Dow hits record high amid encouraging inflation data and dovish FOMC shift

12/18/2023 — In my weekly capital markets review, I cover the factors that have influenced market movements, share insights on stock market performance, and connect the dots on key events to watch for in the upcoming weeks.

Drivers of market movement

The impressive rally in risk assets continues, with the S&P 500^® Index on pace for a seventh week of gains, the longest streak since 2017. The Dow Jones Industrial Average touched a record high for the first time in nearly two years.  During that period, the S&P 500 gained 15% to move within 2% of a record high, now returning 24% through 12/14. The rally during that time has been broad based, with small caps gaining 22%, international stocks adding 14%, and the Bloomberg US Aggregate Bond Index returning 8%. The 10-year Treasury yield now down more than 1% over the past two months. The outlook for 2024 is cloudy due to countervailing forces. The macro "canaries in a coalmine," notably the yield curve and leading indicators point to a recession, while the data tell a different story. Equity valuations are elevated, suggesting the market is pricing in a soft landing, though if the Magnificent 7 are excluded, valuations are reasonable.

The persistent upward pressure on equities has had a material impact on investor sentiment and positioning. Bank of America’s Bull & Bear Index jumped to the highest level since February and the largest two-week rally since 2015, aided by flows into high yield, strong credit market technicals, and improving breath in the global equity market. The Index is now neutral after being a zero on a scale from 0-10 as recently as October. Equity funds and ETFs have seen inflows in each of the past nine weeks, totaling $148 billion for the year, though that has been overwhelmed by the $1.4 trillion this year. The $5.9 trillion in money market assets could act as "dry powder" for risk assets next year as the Federal Reserve moves to cut rates, with last week being the first outflow in eight weeks. On average, the S&P 500 has rallied 19% following the Fed’s first rate cut.

The consumer is showing few signs of fatigue despite budgetary pressures and an easing job market. Retail sales jumped an unexpected 0.3% in November, better than October’s 0.2% decline and the consensus estimate for a 0.1% drop. Versus a year ago, sales rose 4.1%, with real growth of 1.0% despite the fall in gas prices impacting gas station sales. This data was reinforced by Bank of America’s Consumer Checkpoint saw card spending per household up 0.5% in November after falling on October, driven by strong real income growth across all income and age groups. Costco noted that holiday spending is ahead of expectations, with improvement in discretionary spending. The drop in interest rates has spurred optimism for consumers, with the rate on the 30-year mortgage below 7% after approaching 8% last month, driving mortgage applications up 7% in the latest week.

Wednesday’s FOMC meeting release and press conference ignited hopes for a soft landing, with a notably dovish shift by Chair Powell. The committee unanimously voted to keep rates unchanged, with Powell noting that additional hikes are unlikely unless inflation reaccelerates. The changes to the Summary of Economic Projections (so-called "dot plot") included lower inflation for 2024 (2.4% vs. 2.6% in September), but weaker economic growth (1.4% vs. 1.5%). Notably, Chair Powell energized bulls by saying the Fed doesn’t need a recession to cut rates, driving the Fed Futures market to embed six cuts through next year (70% chance of a cut in March) versus the median of the "dot plot" at three cuts. The rally in equities may be making Fed officials uneasy, with NY Fed President Williams telling CNBC that while rates are at or near sufficiently tight levels, it is premature to talk about rate cuts. On Thursday, both the Bank of England and the European Central Bank also voted to keep policy unchanged, while both pushed back against the idea that rate cuts are imminent.

Inflation continues to moderate, with the Consumer Price Index slowing to 3.1% growth and core CPI to 4.0% from a year ago. Shelter (one-third of the calculation) and auto prices continue to be the primary headwind to moderating inflation, but recent data suggests that this will ease in coming months. This improvement was reinforced on Wednesday with a report on producer prices that was flat sequentially and up just 0.9% from a year ago. While the Fed focuses more on the core PCE deflator as an inflation gauge, these reports undoubtedly reinforced the dovish shift.

Details on performance

Equity markets continued their positive momentum, driven by encouraging inflation data and a dovish FOMC meeting. The S&P 500® Index, the Dow and NASDAQ each added 3%. The rally was broad based, with small caps beating large caps and value outperforming growth. Leading sectors for the week included real estate, materials, and industrials, while communication services, utilities, and health care lagged. Volatility remained muted, with the VIX closing below 13 for the fourth week, while trading volume was elevated.

Global markets were strong in reaction to the domestic rally and encouraging inflation data, with the MSCI EAFE Index up 2% and the MSCI Emerging Markets Index up 3%. Asian markets rallied on reports that China’s industrial output was the best since February 2022, driving Hong Kong up 5%, South Korea up 3%, China up 2%, and Japan up 1%. Europe was strong following the ECB and BoE meetings, with France up 2%, and the UK, Germany, and Italy up 1%. The trade-weighted dollar index fell 2% on the dovish pivot, with the index now negative for the year.

Bond yields continued their downward path this week on rapidly shifting expectations for Fed policy, with the 10-year Treasury yield falling 0.31% this week. The 2-year yield also fell 0.31% to 4.41%, maintaining the shape of the yield curve. Credit spreads continued to tighten on the increasingly optimistic outlook. Commodity prices bounced modestly this week following an extended period of weakness, with the S&P Goldman Sachs Commodity Index up 1% this week. Crude prices added 1% on macro optimism, while natural gas prices fell 4% on warm weather. Precious metals rose on falling rates, while agricultural commodities were mixed.

Investor sentiment and positioning continue to follow the direction of the equity market. The AAII Sentiment Survey showed bulls jump to 51%, while the gap between bulls and bears widened to 32%, both at the best level since April 2021. The CNN Fear & Greed Index rose to 67 on a scale from 0-100. Equity funds and ETFs attracted flows for the ninth straight week, the longest streak in two years at $26 billion. Bonds saw inflows for the tenth straight week, with inflows into investment grade and high yield offset by outflows from emerging markets, municipals, Treasuries, and TIPS. Money market funds lost $31 billion in the week.

What to watch

Trading volume will begin to shrink next week given holiday vacations, increasing the chances of volatility. Economic data include housing starts on Tuesday, consumer confidence and existing home sales on Wednesday, revised GDP and leading indicators on Thursday, and the PCE deflator and personal spending and income on Friday.

Trailing Twelve Month S&P 500 Chart