Investors received a dose of optimism recently as the Federal Reserve’s preferred measure of inflation, the core Personal Consumption Expenditures (PCE) price index, fell to a new cycle low in May. The core PCE increased just 0.1% last month, leading to an annualized rate of 2.6%—the lowest since March 2021. Despite this positive development, Fed officials remain hesitant to fully acknowledge the progress in lowering inflation, fearing it might spur excessive investor enthusiasm for risk assets, which could counteract their efforts to manage economic stability.

The Core PCE Index and Fed Hesitancy

In May, the headline PCE remained unchanged, while the core PCE, which excludes volatile food and energy prices, rose by 2.6% over the past year. Notably, the supercore services index, which excludes housing, recorded the smallest monthly increase since August of the previous year. This data should prompt the Fed to start normalizing monetary policy, potentially with a rate cut in July, but a more likely scenario is that they will wait until September.

Fed officials have been reluctant to fully embrace the disinflation trend publicly, maintaining a hawkish tone in their communications. This was evident in the June update to the Summary of Economic Projections, where the Fed raised its year-end target for core PCE from 2.6% to 2.8%, despite no substantial changes in economic growth or unemployment projections. This cautious stance appears aimed at tempering investor excitement and mitigating the risk of asset bubbles driven by the wealth effect.

Market Expectations and Economic Indicators

Chairman Powell seems aware of the progress made in controlling inflation and the potential for further disinflation as lagging indicators like shelter and insurance costs adjust. Recent economic reports indicate weakening consumer spending, a softening labor market, and a stagnant housing market—all suggesting the need for rate cuts to prevent a sharper decline in economic growth during the latter half of the year. The market is already signaling this shift, with 2-year Treasury yields dropping to 4.69% and likely heading towards 4.5%, reflecting expectations of at least three rate cuts by year-end.

Historically, changes in interest rate policy have a delayed impact. Powell acknowledged that the Fed delayed too long in raising rates in 2022, only starting when the core PCE had peaked. Similarly, the Fed should not wait until core inflation hits the 2% target before easing policy. The upcoming months are crucial for the Fed to begin its rate cut cycle to stimulate the economy effectively.

Market Performance and Anticipated Pullback

Despite significant returns for the S&P 500 and Nasdaq Composite in the first half of 2024, the broader market performance has been less impressive. The equally weighted S&P 500 rose only 4.1%, and the Russell 2000 gained just 1%. The surge in major indexes was driven by a handful of mega-cap technology stocks, fueled by excitement over artificial intelligence (AI). These companies, with robust cash flows and minimal borrowing needs, are seen as resilient to economic uncertainties like high interest rates and slowing growth.

However, this narrow rally raises concerns about sustainability, suggesting a market pullback is likely as profit-taking occurs among tech leaders and uncertainty grows before potential Fed rate cuts. This anticipated volatility could lead to increased market fluctuations and a broad pullback, setting the stage for a healthier market in the second half of the year.

Economic Resilience and Future Outlook

Despite some signs of economic stress, consumer spending rebounded in May, with real (inflation-adjusted) spending growth over the past year at 2.4%, supporting long-term economic growth. This resilience in consumer behavior, which accounts for about 70% of economic activity, indicates a stable economic expansion, alleviating fears of a significant downturn.

The core rate of inflation showed renewed disinflation in May, falling from 2.8% to 2.6%. If this trend continues, it could prompt the Fed to begin its rate cut cycle by September, easing concerns about economic growth. Historically, a strong first half performance for the S&P 500 bodes well for the second half, with average returns of 7.7% and minimal drawdowns.

Strategic Shifts and Long-Term Expectations

Given the current market conditions, a modestly defensive asset allocation strategy is prudent, anticipating a pullback to refresh the uptrend. The overbought technology sector, with its high valuations, is likely to see a correction. However, today’s tech giants have strong fundamentals that should support their valuations in the long term.

Small-cap stocks, which have struggled due to higher borrowing costs and recession fears, stand to benefit significantly from monetary policy easing. If the Fed manages a soft landing, small-cap stocks could experience a robust recovery, as they did in the fourth quarter of the previous year. Valuations for profitable small-cap companies remain attractive compared to their large-cap peers, presenting potential investment opportunities.

Conclusion

The stock market faces mixed signals, with strong gains in major indexes driven by a narrow tech rally and broader economic indicators suggesting resilience. As the Fed navigates its policy decisions, potential rate cuts could shift investor focus from inflation to economic growth, leading to a sector rotation and sustained bull market. Investors should remain cautious yet optimistic, positioning themselves strategically to capitalize on future market opportunities.