Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. The stock market is racking up records. I’ll talk with Morningstar Inc. markets reporter Sarah Hansen about the four reasons why that’s happening. Plus—Another cryptocurrency will venture into the mainstream. What you need to know about spot ether ETFs before investing. And, all eyes on the Fed. Morningstar’s senior US economist weighs in on the latest message from Fed Chair Jerome Powell. This is Investing Insights.
Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.
Should You Invest in Spot Ether ETFs?
The market debut of spot ether ETFs remains unknown despite clearing their biggest hurdle to trade. The Securities and Exchange Commission made a surprise move. It approved proposals for the first spot ether ETFs in the US last month. It’s the first cryptocurrency ETF to receive such approval since spot bitcoin ETFs burst onto the scene in January. Bryan Armour is the director of passive strategies research for North America for Morningstar Research Services. Armour says spot ether ETFs will directly hold ether. It’s the cryptocurrency that supports the ethereum blockchain and the second-largest crypto behind bitcoin. Spot ether ETFs will be set up as grantor trusts like spot bitcoin ETFs. That means investors will own a share of the ether held by the trust. Many of the asset managers of spot bitcoin ETFs are approved to offer spot ether ETFs. The list includes Fidelity, iShares, and ARK 21Shares. Unlike bitcoin, holding ether directly could hold a meaningful performance edge over spot ether ETFs for investors willing to engage in staking. However, ether is also highly volatile. Armour says investors should only invest as much as they are willing to lose.
Lululemon on Track Despite Slowdown in Americas
Lululemon has raised its 2024 earnings outlook. The retailer’s fiscal first-quarter results surpassed the previous forecast and Morningstar’s expectations. It lifted its earnings outlook to range between $14.27 to $14.47 for the year. Despite the increase, Lululemon has seen a slowdown in the Americas. Q1 sales growth in the region fell well below Lululemon’s typical double-digit rates. Strong bag sales over the past year may have masked a slowdown in leggings. Morningstar thinks competition in this core category is intensifying. But Lululemon still had strong sales growth elsewhere. Sales rose 45% in mainland China and 27% in the rest of the world. There are likely more opportunities for the retailer to expand overseas. The stock appears fairly valued.
The Fed’s Inflation Outlook Is a Little Too Pessimistic
And then there was one. The Federal Reserve is projecting they’ll trim interest rates only once in 2024 instead of three times. The announcement followed the same-day release of the May Consumer Price Index report that signaled inflation is easing. But is the Fed’s forecast for interest-rate cuts too cautious? Morningstar Research Services’ Senior US Economist Preston Caldwell is here to share his insights.
Thanks for joining me, Preston.
Preston Caldwell: Thanks for having me, Ivanna.
Good News From the Fed’s New Inflation Report
Hampton: So, let’s start with the new inflation report. Why was it considered good news? And where is inflation still proving sticky?
Caldwell: After a rough beginning to 2024, it was really a breath of fresh air. So, core CPI was 0.16% month-over-month. And then that means that later this month when the core PCE data comes out—the PCE is really the final word as far as inflation goes—that probably core PCE inflation will be 0.1% month-over-month. So, we don’t want to overreact to one month’s data, but even zooming out for broader context, it looks like core PCE over the last three months will be averaging about 2.8% annualized. So that’s a pretty improved state compared to where we were in the three months ending in March of this year when the core PCE inflation rate had risen to 4.4% annualized. So that really spooked a lot of people. And after the second half of 2023 when inflation was really back to 2% over that period in terms of core PCE, when it shot up in the first quarter, markets were very worried about that. And the Fed was also worried. And people started to think that this road to normal for inflation could last a lot longer than we had hoped. So, the last several months of data is very positive. It looks like that benign environment that we saw in the second half of 2023 could be returning.
Now, as far as where we stand in terms of the composition of inflation, if we look—so, Core PCE is likely to be at about 2.5% or 2.6% year-over-year as of May, and actually, if we subtract housing, if we were to just look at Core PCE excluding housing, that would actually be at 2.1% year-over-year—so, you could say that excluding housing, we have returned to normal for inflation. And there’s a few other pockets to be sure. But overall, housing is really the one main component that’s single-handedly still propping up inflation. And the leading-edge data still strongly indicates that housing inflation is likely to normalize soon. So that should really encourage us on the inflation front.
