After the release of the latest retail monthly rate and producer price index, expectations have further increased that the Federal Reserve has reached the end of interest rate hikes. Many market participants believe that economic data may continue to be a key catalyst for the year-end rebound.
It is worth noting that small cap stocks that are particularly sensitive to interest rates have recovered this week, with the Russell 2000 index rebounding by over 6%. Bank of America believes that a significant deviation from the historical average valuation level means that the future prospects of small cap stocks will be better than those of large and medium-sized stocks.
Market digestion and interest rate hike expected to end
Federal Reserve Chairman Powell stated during a panel discussion at the International Monetary Fund (IMF) last week that a series of interest rate hikes have brought downward pressure on inflation and economic growth, and it is expected that the economy will slow down in the coming months and help further reduce inflation.
With the emergence of monetary policy effects, the Federal Reserve is gradually achieving the expected results. Data from the US Department of Commerce shows that the monthly rate of retail sales in October fell 0.1% month on month, the first decline in nearly seven months, which indicates that household demand slowed down at the beginning of the fourth quarter. Most low-income families rely on credit cards to fund purchases after exhausting the excess savings accumulated during the COVID-19 epidemic. The decline in consumer spending is also in line with the overall trend of recent economic cooling in the United States.
At the same time, price pressures have further eased. Benefiting from the decline in energy prices and the stabilization of service prices, the Producer Price Index (PPI) unexpectedly fell by 0.5% month on month in October, marking the largest decline in three and a half years. The easing of cost pressures on upstream enterprises will effectively alleviate the pressure on them to raise prices for downstream products and services. Combined with the US CPI report released the day before and signs of a cooling labor market, the anti inflation process is still progressing smoothly.
Oanda Senior Market Analyst Craig Erlam said in an interview with First Financial reporters that the data provided a good response when the outside world reassessed whether the Federal Reserve needed to go further. Even if the Federal Reserve may continue to retain the option of raising interest rates, the probability of achieving this is already low.
However, the 'last mile' is not a smooth journey. Erram's analysis suggests that the resilience of the job market may become an important factor driving the stickiness of core inflation. The Federal Reserve still needs to keep interest rates high for a period of time and patiently wait for inflation to move further towards the medium-term target of 2%. This means that the Federal Open Market Committee (FOMC) is still far from announcing its ultimate victory.
According to the FedWatch Tool of the Chicago Mercantile Exchange Group, the probability of the Federal Reserve not moving next month is close to 100%. At the same time, traders expect the first interest rate cut to be brought forward to May next year, with at least four interest rate cuts throughout the year.
Bank of America had previously predicted that the Federal Reserve would raise interest rates for the last time by 25 basis points in December. Now, the bank has abandoned this view in its latest report, believing that the current interest rate hike cycle has come to an end. The report states that the decline in equal rent inflation among homeowners (a measure of the real estate market) and the cooling of core services, excluding housing, should encourage the Federal Reserve to remain on the sidelines. Bank of America expects the Federal Reserve to start cutting interest rates in June 2024 and cut rates quarterly.
Small cap stock valuation opportunities
After the release of inflation data on Tuesday, the Russell 2000 index of small cap stocks surged 5.4%, reaching a two month high, significantly outperforming the three major indices, and maintaining its leading edge until the close of Wednesday.
As an important component of the economy, small and medium-sized enterprises contribute about 40% of the United States' gross domestic product (GDP), and the Russell 2000 index is the "canary" of the economy for the market. Affected by policy expectations and economic prospects, the index has risen by less than 5% this year, far behind the S&P 500 and Nasdaq. Last month, the pricing ratio of the Russell 2000 Index and the Nasdaq 100 Index hit a record low, surpassing the record of the Internet foam peak in March 2000.
Erram told First Financial that for risky assets, a "soft landing" should be the best scenario, and investors are seeing this hope. Combining data to determine the future path and actively communicating with the outside world by FOMC will help avoid the risk of excessive policies, reduce economic uncertainty, and facilitate sector rotation and the recovery of undervalued sectors and industries, "he said.
According to statistics from Bank of America Global, the valuation of small cap stocks in the US has reached its lowest level since September last year. Although this does not necessarily mean that the stock prices of heavily hit stocks will rise quickly, it may indicate that the long-term returns of the sector will be better.
After a new round of sell-off, Russell 2000's P/E ratio dropped to 12.3 times in early November, with its trading price 19% lower than the historical average. In contrast, the price of medium-sized stocks was only 4% lower than the historical average, while the large cap stocks driven by the artificial intelligence boom were 12% higher than the historical average. The report states that valuation levels will be more explanatory in the long run. Over the next decade, Russell 2000's P/E ratio means that the annualized return is expected to reach 12%.
Market participants are also full of expectations for the year-end market. Historical data shows that November was one of the best performing months for US stocks. Jim Baird, Chief Investment Officer of Plante Moran Financial Advisors, believes that the stock market, which is seeking short-term direction, seems to have found a catalyst (inflation). David Russell, Global Director of Market Strategy at TradeStation, said, "The possibility of an economic soft landing and a permanent Federal Reserve pause is increasing, which will lay the foundation for strong development at the end of the year, and the Christmas market may not be absent