Hopes for a “soft landing” are fueling a stellar stock market rally. Why the US economy is still not out of the woods.

By Isabel Wang

Weakness in the U.S. consumer sector is a canary in the coal mine for the economy, say strategists at Merrill and Bank of America Private Bank

A rally in U.S. stock and bond markets last week defied bears and raised hopes of further gains through the end of the year and into 2024, as Wall Street embraced the idea that the economy would have a “soft landing” after that. will create a series of interest rate hikes by the Federal Reserve.

But market skeptics are alerting investors that the “soft landing” scenario is still at risk as consumer spending and job growth, as well as corporate profits, slow.

“The stock market is misguided,” Josh Schachter, senior portfolio manager at Easterly Investment Partners, said in a phone interview with MarketWatch. “Markets are behaving almost bipolar – some asset classes like bonds BX:TMUBMUSD10Y, oil (BRN00) and dollar DXY are priced for a recession, while other assets like stocks and Bitcoin (BTCUSD) are priced for risk.

U.S. stocks extended November gains last week, with the S&P 500 index SPX ending at a new 2023 high on Friday and the Dow Jones Industrial Average DJIA posting its fifth week in the green. The stock market rally was driven in part by bond investors becoming convinced that the Fed is done raising interest rates and will likely cut them in the first quarter of 2024.

Meanwhile, the narrative that a robust labor market and stronger-than-expected economic growth should keep recession at bay has gained traction, reinforcing the “Goldilocks” scenario for financial markets.

See: These two leading indicators suggest a recession has already begun in the US, according to Wall Street's favorite permabear

But there are signs that consumer spending, which accounts for about 70% of U.S. economic output and has boosted the economy this year, is likely coming to an end after the post-pandemic recovery. Credit card and auto loan default rates are rising, student loan payments have resumed, consumer spending is weakening and there are warnings from top retailers.

Joseph Quinlan, head of CIO market strategy at Merrill and Bank of America Private Bank, said the “softness” in the U.S. consumer sector was visible but not major, calling it “a canary in a coal mine,” he told MarketWatch via telephone on Thursday.

The decline in consumer spending is welcome news for Fed officials, who have raised interest rates 11 times since March 2022 to bring inflation back to their preferred 2% target. But some analysts worry that high interest rates and a decline in pandemic-related savings could ultimately lead to even weaker consumers in 2024, potentially another sign of a long-predicted slowdown in the U.S. economy.

“One of the things I'm most concerned about is consumers' ability to continue to drive the economy forward – there are several headwinds that haven't really panned out yet,” said Jason Heller, senior executive vice president at Coastal Wealth. “Does the consumer continue to behave the way they have behaved over the last 36 months? I think at some point there will be a slowdown in consumer spending, which will lead to a slowdown in the job market.”

Lauren Goodwin, an economist and portfolio strategist at New York Life Investments, acknowledged that a slight slowdown in inflation and job growth could mean that an “emergency Fed rally” in stocks could be sustained, but she fears that state of limbo will continue The past is a “Goldilocks” moment before the real reason for the moderation in inflation – the slowdown in economic growth and employment – ​​becomes clear in the data.

See: “We’re still facing a pretty hard landing,” says former Treasury Secretary Larry Summers

That's why the November jobs report, due out next Friday at 8:30 a.m. Eastern time from the Bureau of Labor Statistics, will be crucial for investors. The U.S. is expected to add 172,500 jobs in November, up from 150,000 the previous month, according to economists surveyed by Dow Jones. The share of unemployed Americans looking for work is expected to remain flat at 3.9%, reaching its highest level since early 2022.

See: U.S. job growth gains traction in the week ahead

In fact, nonfarm payrolls release days were among the most volatile for stocks in 2023, compared to the monthly consumer price index release, which drove some of the biggest daily ups and downs for the S&P 500 and other major indexes in 2022 .

See also: Are CPI days still shaking the stock market? How 2023 compares to 2022

According to figures compiled by Dow Jones Market Data, the S&P 500 recorded an absolute average percentage change of 1.12% on employment release data this year, compared to an average percentage change of 0.64% on CPI days.

However, analysts are skeptical that the employment data can tell “a completely different story” but expect the labor market to remain relatively tight through 2024, Quinlan and Lauren Sanfilippo of Merrill and Bank of America Private Bank said in a telephone interview.

See: What the S&P 500 Predictions for 2024 Really Say About the Stock Market

Too much optimism about earnings growth in 2024

Corporate America and its stocks tell investors a different story about the next year.

With average S&P 500 earnings growth estimated at 11.7% next year, the U.S. stock market is far from affected by recession fears, Heller said. “We have this [the stocks] We have priced in pretty significant growth in 2024.”

Strategists at Merrill and Bank of America Private Bank expect the S&P 500 to deliver “mid-single-digit” earnings growth in 2024 as earnings bottom out and the economy falls back to 2% real growth levels will after high interest rates limit consumer spending and corporate profits and cool a red-hot economy.

Of course, Wall Street analysts tend to overestimate earnings per share (EPS) for the S&P 500, said John Butters, senior earnings analyst at FactSet.

The current bottom-up EPS estimate for the S&P 500 in 2024 is $246.30. If true, it would be the highest EPS number reported by the large-cap index since FactSet began tracking the metric in 1996.

However, over the past 25 years, the average difference between the beginning of the year EPS estimate and the actual EPS number has been 6.9%, meaning analysts have, on average, overestimated earnings a year in advance, Butters said a statement from Friday (see table below).

-Isabel Wang

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03/23/12 1201ET

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