Will the Fed Cut Interest Rates in 2024?
Hampton: And the Fed is predicting they’ll cut interest rates just once. Can you talk about why you consider that outlook too cautious, and what are your expectations?
Caldwell: The Fed put out these updated projections today. The last time they had updated their projections was March. Now, what’s important to remember is that—and Powell talked about this today in his press conference—the committee members who make these projections have the ability to update their forecast after the CPI release that was this morning, but most generally don’t. So, to some extent, this is looking in the rearview mirror because this may not really be totally reflecting the data with the CPI that was released this morning.
So, in any case, the Fed is projecting that core PCE inflation in the fourth quarter of this year will stand at 2.8% year-over-year. So, I think that’s a little too pessimistic. I think based on how inflation will track over the rest of this year, that will be at 2.4%, not 2.8%, year-over-year, core PCE inflation at the end of this year. So that’s much more optimistic on inflation. And so, I think if inflation comes in below the Fed’s more pessimistic estimate, then they will end up cutting two or three times rather than the one cut that they’re baking in. And it looks like markets agree with that. I think markets appear to be a little bit closer to our optimism on inflation right now because you saw markets move sharply in a way that anticipates looser monetary policy when the CPI was released this morning, but they didn’t really move that much. And right now, they’re really not reflecting the Fed’s projection of one cut. The median projection in the Fed fund’s futures market is that we’ll have two cuts by the end of this year, which is about in line with what our view is. So, it really just hinges on inflation, and the Fed will be data dependent and react to however the inflation data comes in.
How Investors Can Interpret the Fed Lifting its Long-Run Interest Rate
Hampton: And meanwhile, the Fed lifted its long-run interest rate that some see as a stand-in for the so-called neutral rate. How should we interpret this move?
Caldwell: The Fed upped its projection of the neutral federal-funds rate to 2.8% from 2.6% back in March. And for years, this estimate had been anchored at 2.5%, so, it’s starting to tick up. Now just to back up here—so, the neutral rate of interest or neutral federal-funds rate, in this particular instance, is a theoretical concept, which marks the interest rate which allows the economy to grow right in line with its potential. So that means that the Fed is able to achieve both parts of its dual mandate, full employment and 2% in inflation, should that state of the economy prevail. So that basically means it’s a good guide for what the long-run interest rate is likely to be, or the interest rate is likely to be in the long run.
Now I think the fact that the economy has been so strong over the past few years even as interest rates have been high in reality has led some people to think that the neutral rate might be higher than that 2.5% that they previously expected. So, we’re starting to see that gradually be reflected in Fed members’ expectations. But still though, they haven’t changed their year-end 2026 federal-funds rate expectation at all over this period. So that’s still at 3.1%, which is unchanged from last meeting. So, it’s unclear how this really actually affects the ultimate trajectory of the federal-funds rate. And Powell himself acknowledged in the press conference today that there’s still a lot of debate about this, about how much the neutral rate has really shifted because the neutral rate reflects slow-moving forces in the economy like demographics and long-run productivity growth. And these kind of forces—it’s hard to imagine really how much has changed since before the pandemic. And we’re going to need a lot of data and a lot of debate before we start to revise our views on this topic.
So, I still think that the neutral rate is probably quite low as it was before the pandemic. And that’s a big reason why I think the federal-funds rate will ultimately subside much lower than ultimately than markets expect. I think the federal-funds rate will drift down to a target range of 1.75% to 2% by year-end 2026. And that’s my long-run expectation.
Hampton: Well, Preston, thank you for sharing your insights today.
Caldwell: Thanks for having me, Ivanna.
Why Are Stocks Hitting Record Highs?
