A return to 60/40 balance? [PODCAST]
This strategy fell out of favor, but it may be poised for a return.
This strategy fell out of favor, but it may be poised for a return.
2024 MARKET OUTLOOK
2023 has had its share of challenges. Treasury yields surged, mortgage rates hit 20-year highs, we saw two of the largest bank failures in recent U.S. history and a new conflict erupted in the Middle East. But despite these (and so many other) economic and political challenges, the S&P 500® Index looks likely to end the year up around 20%, approaching a new all-time high.
While the devil is in the details, the primary reason for this strength is that the U.S. economy is weathering the storm. Softening, to be sure, but holding up. And inflation is steadily falling, bringing government, corporate and consumer borrowing costs (particularly mortgage rates) down with it.
In our view, there is a good chance the combination of modest growth and fading inflation will allow stocks to generate another year of positive returns and bonds to (finally) see a significant rebound in total returns. Simply put, we believe the outlook for 2024 looks pretty good.
If we are right, and the U.S. economy manages to muddle through the lagged effect of monetary tightening over the course of 2024, it will have navigated one of the most aggressive U.S. Federal Reserve (Fed) tightening cycles in 50 years without falling into recession. That is no small accomplishment. Indeed, it begs a question: If tightening cycles usually end in recessions, why would we think it will be different this time?
In our view, the answer is simple: The sources of inflation were different. This time, inflation didn’t spike because the economy was too strong, fueled by over investment or excess corporate or consumer borrowing. Rather, inflation surged because a global pandemic upended the global economy, provoking both historic fiscal stimulus and a historic supply-chain morass that created deep and sustained shortages of core goods.
As it can be difficult to get your head around just how massive the disruption and the monetary response was, consider that 25% of all the money currently in circulation today was created since the pandemic. The flood of stimulus cash to consumers, companies, and government projects, as shown in Figure 1 below, was truly historic.
FIGURE 1: Money supply surged ~25% into 2022
Insofar as inflation was fueled by a stimulus-driven demand meeting a pandemic-created supply shortage, one could make the argument that inflation was going to fall as both those factors faded, regardless of what the Fed did. Put differently, perhaps those who argued inflation would be transitory were right. They were just wrong about how bad it would get in the meantime—forcing the Fed’s hand—and how long it would last.
Bottom line, the unusual causes of recent inflation may make it easier to subdue.
As of this writing, the U.S. Consumer Price Index (CPI) has retraced about two-thirds of the 2021-2022 surge, as can be seen in Figure 2 below. While we have previously written that the last third is usually the hardest to wring out of the system, it may be that—because of inflation’s unique triggers this time—the last third could fade more easily than expected.
FIGURE 2: Consumer Price Index (CPI), and Core CPI
For example, the inflation rate on goods prices today has fallen to almost zero. While services and shelter (rent) inflation rates are still high, zero goods price inflation suggests the supply-chain shortages and fading consumer stimulus may have found an equilibrium. And because shelter prices are highly sensitive to interest rates through the mortgage rate, they could fall further as Treasury yields decline.
Interest-rate markets have become optimistic enough that inflation will glide lower, and have started to forecast more aggressive Fed rate cuts in 2024. Today, between five and six rate cuts are priced into the short end of the yield curve. While we agree with this bullish sentiment, this many rate cuts strikes us as optimistic given current economic data.
Remember, the Fed is widely perceived to have made a mistake in 2021. Whether it was ultimately right that inflation would prove to be transitory or not, members were slow to raise rates in the face of rapidly rising inflation, creating concern about their credibility as stewards of moderate growth and low inflation. We don’t think the Fed can afford to make the same mistake twice and will favor lower inflation over higher unemployment until members can credibly claim they wiped inflation.
Bottom line: We expect inflation will continue to fall, allowing the Fed to credibly lower interest rates in the second half of the year.
