In early February, broad-based strength saw the benchmark S&P 500 Index^® break the 5,000 level for the first time in history as investors maintained their optimism for a soft landing, slowing inflation and easier monetary policy likely just months away.

Earnings, broadly speaking, were supportive. Five of the Magnificent Seven reported over the month, with all meeting or exceeding expectations. But it was chip-maker Nvidia’s earning results reported late in the month that shocked markets. The company gained $277 billion in market cap in one day—the largest market cap gain on record by a U.S. company—as revenues exceeded the company’s own already elevated expectations. Its guidance was equally encouraging with forecast revenues well above consensus expectations, fueled by demand for artificial intelligence (AI) processing power by the company’s largest clients, which include Microsoft Corp. and Meta Platforms, Inc. With the outbreak of demand for AI continuing to surprise many investors, some Wall Street strategists have struggled to keep pace, steadily raising their forecasts for the S&P’s 2024 return with barely two months gone by.

Meanwhile, economic data continued to support the consensus view of a soft landing. On the plus side, January’s employment report showed 353,000 new jobs were added—well above both expectations and the recent trend—and both the Philadelphia and New York manufacturing surveys were stronger than expected. However, retail sales disappointed, falling 0.8% in January—well below expectations closer to a 0.3% drop—and worries persist about the lagged effect of higher interest rates. Regional banks particularly vulnerable to the commercial property market were again in the headlines last month as higher rates weighed on the value of buildings across the world, while workers—particularly in the U.S.—have been slow to return to the office. Outside of the U.S., data released in February revealed that both the U.K. and Japan slipped into a recession, with the latter losing its status as the world’s third largest economy to Germany.

Nevertheless, both U.S. stock and bond markets remain justifiably attentive to the outlook for inflation, insofar as inflation will determine when the U.S. Federal Reserve (Fed) will begin its long-awaited monetary policy easing. In February, inflation data was mixed. The January Consumer Price Index (CPI) figures were higher than expected, with headline inflation up 0.3% from December while core inflation (excluding the more volatile food and energy components) rose 0.4% on the month and was up 3.9% relative to a year ago. But late in February, the Personal Consumption Expenditures (PCE) Index—the Fed’s preferred measure of inflation—showed inflation falling closer to the Fed’s target, but not as much as many investors would have liked. 

Outlook: February’s economic data supports our outlook for a soft landing, and an eventual easing of monetary policy. While we have been skeptical of the market’s optimism over the pace of interest rate cuts, it is slowly moving closer to our view that rate cuts are not likely before mid-year. Indeed, there is some risk that the economy—which continues to surprise investors with its resiliency—could regain some steam while we, and the Fed, wait for inflation to reach its target. Should this happen, rate cuts could be further delayed insofar as their primary purpose—to add fuel to economic growth—may not yet be needed.

That said, it is clear that some areas of the economy are feeling the lagged effects of higher interest rates, whether by consumers eager to buy a house or a new car, or in the commercial real estate market where regulators are closely watching the balance sheets of the most exposed banks.

While we believe the economy will remain resilient, and is more likely to surprise with its strength than its weakness, we maintain our view that the Fed is determined to be conservative. The Fed created justifiable concerns about its credibility as stewards of moderate growth and low inflation when it was slow to raise rates in the face of rapidly rising inflation. We don’t think it can afford to make the same mistake twice and will thus favor lower inflation over more accommodative monetary policy until it is confident inflation is not just correcting lower, but is at a stable, fundamentally-based equilibrium closer to its target.

We remain optimistic on U.S. equities, despite recent strength. While much of the recent gains have been driven by the largest, mega-cap companies, we are encouraged by the breadth of February’s rally. We expect sustained economic growth (and, eventually, more accommodative monetary policy) would allow stronger earnings growth to spread into the broader market, favoring sectors such as the small- and mid-cap markets, companies with relatively lower credit quality and more value-oriented stocks.

We also maintain our positive outlook on bond markets, although the path is likely to be bumpy. We believe U.S. Treasury yields are near their peak for this economic cycle, and believe both long- and short-dated Treasuries will end 2024 at lower yields, justifying long-term exposure. However, we expect periods of optimism will be balanced by periods of skepticism (as we saw in February), keeping volatility relatively high during the transition from a restrictive to a more accommodative monetary policy. Corporate bonds, which offer a yield spread over similar maturity Treasuries, also remain attractive insofar as they provide both higher income and the potential for greater capital appreciation should credit spreads tighten as yields fall.