It is often said that economic and market forecasts exist solely to make astrology look respectable, but since year-ahead predictions are an age-old tradition in the financial community we too shall again partake in this annual exercise. Before looking ahead, though, we should first reflect back on what happened during the past twelve months.
In 2023, technology stocks, particularly mega-cap firms that could cram mentions of “AI” as much as possible into every press release, were the clear winners. This should not be too surprising considering that these same stocks were the biggest losers in 2022. One could therefore argue that 2023 in many ways simply offset what occurred in 2022, and in fact this is supported by the performance of the S&P 500, which is essentially flat (as of this writing) since the end of 2021.
However, one could not argue that as a result of this performance the markets are beginning 2024 from exactly the same starting place as they did in 2022. Indeed, two years ago the economy was still rapidly expanding, inflation was accelerating, and the Fed was about to embark on one of the most aggressive hiking cycles in history. Fast forward to today and economic growth is clearly slowing, inflation is coming down, and rate cuts are perceived as almost a certainty.
This alone makes it difficult to believe the next two years will be a mirror of the past two years, but this also does not necessarily mean that history cannot help provide a useful guide, only that we must instead look elsewhere in history for clues on what to expect. With respect to the economy, for instance, history suggests that we are on the precipice of a recession. There is of course the infamous yield curve, particularly the 2s/10s, which first inverted back in July of 2022.
The inversion itself is not the imminent warning of an impending recession, but rather the subsequent re-steepening. Indeed, recessions have tended to begin shortly after a re-steepening in the curve, meaning potentially as early as the Q1 2024 based on recent bond market price action. Of course the yield curve is far from a perfect indicator, in part because an inversion simply implies that current conditions are more sensitive, or exposed to, potential economic shocks.
We must therefore look for additional evidence elsewhere, which unfortunately for the economy is also not short of red flags. The labor market is perhaps the most important place to look because changes in the dynamical system can have a direct impact on consumer spending, inflation, and many other arenas, all of which can eventually turn into a positive or negative feedback look. A lot of the headline data that gets the bulk of the media focus, such as monthly payrolls gains and the unemployment rate, do not seem too bad at all at the moment and in fact might have even provided some economic re-acceleration red herrings of late.
However, continuing claims for unemployment benefits, multiple jobholders, the quits rate, and many other less popular labor market indicators have all been flashing warning signs of late. More worrisome are the rates of change in such metrics, particularly the second derivative, which represents acceleration (or in this case deceleration). Moreover, we are seeing many of these trends happening at both the national and state level, which altogether based on our research points to a high probability of a recession in 2024. So perhaps the real question to ask is not if a recession occurs but when, and how severe will it ultimately be.
This of course leads to the question of whether the economy will experience a soft-landing or a hard-landing. An encouraging development was provided during the last FOMC meeting of 2023, when a combination of wording and changes in economic forecasts have potentially signaled a dovish pivot from the Fed that occurred sooner than the prevailing consensus was expecting. Put simply, if the time horizon for a policy pivot (rate cuts) has been brought forward then the risk of the Fed staying too hawkish for too long has been reduced. This matters because it is likely that at least in 2024 the FOMC will have to do all of the heavy lifting when it comes to propping up the economy.
Indeed, we have seen the power of fiscal stimulus time and time again, most recently via the government’s response to the pandemic and the prolonged period of economic growth (and inflation) that resulted. This year, though, it is highly unlikely that Washington will be able to provide any sort of meaningful economic stimulus in response to a recession because not only is political divisiveness already at an extreme level but 2024 is also an election year, meaning it is doubtful any one party will want to give the other a win. With little help to be expected on the fiscal front it will therefore be monetary policy that determines what kind of landing the economy experiences.
So perhaps the December FOMC meeting is a sign that the Fed has arrived at this same realization and will in turn succumb to political pressures and front-load rate cuts in an election year. This could be at the expense of the economy in 2025 should inflation have not in fact peaked, but ultimately our base case is that an early pivot by the Fed is the right move based on the greater recessionary risk we see in 2024. What does all of this mean for the year ahead? Well for the economy a soft-landing is a possibility thanks to an early Fed pivot but since the exact timing and scale of the FOMC’s eventual move is still uncertain our base case is for more of a medium-landing as the slowdown in the labor market accelerates, in turn putting increasing strain on consumer balance sheets. There are also the lingering risks of further banking turmoil, increased geopolitical tensions, and other exogenous shocks.
As for interest rates, current Fed projections imply three cuts this year, whereas market pricing is expecting double that, so reality will likely be somewhere in between. As for stocks, historically equities in general tend to do well in the months leading up to the first rate cut and then volatility picks back up markedly following the first cut, similar to buy the rumor (potential cuts) sell the news (actual cuts), and perhaps akin to the price action we have seen recently. However, when it comes to using historical comparisons as a guide things become more complicated when trying to determine how specific market sectors will behave, and whether or not the economy is in an expansion or recession, whether we are experiencing inflation or disinflation, and various other conditions can all have a big impact.
So altogether it would not be surprising if 2024 does not see a repeat of 2023’s winners and losers, and at the very least it is likely that this year will be a choppier year for equities than what we were spoiled with in the latter part of 2023. This does not mean stocks cannot keep rising in 2024 but simply that the ride may be bumpier. Fortunately, this should not be a problem for 401(k) retirement investors who can remain focused on the long-term and potentially even use any transitory uptick in volatility as an opportunity.