The current Goldilocks environment (growth not too slow, inflation not too hot) suggests a soft-landing or maybe a bumpy landing (a little more volatile than a soft landing but still avoiding recession) is the most likely outcome in 2024. But, because higher interest rates can have a lagged effect even two years after a tightening cycle begins, we believe it is too early to assume that tighter financial conditions won’t continue to weigh on the economy into 2024.
The consumer sector, while strong, is the most likely to suffer under this weight and, given increasing signs of stress, warrants continued monitoring. But while consumption has slowed, it remains positive, and has recently ticked up again. Meanwhile, work force participation is increasing and unemployment remains low. The consumer may have a bumpy ride ahead, but with the corporate and financial sectors largely already transitioned to a weaker outlook, we see few signs of significant vulnerability in the overall U.S. economy.
Bottom line: The economy is unlikely to enter a recession or strengthen significantly, allowing the Fed to stay focused on inflation.
Despite stocks being near all-time highs while the economy is still weak and interest rates remain relatively high, there are a number of reasons to be positive on U.S. equities.
First, just a handful of mega-cap technology stocks have been responsible for a large part of the market’s recent strength with the so-called Magnificent Seven (Alphabet Inc., Amazon.com Inc., Apple Inc., Meta Platforms, Inc., Microsoft Corp., Nvidia Corp., and Tesla, Inc.) accounting for a whopping 30% of the S&P 500 Index’s valuation at various times over the past year. In our view, if the economy manages a soft/bumpy landing, the strength of these seven companies should widen to the other 493. With earnings growth—which we believe drives markets in the long-run—recently turning positive on a quarterly basis for the first time in a year, that process may have already begun.
Second, we remain steadfast in our view that the widespread emergence of artificial intelligence (AI) could fuel a longer-term investment cycle. Put differently, there are many reasons for the dominance of the Magnificent Seven, but their success reminds us that the U.S. economy is, and will likely remain, vibrant, creative and quick to capitalize on emerging technology. While the long-term effects of AI on the economy will only become clearer in the long-term, in the short-term we see cause for optimism.
Third, bears remain in the forest. A recent National Association for Business Economics survey of economic forecasters showed a roughly 50% chance of a recession in the next 12 months. Should this number slide lower, there could be new money allocated to the market, the covering of short positions, or just more bullish headlines. These scenarios can be more impactful than you might think. History shows that markets usually rally after the Fed stops hiking rates, and continue to rally after the Fed begins cutting rates. Surely 2023 is not the first year that markets anticipated a turn in the monetary policy cycle and have fully priced in all the potential gains.
While we are optimistic, markets never move in a straight line—economic data can swing, investors can get greedy or become afraid and external factors, such as politics, can sway sentiment. But for investors taking a longer-term view, we think the overall market should generate positive returns in 2024. And should the economy achieve a soft landing, we expect the breadth of performance to widen—particularly favoring allocations to small-cap stocks, companies with relatively lower credit quality and the more value-oriented stocks which have lagged the overall market.
Bottom line: We are positive on U.S. large- and mid-cap stocks and looking for the right time to add small-cap exposure.
Historically, Treasury yields typically peak around the time the Fed stops raising interest rates, and then fall as the Fed cuts rates, as can be seen in the chart below. As we have little doubt the Fed has stopped raising rates, Treasury yields have likely already peaked. When they fall further, and by how much, is a more difficult question. In our view, both short- and long-dated Treasury bonds should end 2024 at significantly lower yields.
FIGURE 3: Fed Funds and 10-year Treasury rates
Corporate bonds, which offer a yield spread over similar maturity Treasuries, provide both higher income and the potential for greater capital appreciation should credit spreads tighten as yields fall. In the short term, however, spreads in the investment-grade market look to be already pricing in a more optimistic outlook. But some of this richness could be explained by the simple fact they have such compelling yields. After a decade of paltry yields, bond investors can be forgiven for happily earning around 6% a year, regardless of where spreads go.
