Bull market or bull trap?

Global equity markets finished the calendar year on a euphoric note as the US Federal Reserve held off on further rate hikes. This pause released a pressure valve on stock valuations as interest rates have been a key driver of market direction in recent times.

Source: FactSet

When the Fed pauses it often correlates with market cheers. However, history highlights that some caution is required. Since the late 1970s, there has been six hard landings following Fed pauses, compared to just three soft ones.

Source: Piper Sandler

So, will 2024 succumb to the historical prevalence of hard landings, or is there something unique about this economic cycle that could defy the odds and deliver a soft landing?

One key anomaly is the surprising resilience of US borrowers to rising rates. Unlike past cycles, higher rates have not led to a proportionate increase in interest payments. This suggests a potentially "broken" monetary transmission mechanism, where rate hikes aren't translating into the usual profit headwinds.

Source: Barrenjoey

Another twist is the robust US consumer, buoyed by a tight labour market. Traditionally, a slowing economy tends to push the unemployment rate upwards. But in this unusual cycle, job openings have reduced without a significant rise in unemployment.

These anomalies of low interest payments and resilient consumer have supported corporate earnings over the last couple of years. In fact, the S&P500 has also begun to exhibit some earnings growth recently. However, it has been driven by a handful of mega-cap giants as the top 10 stocks by market capitalisation now account for more than 30% of the benchmark. A more accurate reflection of the market, represented by the equally weighted S&P500, has not enjoyed the same earnings revival.

Source: FactSet

Both the US and Australian stock markets have been stuck in a trading range for a while now, reflecting the plateauing of corporate earnings since the post-pandemic rebound. This stagnation highlights its anchor to flat corporate profits. While in the short term, interest rates have been the key driver of short term market fluctuations. The stock market surge in the final month of the year meant that the PE multiples of both the US and Aussie markets expanded without the confirmation of rising earnings.

Source: FactSet

The excitement surrounding the Federal Reserve's dovish pivot ignores a crucial reality, it may not be enough to boost corporate profits. For many US borrowers who enjoyed temporary immunity to rising rates, the looming wave of debt refinancing will bring them face-to-face with a new, high-interest world.

For instance, if a BBB-rated company refinanced debt from 7.4% in 2021 to 13.6% currently it means interest payments would increase by more than 80%. If we conservatively assume 8 rate cuts by the Fed or 2% reduction in interest rates it still means interest cost still rise by more than 50%. Only a massive, COVID-era rate reduction back to 2021 levels could safeguard corporate profitability.

With a wall of debt maturities approaching for many companies, revenue growth must take centre stage if profits are to be sustained. Failure to achieve this may trigger workforce reductions, further dampening economic prospects. Typically, there is a strong correlation between corporate earnings prospects and the health of the job market.

Source: Variant Perception

In addition, cracks are beginning to appear for the seemingly robust consumer. Credit card utilisation rates is at their highest in a decade, which highlights that excess savings from the pandemic stimulus checks are depleted. Rising delinquency rates is ringing alarm bells on the health of the consumer. Job losses could further stress this already vulnerable consumer base.

Conclusion

Interest rates have climbed at historic speeds, but corporate profitability has surprisingly held steady. The Fed’s recent pause on hikes has ignited a celebratory fire in the stock market. Could this be the dawn of a new bull market? The good news is that the valuation impact from rapidly rising rates is now more subdued. However, the earnings outlook remains shrouded with uncertainty. Many companies have not yet navigated the treacherous waters of refinancing their “once in a lifetime” ultra-low interest rate debt. Poor earnings prospects could lead to more job losses and squeeze the consumer further. Only time will tell if corporations can overcome these hurdles, but, if earnings falter then the current stock market rally is a bull trap.