By Tim Courtney, Chief Investment Officer
As we transition into the next quarter, our focus remains on three pivotal areas of the market: interest rates, valuations and earnings. Below, we examine how each of these facets intertwines with the other to paint our broader economic picture.
Interest Rates. Lately, the market hasn't been paying much attention to changes in interest rates, which is a major shift from the market’s obsession with them in 2022 to mid-2023. Despite this change, we're still keeping an eye on them. Why? Because inflation is sticking around—prices have gone up 18% over the last three years1 and they're not dropping.
It’s also an election year, which adds another twist. Politicians typically prefer low interest rates because it makes it cheaper for the government to borrow and spend money, while investors want low rates because it can make assets like stocks more valuable. However, if rates are cut too much, it could backfire by causing inflation to spike.2 In 2021, low rates were fun for a while because they helped boost the economy, but when inflation jumped, it wasn't so fun anymore. So, while the market might not be focused on interest rates right now, we will continue to watch them closely.
Valuations. Most of the global market appears reasonably valued. However US large caps, particularly US mega caps, look expensive. With the S&P 500 trading at a 30% premium relative to the last two decades' average3, this valuation surge is primarily driven by a select group of mega-cap tech companies, within an even smaller subset of companies with exposure to AI pushing valuations to extreme heights. This mania has significantly influenced market cap weighted indexes like the S&P 500 as opposed to other weighting strategies like the S&P 500 Equal Weight which is close to normal valuations. It’s too soon to tell if AI can deliver and what the benefits will be. So far, benefits have been relatively few considering to the massive amount of capital that has been poured into the space. We’re keeping a close eye on what happens next.
Earnings. Ultimately, the justification for these high valuations hinges on earnings performance. As we look at the first quarter's earnings reports, we want to see if companies are growing at the speed of their valuations, especially in sectors like tech and AI. The backdrop of 2021's earnings, buoyed by zero percent interest rates and stimulus spending, serves as a reminder of the need for growth to sustain current market levels.
In summary, our attention to these areas—interest rates, valuations and earnings—will be critical as we move into the next quarter of the year. Our investment approach will be informed by these factors, enabling us to adapt to evolving market conditions and prices. The election and potential tax law changes will also play a role in markets as well, and we’ll look into these in coming quarters. If you have any questions, please contact your Exencial advisor.
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