FIGURE 4: Current yields of major bond markets
In the sub-investment grade universe, including high-yield corporates and emerging market debt, yields are higher, but so are the risks. Given slower economic growth and the lag effect of tighter monetary and financial conditions, we expect high-yield corporate bond and leveraged loan default rates to rise over 2024. However, the sub-investment grade universe is vast, and corporate bonds at the higher end of its rating spectrum are, in our view, more attractive. For example, so-called fallen angels—companies which had investment grade ratings but slipped into the sub-investment grade market—may offer a more compelling balance of risk and return.
Bottom line: Bond yields are attractive. We expect Treasury yields to rally into year-end 2024. Corporate bonds may not see much spread compression, but their yields are compelling.
Our assumption that both stocks and bonds are likely to see positive returns in 2024 raises something of a conundrum: How can a balanced portfolio of stocks and bonds be diversified when they are both forecast to rise?
The uncomfortable answer to this question is that the diversity in a traditional balanced portfolio is more volatile than one might think. The chart below shows the rolling correlation of returns between stocks and long-term bonds since 1990. While the line is noisy, and the 33-year average correlation may be pretty close to zero, three distinct phases are clear: Two periods of a positive return correlation, where returns move up or down together, and one period of a negative correlation. Today we are back to near the highs, raising the question of how long a positive correlation will persist.
FIGURE 5: Correlation of S&P 500 Index and Treasury bond returns
The two historical periods of higher correlation have something in common: They are all the result of significantly higher interest rates hurting both bonds (where prices fall as yields rise) and stocks (where prices typically fall when the economic outlook deteriorates). Simply put, large or sudden moves in interest rates tend to cause stocks and bonds to move together. The past 18 months certainly met those requirements. But, when the uncertainty and volatility fades, the correlation generally fades. If the U.S. economy can achieve a soft landing in 2024, allowing uncertainty and volatility to decline, we expect the correlation to moderate, and bonds will eventually play a better diversifying role again.
There are many concerns to watch as we head into 2024. It is unlikely, but employment could take a turn for the worse and deteriorate quickly. The Fed—which has done a pretty good job since it started raising rates—could make another policy mistake as done in 2021. Or, in a worst-case scenario, inflation could reignite. While that would almost certainly be the result of another unforeseen shock to the global economy, COVID-19 reminds us that those too can happen anytime.
2024 is a U.S. presidential election year. While most elections have a relatively modest impact on markets, many Americans would agree that our politics has become more polarized. As such, there is some risk that the election itself could have a destabilizing effect that could prompt a more significant market reaction, although that is not our base case.
Outside of the U.S., political risk has also been steadily rising in both breadth and depth. We have two wars, in Ukraine and the Middle East; increasing chances of a conflict between the U.S. and Iran; China remains determined to integrate Taiwan; democracy looks to be increasingly under threat in South America; and the number of democracies in Africa is shrinking.
Bottom line: We do not believe any of these economic, political, or policy risks are likely to derail markets in 2024, but the risks are out there, and investors should assume there will be surprises.
If 2023 proves to be the peak of the current interest rate cycle, then one part of the transition back to equilibrium will be complete. As such, uncertainty (and thus volatility) in financial markets may likely wane over the coming year. But transitions are always hard to predict. In 2023, most analysts were calling for a recession early in the year. They were wrong. In 2021, the Fed was clear it thought inflation would be transitory. It was (mostly) wrong. Turning points in the economy are so hard to predict that even an organization with the resources, education and insights from the Fed can get it wrong.
But barring the unforeseen, or unforeseeable, interest rates have probably peaked, and the economy will likely find a bottom in the first half of 2024 that avoids a recession. If this view is roughly right, it should support both stock and bond markets in 2024, allowing diversified portfolios the best kind of correlation—when everything goes up together.
All information and representations herein are as of 12/14/2023, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.
This article refers to specific securities which Thrivent Mutual Funds may own. A complete listing of the holdings for each of the Thrivent Mutual Funds is available on thriventfunds.com.
Any indexes shown are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.
The S&P 500® Index is a market-cap weighted index that represents the average performance of a group of 500 large-capitalization stocks.
Past performance is not necessarily indicative of future results.