Q1 2024 Market & Economic Outlook
The U.S. economy continued to surprise to the upside during 2023, but it is moderating. Higher interest rates are starting to impact various sectors. It is very likely the Federal Reserve will start cutting rates this year and a soft landing (or no landing) is looking more probable.
Q1 2024 Market & Economic Outlook
Current Economic Views
Throughout 2023, the U.S. economy remained resilient, largely due to a strong labor market that led to ongoing consumer spending. In the fourth quarter, multiple measures of inflation (CPI, PPI and PCE) continued to trend lower which led to the Federal Reserve signaling the end of interest rate hikes.
In the third quarter of 2023, the U.S. economy posted strong growth of 4.9%, led by robust consumer spending, all while inflation continued to decline. Job gains continued, with the unemployment rate at a low level of 3.7% at the end of the year.
In December, the Federal Reserve released its quarterly Summary of Economic Projections. In it, the central bank increased its expectation of economic growth (real GDP), maintained its estimate of unemployment, while lowering its estimates for inflation and interest rates from September. The GDP for 2023 was raised from 2.1% to 2.6% while 2024 was relatively unchanged from 1.5% to 1.4%. The 2023 unemployment rate was unchanged at 3.8% (very close to actual/reported number), and the 2024 figure is expected to be 4.1%. Inflation (PCE) for 2023 was lowered from 3.3% to 2.8% and from 2.5% to 2.4% for 2024. Core PCE (which excludes volatile food and energy prices) was also cut from 3.7% to 3.2% for 2023 and from 2.6% to 2.4% for 2024. The improvement in inflation led to lower estimates for the Federal Funds rate for 2024 from 5.1% to 4.6%.
While measures of consumption remained strong, other portions of the economy remained slower, including manufacturing and housing. The market survey measures of manufacturing and measures of activity were relatively flat. The housing market continued to see ongoing housing starts and sales, but at a slower rate due to mortgage rates that are relatively high compared to the historically low levels seen during the pandemic.
Falling inflation, ongoing job gains, and continued economic growth, as well as the Fed “pivot” all point towards a “soft landing” in 2024. The last Fed interest rate hike was back in July 2023, and the market is anticipating the next move will be an interest rate cut. Ongoing job growth should lead to continued strong personal consumption data.
Currently, the market is anticipating three interest rate cuts (or more) in 2024, with the first potentially as soon as March. Our view is that measures of inflation, including wage growth, will need to continue to improve before the Fed cuts.
Economic growth will likely moderate in 2024 after the solid 2023. Excess savings from the pandemic-related stimulus programs are gone. Higher rates for all borrowers (consumers, businesses, and governments) imply higher interest rate expense, freeing up less money to spend on other goods.
Finally, geopolitics can always impact the global economy in 2024. The ongoing wars remain unresolved.
In a confusing scenario, the Bloomberg consensus for economic growth in 2024 is 1.3%, yet the probability of a recession is 50%. So, economists think a recession is a coin flip in the coming 12 months.
Current Investment Views: Equities
The S&P 500 increased 26.3% and 11.7% for the full year and the fourth quarter by total return, respectively. The market rally widened late in the fourth quarter as well. Equities that were smaller in size and had higher volatility characteristics were two of the better performing groups. (It should be noted that many companies share both of those characteristics.)
Despite the conservatism expressed during earnings calls earlier in the year, the fourth quarter should be remembered for the risk-on rally. The soft-landing narrative gained traction and confidence improved during the quarter as the pace of inflation declined and resilient economic activity continued.
U.S. Treasury rates declined during the quarter, which drove an improvement in sentiment and expansion in equity price multiples. The price-to-earnings ratio for the next 12 months increased from 17.9x to 19.3x, – and negated the previous quarter’s multiple compression but left the market higher on better forward earnings estimates.
Banks rallied considerably, with the KBE (a bank index fund) up 25.8% in the fourth quarter. That increase is considerable since the group struggled during most of the year as higher interest rates caused investor concern related to deposit outflows, higher funding costs, and unrealized losses on a portion of their securities portfolios. Meanwhile, recession risks caused many investors to question future credit costs related to the loan books. As these fears dissipated throughout the quarter, the relative performance improved considerably.
