Stocks Retreat as Strong Economic Data Damps Rate Cut Hopes

Stocks pulled back on Wednesday as unexpectedly strong U.S. retail sales data dashed investor hopes for an imminent interest rate cut by the Federal Reserve. However, tech stocks showed resilience, extending the Nasdaq’s win streak.

Improving Economic Picture Clouds Rate Cut Outlook

The Commerce Department reported robust retail sales growth of 1.8% in December, well above expectations of a 0.1% increase. Additionally, November’s numbers were revised upwards to show a 1.3% gain instead of 0.2%¹. The solid spending data indicates economic strength, reducing the likelihood of the Fed aggressively easing policy in the near term.

Treasury yields spiked on the news, with the benchmark 10-year yield jumping back above 3.5% after dipping below that level earlier this week². Higher yields tend to weigh on stocks, especially high-growth tech names.

The odds of a 25 basis point rate cut at the Fed’s March meeting plunged to just 4% from 33% a day earlier according to CME Group’s FedWatch tool. The prospect of less accommodative Fed policy going forward led to broad risk-off moves across asset classes:

• The Dow shed 200 points
• The S&P 500 dropped 0.2%
• Oil prices declined nearly 2%
• Bitcoin fell below $21,000 for the first time since 2020
• The U.S. dollar index rallied 0.7%

Major Index Performance

Table 1: Major Stock Index Returns in 2023 (through Jan 17)³

Growth Stocks Outperform

Though the major indexes declined, growth and tech stocks showed resilience with the Nasdaq Composite eking out a slight gain. Apple stock rose 1.6%, extending its January rally, while Nvidia surged nearly 6% after announcing a new product⁴. Tesla bucked the trend within tech, falling 6% to new 2-year lows after announcing additional price cuts in China⁵.

Software and semiconductor stocks also outperformed, reflecting rotational buying into recent laggards. The Philadelphia Semiconductor Index gained 1.3%, while the S&P Software & Services Select Industry index finished flat.

Riskier segments of the market like meme stocks and profitless tech saw substantial volatility. GameStop spiked as much as 20% before surrendering most gains to close up 2.7%. Meanwhile, Carvana plunged 12% to new all-time lows as short sellers pile on amid concerns over the used car dealership’s cash burn.

Wall Street Still Hopeful on Eventual Rate Cut

Though a March cut now appears very unlikely, investors still expect easing later in 2024. The fed funds futures market is pricing in a quarter point cut by July and an additional 25 basis point reduction by November⁶.

This aligns with Wall Street economist projections of cuts starting in Q3 or Q4 as growth slows and disinflationary trends take hold. Morgan Stanley equity strategist Michael Wilson believes corporate earnings estimates remain too high given deteriorating economic data. He thinks consensus expectations for 8% S&P 500 profit growth this year are unlikely to be achieved⁷.

If earnings fall short, stocks could come under more pressure. However, any meaningful decline should be viewed as a buying opportunity ahead of Fed easing later this year according to Wilson.

Market Outlook – Cautiously Optimistic

The recent pullback leaves stocks attractively valued compared to still-elevated bond yields in the eyes of many strategists. The S&P 500’s forward price-to-earnings ratio sits near 18x, a discount to the past 5 years’ average near 19x. With inflation showing signs of peaking, corporate profits poised to accelerate in the back half of 2024, and the Fed likely to trim rates by Q3/Q4, stocks appear positioned for solid gains by year-end⁸.

However, volatility will remain elevated in the coming months until inflation moves decisively below the Fed’s 2% target. Additional near-term catalysts that could drive stocks higher include a loosening of COVID restrictions in China, stabilization in the global bond market, and receding geopolitical tensions in Russia/Ukraine. But risks like an earnings recession, higher for longer interest rates, or an exogenous shock could lead to additional downside. Investors should brace for more choppiness while staying allocated for further upside over the medium to long term.

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