Hampton: The stock market is riding high. The S&P 500 and Dow Jones Industrial Average have hit records. There are four reasons for Wall Street’s optimistic mood, but what risks could sour its spirit? Morningstar Inc. Markets Reporter Sarah Hansen is joining the podcast to discuss her article.
Thank you for being here, Sarah.
Sarah Hansen: Thanks for having me. Great to be back.
How the Growing Economy Has Supported Stocks’ Impressive Performance
Hampton: So, the stock market has racked up some impressive performance this year. The economy is part of it. What are analysts telling you?
Hansen: So, you’re right. The stock market is up about 12% this year, which is pretty impressive, especially given that we are in a really prolonged period of high rates. And one of the biggest reasons that stocks have continued to rise is the fact that the economy has remained healthy and continued to grow, despite those high rates. The labor market is looking really strong. And for the most part, consumers are continuing to spend money. This is looking like it could be a soft landing for the economy, and that’s a very supportive environment for stocks.
Is Inflation Finally Trending Down Again?
Hampton: And higher inflation readings shook the market in Q1, but the mood has changed. Talk about what you’re hearing?
Hansen: We saw three consecutive months of hotter than expected inflation in January, February, and March, and that made investors really nervous. The worry was that the Federal Reserve was losing the fight against inflation, and stocks fell as investors recalibrated their expectations about how much rates could actually fall this year. And that’s a major reason why we saw such a big pullback in stocks in April. But now we’ve seen two consecutive months of much better inflation. Evidence that inflation is improving again came in April, and it came in the May report that was released just this week. And that progress on inflation is really reassuring investors.
Why Wall Street’s View of the Fed Is Changing
Hampton: Now, it appears Wall Street’s view of the Federal Reserve has thawed. Why is that?
Hansen: One reason is what we just talked about: With inflation improving, it’s looking more likely that the Fed will be able to ease policy this year by lowering rates. On a really basic level, that’s good for stocks. Low rates make it cheaper for companies to borrow money, and they make it cheaper to do business. And then relatedly, the Fed has been really deliberate this year about reassuring the market that if there is a major slowdown in growth or a serious problem in the jobs market or another issue in the economy, that it won’t hesitate to cut rates if it needs to. So, investors now trust that the Fed will take action quickly if it’s necessary. And some analysts say that’s even more important than the timing or the scope of this upcoming easing cycle.
Will Record Profits During Company Earnings Continue?
Hampton: And speaking of companies, many of them reported record profits during earnings season. Should investors expect that to continue?
Hansen: Yeah, so we had a really great first-quarter earnings season, thanks to a lot of the factors that we’ve already talked about. Much of that growth was still concentrated in a handful of Big Tech names, but analysts see room for broadening out, which will help support the market as a whole. Strategists also pointed to an interesting phenomenon this time around: Earnings estimates for the upcoming quarter were much higher than they usually are, and they weren’t revised down as much as they usually are. And that’s a sign from companies that they’re confident that their growth can continue. And it’s another piece of good news for investors.
What Risks Could Cause the Stock Market to Fall?
Hampton: We got the four reasons why the stock market is up. What are the risks that could cause it to fall?
Hansen: All those reasons actually can also be risks if momentum swings in the opposite direction. One of the biggest and most front-of-mind for investors is the risk that the Fed keeps interest rates too high for too long and damages the economy in the process. That could lead to a recession, which would really dent growth for stocks.
And another has to do with earnings and valuations. So, if companies, especially those Big Tech companies, start missing their earnings when they’re already expensive, if they start performing worse than investors expect them to, that could spark some big losses in the stock market as well.
Hampton: Well, you’ve given us some things to watch for. I want the audience to know that, Sarah, that you’re going to sit in the host chair in a couple of weeks. How are you feeling?
Hansen: Oh, I’m really looking forward to it. We’ve got a great group of experts, and I’m excited to hear from them.
Hampton: And I can’t wait to check out the episode. Sarah, thank you for your time today.
Hansen: Thanks for having me.
Hampton: That wraps up this week’s episode. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake VanKersen, Associate Multimedia Editor Jessica Bebel, and Editor Margaret Giles. And thank you for watching Investing Insights. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.