Increasing geopolitical risk was another notable consideration after conflicts in the Middle East resurfaced, but thus far tensions remain relatively contained and the market reaction modest.
In our last quarterly outlook, we thought inflation would continue its downward trajectory without tighter financial conditions triggering large layoffs and poor economic activity. We also forecasted a recession would likely be avoided and the path of least resistance for equities in 2024 would be higher.
Our expectation appears to have materialized in the consensus opinion earlier than we had anticipated, with the S&P 500 posting a blistering total return during the fourth quarter. While we are pleased to see our base case supported by the trajectory of economic data and accepted more broadly in the investment community, it does reduce the potential upside for 2024 – as some of the expected return on equities was pulled forward into 2023. This year started at a high point, so there likely is only so much room for growth.
We project inflation will continue the normalization process while employment remains strong, allowing the Federal Reserve to cut rates in 2024 and avoid a recession. In other words, a soft landing. As this occurs, we expect equities can continue to appreciate but at a more muted pace, given historically elevated (but not yet excessive) price multiples and lofty forward earnings estimates.
Current Investment Views: Fixed Income
The fourth quarter’s fixed income environment was characterized by large volatility in yields and a historic rally. The U.S. 10-Year Treasury initially continued its rise in October, peaking around the 5% level. However, this proved too difficult to sustain as yields fell rapidly throughout November and December to reach about 3.9% by year end. Overall, U.S. 10-Year Treasury yields fell by almost 70 basis points throughout the fourth quarter. Reasons for the decline in yields include:
- Inflation continued to fall as the Core PCE Deflator, the Federal Reserve’s primary gauge of inflation, reached 3.2% year over year for November.
- With inflation data trending down, the market began to price in more rate cuts for 2024 with 150 basis points of possible cuts priced in by the end of the year.
- The economy showed signs of slowing as the labor market appeared to loosen and consumers slowed spending to a degree.
The sentiment that an economic soft landing is on the horizon brought movement to riskier assets, causing an even greater rally in the U.S. corporate bond market. As investors demanded riskier corporate bonds (treasuries are thought of as “risk free”), credit spreads tightened to levels not seen in years, fueling excess returns on these assets in relation to treasuries. In addition to tightening credit spreads, the call for a soft landing kept long-term yields high relative to the time before the Fed’s rate hike cycle.
The Fed also transitioned to a more positive outlook as it held rates steady, improved its economic projections, shifted to a more dovish tone, and signaled that its next move is more likely to be a cut.
In the Fed’s latest Summary of Economic Projections, the median dot plot projection (the Fed’s expectation for the economy) for 2024 GDP was slightly lowered from 1.5% to 1.4%. Despite this, the median unemployment projection for the end of 2024 remained unchanged at 4.1%.
Furthermore, the Fed’s median inflation projections for the end of 2024 were also revised lower from 2.5% to 2.4% for headline PCE and from 2.6% to 2.4% for core PCE. Perhaps most noteworthy was the average Fed member’s forecast now projects 75 basis points of rate cuts throughout 2024. The Fed and the market are still far off in their expectations for 2024, but they are trending in the same direction — a (mostly) soft landing.
Risks still exist that inflation could remain elevated, however. An outside shock, such as a broader war in the Middle East, or loosening financial conditions are potential roadblocks. The tight labor market is more resilient than once thought, and upward pressure on wages could make inflation sticky. Resilient consumer spending and strong economic growth were a theme in 2023, and 2024 has the potential to tell a similar story.
On the other hand, the economy could still fall into a recession. Consumer savings levels remain historically low, student loan repayments restart for many, and credit card delinquencies continue to rise. The growing national debt and political uncertainty also create more unknowns.
Asset Spotlight: Magnificent 7
The S&P 500 increased about 26% year over year on a total return basis while the Magnificent 7 (Apple, Microsoft, Alphabet, Amazon.com, Nvidia, Tesla and Meta) was responsible for much of the overall gain. For comparison, the index was up about 14% on an equal-weighted, total return basis (which is when company size is not factored).
The Mag 7 was one of the biggest equity stories of 2023. Collectively, the seven stocks now make up about 30% of the S&P 500’s weighted value, which is close to the biggest share for any seven stocks ever.
