To say that the S&P 500 has had a good year feels like somewhat of an understatement. On June 17, the index hit its thirtieth record closing high in 2024 alone. As of that same date, the index was up nearly 15% for the year, on top of gaining 24% in 2023. And yet, all this good news still begs two questions: How much higher can markets go, and how much of a financial cushion is in place if things start to go sour?
Certainly, one of the factors that will impact financial markets in the third quarter is economic growth. Although first-quarter gross domestic product (GDP) was lower than what we experienced in the last six months of 2023, the job market has remained relatively strong, which has supported U.S. consumers, even as they're contending with a higher cost of living and inflation. Yet some weakness in the job market has been starting to show, as the number of job openings having been coming down and weekly jobless claims have been inching higher. As the gap between labor demand and supply continues to close, that should help bring inflation down—but also slow down growth. After all, any weakness in the job market also impacts consumers' incomes and spending, which is the backbone of U.S. economic growth.
Presidential election likely to be good for financial markets
Meanwhile, federal spending has been buoying economic growth, even as the Federal Reserve has been purposely trying to slow growth by maintaining high interest rates. And there's the election to consider. Presidential election years where an incumbent is running for reelection tend to be good for economic growth—and, consequently, good for financial markets—because the incumbent does everything he can to maintain economic growth and keep financial markets stable. In fact, since 1944, the S&P 500 total return has been positive in election years where an incumbent has been running. In President Biden's case, he may authorize the release of Strategic Petroleum Reserve (SPR) oil to help keep gas prices down. He may also increase short term liquidity, drawing down the Treasury General Account to put more cash into financial markets. In either of those cases, such a move would be positive for financial markets on top of the broader positive trends, such as the still-relatively-strong job market.
Source: Strategas - Macro Institutional Research & Advisory Brokerage Firm
Little financial cushion in place
Yet even with resilient-but-moderated economic growth supporting financial markets, the question of how high markets can go in the short term is still lingering. On the equity side, much of the S&P 500's gains have been due to the performance of the "Magnificent 7" technology stocks and excitement over developments in artificial intelligence (AI). With this concentrated performance in the large cap index, overall market multiple valuations are skewed to high levels. Meanwhile, on the bond side, credit spreads are near the tightest level they normally get, which means that investors are confident in a strong economic outlook and assess less risk of corporate defaults.
Still, there is a potential downside within all this positivity. What if we all have it wrong on inflation and the Fed has to restart a rate hiking cycle? What if U.S. corporations finally buckle under the weight of the higher for longer interest rates?
Unforeseen things can and should be expected to happen as they always do when managing investments in volatile global financial markets. It's a reminder to rebalance broadly diversified wealth portfolios by trimming winning segments to avoid concentrations that could potentially derail long term objectives if the market turns.
Right now, the Federal Open Market Committee (FOMC) is still projecting at least one rate cut this year. When the Fed does cut rates, it will be more of an adjustment to existing policy, rather than an about-face. Unless there is a major economic slowdown, which seems unlikely at this point, the rate cut will probably be in a small increment, which means that there will be very little impact to financial markets or economic growth from the single rate cut itself.
And what would happen if the Fed doesn't cut rates in 2024 after all? Equity markets can continue to go higher, even if rates stay where they are. One of the lessons that this rate-hiking cycle has taught is that economic growth can continue and external factors such as excitement over AI can drive stocks higher—even in a high-rate environment. However, just how high remains to be seen.
