Investors eye Fed rate cut, earnings as key to sustaining market rally

NEW YORK (Reuters) – After an impressive start to the year for stocks, investors are bracing themselves for potential challenges in the second quarter as they assess whether the Federal Reserve will deliver an anticipated interest rate cut by June and shift their attention to upcoming earnings reports.

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The S&P 500 concluded the first quarter with a gain of over 10%, marking its largest first quarter advance since the nearly 13.1% surge in the first quarter of 2019. While stocks like chipmaker Nvidia (NASDAQ:NVDA) and Facebook parent Meta Platforms (NASDAQ:META), known as the Magnificent Seven, led the gains for the quarter, economically-sensitive sectors such as energy and industrials have rallied in the past six weeks.

The continuation of this rally into June is likely contingent upon the actions of the Fed, which has yet to indicate that inflation has sufficiently receded to warrant a rate cut. At the start of January, the markets priced in 6 to 7 rate cuts over the course of 2024, but that number has now reduced to 3 following signs of resilience in the US economy, bolstering investor confidence in a so-called soft landing.

Joe Kalish, Chief Global Macro Strategist at Ned Davis Research, remarked, “The market and the Fed are finally aligned on expectations, but that puts even more pressure on every economic report that comes out because it doesn’t take a lot to make everyone run the same way. We are expecting more volatility if we don’t see more progress on the inflation front.”

According to CME’s FedWatch Tool, futures markets are now implying a 61% chance of a 25 basis point rate cut at the Fed’s policy meeting concluding on June 12, which would bring benchmark rates to a range of 5 to 5.25%.

Jason Alonzo, a portfolio manager on Harbor Capital’s multi-asset strategies team, predicts that sustained economic growth in the US will further broaden the market rally into cyclical sectors and small-cap stocks as investors seek more appealing valuations. The Russell 2000 index of small-cap stocks closed the first quarter with a 4.8% gain, while the S&P 500 industrials sector surged by nearly 11% during the same period.

“If the Fed remains in control despite a potential re-acceleration of the economy, that’s all the market cares about right now,” Alonzo stated. “However, any indication that rate hikes are back on the table could disrupt investor sentiment and pose a real challenge for all assets.”

Upcoming economic indicators, including ISM manufacturing data, ISM services, and the non-farm payrolls report, are expected to shed light on the state of the economy. Economists polled by Reuters anticipate a growth of 198,000 jobs in March.

Sam Stovall, chief investment strategist at CFRA Research, cautioned that investors should not be surprised if the market rally slows down as the Fed approaches a potential rate cut. He noted that historically, the S&P 500 has seen an average gain of 15.5% between the last rate hike of a cycle and the first rate cut, compared to an average gain of just 5.4% in the six months following the first rate cut.

However, Keith Lerner, Co-Chief Investment Officer at Truist Advisory Services, remains optimistic, stating, “The market deserves the benefit of the doubt and at this point we think bull market rules apply.” He highlighted that out of the 11 times the S&P 500 posted a total return of 10% or more in the first quarter, the market continued to advance in the second quarter 9 times, with an average gain of 6.2%.

Emily Roland, Co-Chief Investment Strategist at John Hancock Investment Management, emphasized the importance of corporate earnings in determining the market’s direction. She noted that robust earnings in the last quarter of 2023 helped propel the S&P 500 to record closing highs despite shifts in interest rate policy. With analysts expecting a 5.1% earnings growth over the first quarter, corporate earnings reports in the second week of April will be closely watched.

“If earnings continue to surpass expectations, the Fed may find it difficult to justify 3 rate cuts this year,” Roland said. “However, if we observe a stabilization of inflation, this economic re-acceleration could evolve into something more sustainable.”