All the stocks in the Mag 7 have at least one thing in common: a tie to Generative Artificial Intelligence. The technology created a gold rush and the belief that it can generate massive profits in part because of the possible time and workforce savings. Last year, investors were excited about the prospect of the technology and the Mag 7 were the primary beneficiaries. This year, the market wants to see the technology come to fruition.
Mega cap companies have always driven returns in the S&P 500, but what appears different this time is technology is becoming a larger part of our everyday life and an increasingly larger part of the index. As interest rates rose over the last two years or so, investors looked to park money at companies with quality/predictable earnings (such as the Mag 7) – again showing how tech is part of so many aspects. The innovation component of tech companies is a current driver in value, which investors know.
It should be noted that the S&P 500 is different from other indexes since it is an active index. The S&P 500 is governed by quantitative measures – such as financial viability, adequate liquidity, and company type — that determine whether a company can be included. A committee meets to decide which companies are in this index, with quality being a large factor. Other indexes, such as the Russell 2000, simply use size (market cap, for example) as the only criteria.
The Mag 7 is interesting, but there are potential headwinds.
Some of the Mag 7 companies receive much of their revenue from advertising sales, which will likely run up against the law of numbers at some point. Generative AI is promising, but the technology may materialize later than expected and impact near-term earnings as a result. Also, the multiples these companies now trade at are so high that a pullback seems possible. Finally, the Mag 7 companies as a group carry higher geopolitical risk with elevated economic exposure to China and increasing restrictions on exports of American technology.
Something else to consider is the mega cap companies often change. (Few knew of Nvidia until relatively recently. Even then, it was known primarily for being a leader in video gaming graphics cards and for its use in cryptocurrency mining.) It is likely a new company will make headlines in the coming years and help drive overall index gains.
While the Mag 7 had an incredible year, the market widened in the fourth quarter. At the end of October, only four of the 11 S&P 500 sectors posted positive gains in 2023. By the end of the year, only three sectors were negative and two of those were nearly flat. Lastly, the Russell 2000 was up almost 17% annually, further showing other companies had solid years, albeit not as strong as the Mag 7.
Topic of the Quarter: The U.S. as the Reserve Currency
While the debt the U.S. accrues has been a topic of debate for years, the interest costs on borrowing money is now a considerable expense. Aside from interest expense crowding out other spending, there are other potential consequences in the coming years if the problem is not addressed.
In 2023, the federal government took in about $4.4 trillion in revenue. The total outlays amounted to roughly $6.1 trillion for a deficit of almost $1.7 trillion. The largest receipts for 2023 include:
- Individual Income Taxes: $2.2 trillion (49% of total receipts)
- Social Security Taxes: $1.6 trillion (36% of total receipts)
- Corporate Income Taxes: $420 billion (10% of total receipts)
- The remaining revenue streams account for just $229 billion in total (5% of total receipts)
The largest expenses for 2023 include:
- Health and Human Services: $1.7 trillion (28% of total outlays)
- Social Security Administration: $1.4 trillion (23% of total outlays)
- Dept. of the Treasury: $1.1 trillion (18% of total outlays)
- Dept. of Defense: $776 billion (13% of total outlays)
The government’s net interest expense, which is part of the Dept. of Treasury’s outlays, totaled $659 billion. It is possible interest expense could top $1 trillion in the coming years and, by itself, become one of the three largest expenditures. The cost of borrowing increased dramatically in the last several years as the Federal Reserve pushed interest rates higher to combat inflation. Also, the U.S. government is increasing public spending and issuing more debt, which is creating a snowball-like effect where more deficit spending is needed to continue covering outlays. The U.S.’s political leaders have been spending more recently, while tax cuts in recent years have also contributed to the problem.
All of this means the interest expense could harm the U.S.’s status as the reserve currency for the world.
In short, this means other countries hold U.S. currency for transactions with other countries. The U.S. dollar is seen as stable and safe. Foreign currencies are also pegged to the dollar, which is one of the nation’s strengths.
If the U.S. loses its status as the world’s reserve currency, it will likely mean the country has less access to capital, higher borrowing costs, and lower market valuations. The counter argument is there is currently no other clear rival. With the implementation of digital currencies, strong foreign competition, and domestic discord, it is theoretically possible another currency will become more attractive in the future, however when and if are unknowns.