a number of years. We’ve been overweight. We thought that corporate credit spreads for the past couple of years, were attractive for the amount of, corporate credit risk that you were taking. Beginning of this year, we moved from an overweight to a market-weight recommendation. At this point, I think you need to move to an underweight in corporate bonds, both investment-grade and high-yield. When we ran the numbers here on March 22, the investment-grade index was trading at only 86 basis points over Treasuries. High-yield was only 302 basis points over Treasuries. At this point, I just don’t think that you’re getting paid any more for the downgrade risk or for default risk going forward.

And when I look at these, over the past 24 years, I would note, only 2% of the time have investment-grade bond spreads been this tight or tighter. And over that same time period, only 3% of the time have high-yield spreads been this tight or tighter. Putting that into perspective, on a long-dated chart, with that red line at the bottom showing where we are today. I mean, to some degree, you’ve got to go all the way back to before the credit crisis, in 2007, to see credit spreads get any tighter than where we are today. So again, I do think it’s a good time to take profits.

Dziubinski: Well, I’d like to thank Dave and Preston for their time today. And, of course, thank everyone for joining Morningstar’s second-quarter 2024 US Stock Market Outlook Webinar. We hope you’ll join us again next quarter. Happy investing.