A soft landing is in sight, but recession risks remain.
The U.S. economy saw impressive resilience last year, with the first three quarters showing above trend real GDP growth. Easing inflation and improved prospects for growth have helped fuel optimism for a soft landing. However, a quick look across each sector of the economy tells us that economic momentum in the year ahead is set to be moderate, at best.
Overall, the U.S. economy should continue to grow at a moderate but slowing pace from here. That said, a slower-moving economy will be increasingly sensitive to shocks. Whether it be the U.S. election, higher policy rates, significant geopolitical tension or something else entirely, risks remain that could push the economy into recession in 2024.
The unemployment rate should remain low until we see a recession.
After a red-hot labor market sent wages higher and brought unemployment down from a pandemic peak of 14.7% to a 50-year low of 3.4%, the labor market is now getting back to normal.
Overall, a combination of subdued job growth and slowing wages should give the Federal Reserve further confidence that inflation is sustainably coming down.
Sustainable earnings will differentiate winners and losers against a backdrop of slowing growth.
Looking to 2024 and 2025, expectations for double-digit earnings growth seem too optimistic as defending profit margins will become increasingly difficult in an environment of slowing economic growth and waning pricing power. However, high-quality companies with strong balance sheets, ample cash balances and sustainable earnings should perform well relative to the broader index.
Inflation is steadily trending back to target.
After inflation reached 50-year highs in 2022, the inflation heatwave met a cold front in 2023. Headline CPI eased to 3.1% y/y in November, well below the 9.1% peak reached in June 2022. While still above the Fed’s target, the underlying components of inflation provide us with confidence that this downtrend has room to run.
Overall, inflation made impressive progress towards more normal levels in 2023. While we are not quite back to the Fed’s target, 2% inflation by the middle of 2024 is attainable even without a recession. This should give the Fed assurance that inflation is under control as they debate easing policy.
The Federal Reserve is near the end of its tightening cycle.
The Federal Reserve has hiked rates by a cumulative 5.25% since the beginning of 2022 to combat inflation. However, with inflation steadily trending towards their 2% target and labor market conditions easing, the July rate hike was likely the last of this cycle. At their December meeting, the Fed voted to leave the federal funds rate unchanged at a target range of 5.25%-5.50% and strongly hinted that rates are at their cycle peak. Fed Chairman Powell did not push back against easing financial conditions or the idea of rate cuts, as he has done in the past, and forward guidance was decisively dovish.
Overall, the Fed is likely at the end of its hiking cycle, which means investors are now more interested in the timing and extent of eventual rate cuts. If the economy remains afloat, the Fed may only deliver minor policy cuts. However, if the U.S. economy enters a recession, the Fed may be forced to cut rates more aggressively to try and stimulate the economy. Either way, it is increasingly likely that rates will move lower in the year ahead, but they may settle at a higher level compared to previous policy easing cycles.
Divergent global growth should converge in the year ahead.
Despite the negative headlines, the global economy proved to be more resilient than expected in 2023, but some countries clearly did better than others. The Eurozone, UK, Canada and China struggled, while the U.S., Japan and emerging markets outside of China were stronger, as evidenced by their composite PMIs remaining above 50 for much of last year.
In China, depressed consumer and business confidence continues to challenge growth, while the full effects of stimulus measures from policymakers have yet to be realized. China’s weakness also spilled over to Europe, which is similarly experiencing weak domestic consumption and elevated manufacturer pessimism. Activity is now showing signs of stabilizing, albeit at low levels, and there is hope for a modest reacceleration in Europe as falling inflation boosts real incomes. Elsewhere, India continues to see strong growth, supported by its growing middle class and government support for private businesses and digitalization.
Global growth should be less divergent in 2024, with the US economy slowing down and China’s economy stabilizing. However, the key question is how much this gap will close, and whether it is driven by a U.S. slowdown or a pickup in overseas growth.
Despite the recent bond market rally, yields still look attractive.
In bond markets, volatility was a defining feature of 2023 as investors grappled with resilient economic data, a hawkish Fed and various technical factors. The yield on the 10-year Treasury climbed by nearly 170 bps from early April to late October, before expectations for a soft landing and an end to tightening helped drive the yield lower by more than 100 bps in less than two months. Even with this move lower, current yields across the fixed income landscape still offer investors much better income and total return opportunities than existed a year ago.
With peak interest rates likely behind us, bonds also offer the potential for price appreciation in the event of lower rates and diversification benefits as lower rates coincide with recession. This potential for asymmetric return in bonds may not last long, underscoring the importance of leaning into fixed income while yields are at these elevated levels.
Broadening U.S. equity market performance will create opportunities for active management.
After a very troubled year for investors in 2022, U.S. equities rallied in 2023, largely recovering their losses in the prior year. This performance owes to a combination of better-than-expected consumer spending, resilient corporate profits and enthusiasm around the advancements in AI. However, equity market performance was not broad-based, with the largest stocks in the index by market-cap accounting for the majority of gains.
In 2024, if economic growth remains positive and technological advancements yield significant productivity gains, markets could still perform well. That said, gains should broaden out beyond the largest names. In environments like these, active management is best suited to identify those companies with sustainable, high-quality earnings that are being overlooked by the markets.
There are attractive opportunities across international markets.
Strong equity market performance in 2023 was not only a U.S. phenomenon. International equities also experienced impressive growth, with the MSCI All Country World Index climbing more than 10%. Taking a quick trip around the globe, Japanese equities had a very strong year, rising roughly 16% in dollar terms, as an improved interest rate backdrop and corporate governance reform propelled new enthusiasm from investors. Elsewhere, promising fiscal reforms and strong economic momentum bolstered the case for Indian equities, which similarly rose over 16%. In Europe, markets also saw strong performance in the first half of the year as the end of negative interest rates supported banks and economic activity stabilized from Russia-induced energy shortages.
Looking ahead, while the global growth backdrop looks set to slow, there are still strong opportunities outside of the U.S. for long-term investors, and at better valuations. Indeed, international equities continue to trade at a steep discount of over 30% compared to U.S. equities, near 20-year lows. International equities also offer greater income, with dividend yields trading at a 1.8% spread above that of U.S. equities.
Combine this attractive entry point with structural tailwinds, attractive relative fundamentals and a weakening dollar, and the year ahead could be a much more favorable environment for U.S. based investors investing overseas looking to diversify and add exposure to important global secular trends and themes.
While peak cash yields may look attractive, holding too much cash can be costly.
Policy tightening from the Fed has pushed yields on cash-like instruments to their most attractive levels in over a decade. With yields north of 5% and minimal risk, many investors have decided to allocate more heavily to cash.
However, history shows that staying parked in cash after the peak in interest rates usually leaves money on the table. In the last 6 rate hiking cycles, the U.S. Aggregate Bond Index outperformed cash over each of the 12-month periods following the peak in CD rates, while the S&P 500 and a 60/40 stock-bond portfolio outperformed in 5 of these periods.
This is not to say that investors should abandon cash altogether, as liquidity is an important allocation in any portfolio. However, there is an opportunity cost in holding onto too much cash, and investors should put long-term money in long-term assets. Following a peak in interest rates there has always been a better asset than cash to deploy capital.
However, history shows that staying parked in cash after the peak in interest rates usually leaves money on the table. In the last 6 rate hiking cycles, the U.S. Aggregate Bond Index outperformed cash over each of the 12-month periods following the peak in CD rates, while the S&P 500 and a 60/40 stock-bond portfolio outperformed in 5 of these periods.
