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.

Inflation could fall faster than usual

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.
 

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.
 

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.

Will balance come back to a balanced portfolio?

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.
 

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.

What we do worry about

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.

A new chapter begins

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.