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.
A Goldilocks-piloted soft landing?
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.
We believe stocks are positioned for a positive year
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.
Bonds, too, are likely to have a positive year
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.