2023 wasn’t as bad as expected. Coming up, we look forward with, dare we say, optimism? From Thrivent Asset Management, welcome to Advisor’s Market360™, a podcast for you, the driven financial advisor.

2023 was not without its share of challenges. Treasury yields surged, mortgage rates hit 20-year highs, two large U.S. banks failed, and a new conflict erupted in the Middle East. And yet, the S&P 500 looks likely to end the year up around 20%—approaching a new all-time high. 

How is that possible? The answer is rather straightforward, it turns out that the U.S. economy is doing, well, okay. And while there was softening, the economy is holding up. And inflation is steadily falling, bringing government, corporate, and consumer borrowing costs—particularly mortgage rates—down with it. 

Our guide for this tour of the 2024 economy, Thrivent’s Chief Investment Strategist Steve Lowe, reports 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 may finally see a significant rebound in total returns. 

Simply put, the outlook for 2024 appears pretty good. We are optimistic about the prospects for balanced portfolios in the coming year.

As your clients will likely have questions, you may want more details and insights to share. Keep listening, there’s lots of great information coming your way. 

The economic issue that dominated in 2023 was inflation, and the attempts by the Federal Reserve, or Fed, to rein it in. Will inflation concerns continue to be the big story in 2024? We think not.

If we’re right, and the U.S. economy muddles through the lagged effect of monetary tightening over the course of 2024, it will have navigated one of the most aggressive Fed tightening cycles in 50 years, without falling into recession. That’s no small accomplishment. Indeed, it begs the question: If tightening cycles usually end in recessions, why would it be different this time?

In our view, the sources of inflation this time were different. 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 pandemic upended the global economy, provoking both a historic fiscal stimulus and a historic supply-chain mess that created deep and sustained shortages of core goods.

It can be hard to get one’s head around just how massive the monetary response was. Consider 25% of all money currently in circulation today was created since the pandemic. The flood of stimulus cash to consumers, companies, and government projects, was truly historic.

Inflation was fueled by stimulus-driven demand meeting a pandemic-created supply shortage. It could be argued that inflation was going to fall as both of those factors faded, regardless of Fed actions.

As of this recording, U.S. Consumer Price Inflation has retraced about two-thirds of its 2021 to 2022 surge. Usually the last third is the hardest to wring out of the system. But it may be that—because of inflation’s unique triggers this time—the last third could fade more easily than expected. It’s looking like a soft landing, or at least one with only mild turbulence.

For example, the inflation rate on goods has fallen to almost zero. While services and shelter inflation rates are still high, zero goods price inflation suggests that 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 fall.

The interest-rate markets have become optimistic enough that inflation will glide lower that they have started to forecast more aggressive Fed rate cuts in 2024. In fact, between four and five rate cuts are priced into the short end of the yield curve. While we agree with the bullish sentiment, this many cuts strikes us as overly optimistic given current data. 

Remember, the Fed is widely perceived to have made a mistake in 2021. They 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 they can claim they have whipped inflation.

The bottom line? We expect inflation will continue to fall, allowing the Fed to lower interest rates in the second half of 2024.

The tale of Goldilocks is an apt metaphor for the current economic environment—growth is not too slow, inflation is not too hot—conditions that are “just right” for a soft landing. Whether it is truly a soft landing, or maybe a little bumpy, at this point a recession in 2024 seems unlikely. 

Keep in mind that because higher interest rates can have a lagged effect even two years after a tightening cycle begins, we believe it’s too early to assume that tighter financial conditions won’t continue to weigh on the economy into 2024. That said, we see few signs of significant vulnerability in the overall U.S. economy.

So what’s the bottom line? We believe the economy is unlikely to enter a recession—or strengthen significantly—allowing the Fed to stay focused on the inflation outlook.

What’s the outlook for stocks in 2024? Despite stocks being near all-time highs while the economy is still weak and interest rates are still relatively high, there are a number of reasons to be positive about the U.S. stock market.

First, just a handful of mega-cap technology stocks are responsible for a large part of the market’s recent strength with the so-called Magnificent Seven: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla, accounting for a whopping 30% of the S&P 500’s valuation at various times over the past year. 

In our view, if the economy manages a soft or bumpy landing the strength of these seven companies should widen to the other 493 in the index. With earnings growth recently turning positive on a quarterly basis for the first time in a year, that process may have already begun.

Second, we continue to believe the emergence of Artificial Intelligence, or AI, could fuel a longer-term investment cycle. While the effects of AI on the economy will only become clear in the long-term, in the short-term we see cause for optimism.

But 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. All of which can be more impactful than you might think. History shows that markets usually rally after the Fed stops hiking rates and continues to rally after the Fed has begun cutting rates. Surely, 2023 is not the first year markets anticipated a turn in the monetary policy cycle and fully priced-in all potential gains.

While we are optimistic, markets never move in a straight line. Economic data can swing, investors can react with positivity or become cautious. 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 indeed 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. 

When it comes to stocks, the bottom line is that we are positive on U.S. large- and mid-cap stocks and are looking for the right time to add small cap exposure.

Next up on our 2024 outlook is the bond market. Spoiler alert: We anticipate a positive year.

Historically, Treasury yields peak around the time the Fed stops raising interest rates, and then fall as the Fed cuts rates. As we have little doubt that the Fed has stopped raising rates, Treasury yields have likely already peaked. When rates will fall further, and by how much, is a more difficult question. We believe both short- and long-dated Treasury bonds should end 2024 at significantly lower yields. 

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 about 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 the course of 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. 

Our bottom line on bonds yields is that they 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 traditional balanced portfolios is more volatile than you might think. Large or sudden moves in interest rates tend to cause stocks and bonds to move together. The past 18 months met those requirements. 

But, when uncertainty and volatility fades, the correlation generally falls back. 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. 

While there is plenty to be optimistic about as we head into 2024, there’s always uncertainty.

It is unlikely, but employment could take a turn for the worse and deteriorate quickly. Or the Fed could make another policy mistake. 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 can happen at any time. 

2024 is also a Presidential election year. While most elections have a relatively modest impact on markets, there is some risk that the election itself has a destabilizing effect that could prompt a more significant market reaction.

Outside of the U.S., political risk has been steadily rising. We have two wars, in Ukraine and the Middle East, rising 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.

The bottom line? We do not believe that 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.

In summary, 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 in financial markets should wane over the coming year. 

But transitions are hard to predict. In 2023, most analysts called for a recession early in the year. They were wrong. In 2021, the Fed was clear they thought inflation would be transitory. They were mostly wrong. Turning points in the economy are so difficult to predict that even an organization with the resources, education, and insights of the U.S. Federal Reserve can get it wrong. 

But barring the unforeseeable, interest rates have probably peaked. Further, the economy will likely find a bottom in the first half of 2024, and we should avoid a recession. If this view is even roughly correct, it should support both stock and bond markets in 2024, allowing diversified portfolios the best kind of correlation—when everything goes up together. 

Once again, we would like to thank Steve Lowe for his insights. More episodes of Advisor’s Market360^™ are available wherever you get your podcasts. Email us at podcast@thriventfunds.com with your feedback, questions and topic suggestions for future episodes. And as always, you can learn more about us at thriventfunds.com and find other insights of interest to you, the driven financial advisor. Bye for now.

All information and representations herein are as of December 14, 2023, unless otherwise noted.

Past performance is not necessarily indicative of future results.

This 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.

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. 

Any indexes are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.

Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC is a member of FINRA and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.