An Encouraging Start to 2024
- Economy grew 2.5% in 2023
- Some deceleration expected in 2024
- Fed’s next move will be a cut
- Labor market remains strong
- Recession still possible
The US economy enters 2024 in good condition, with ongoing growth in real GDP and consumer spending. Consumer sentiment is finally improving, inflation is responding to some of the most stringent monetary tightening ever, and the labor market remains robust. The argument for a “soft landing” appears to be strengthening, but we remain attentive to the many risks still facing the US economy. These include:
- a deteriorating geopolitical environment with two wars and mounting tensions between major powers
- a partial retreat from the globalization of supply chains
- political uncertainty—half the world’s population will elect new leaders in the next twelve months
- risk of an overshoot on monetary tightening
- rapidly rising debt and a near-total breakdown in the management of America’s fiscal affairs
Some of these risks will either strengthen or fade in the next twelve months. Others, such as the rapidly rising level of US debt, may not have a direct economic impact for several more years.
The American economy grew at a rate of 2.5% in 2023, according to the first estimate. This compares to a real growth rate of 1.9% in 2022. Despite the strong start to this year, most analysts expect growth to slow to some extent in 2024. That is because the impacts of monetary tightening typically hit the economy with a lag of 12–24 months. It would be a fairly typical occurrence for the interest rate hikes of the past year to more fully impact the economy in 2024. Please recall that in addition to raising rates, the Fed is also draining liquidity from the financial system through quantitative tightening. Nothing in the current measures for the US economy suggests recession, and yet we cannot comfortably rule out recession for 2024. That is because most of the hard measures for the broad economy discussed here are lagging indicators. The leading economic indicators continue to flash strong warning signals, consistent with those that precede recessions. We believe that current probabilities for recession in 2024 are slightly below 50%, but certainly not negligible. Should the US fall into a recession, the Fed has considerable scope to rapidly lower rates and restore liquidity.
- 216,000 jobs added in October
- Unemployment at 3.7%
Payrolls rose 216,000 in December, and unemployment held steady at 3.7%, about where it has been since March of last year. Job openings continue to trend down, as do hires and “separations.” There is a softening in the labor market, but it has not impacted the unemployment rate yet. Low unemployment, ongoing growth, and declining inflation together form the strongest arguments for the “soft landing” scenario.
- Inflation ticked up in December
- Core CPI at 3.9% and still trending down
- Road down to 2% may be rocky
The monthly “all items” inflation index ticked up to 0.3% in December after registering a subdued 0.1% in November. Many media observers suggested that this result may represent a concerning change for the worse in the battle to control inflation and might even justify further tightening by the Federal Reserve. Economic data never moves in a straight line, particularly in its monthly intervals. The road to lower inflation was eventually going to hit a bump. Today, as we look at the larger picture of improving inflation, we do not view the December result as a change in direction. However, we have said for some time that the last few percentage points down to the Fed’s target of 2% may be harder to achieve than the early gains that were so clearly supported by repairs to global supply chains and declines in energy pricing. It is probably also true that once the current decline in inflation has run its course, inflation in the future may very well be more volatile than it was for the two decades prior to COVID. That is because one of the primary forces that constrained inflation during that period, globalization, seems to have exhausted some of its anti-inflationary power, and is now being disrupted by renewed geo-political strife. Our relations with China are not as constructive as they once were when our collaboration helped make that country one of the most effective low-cost producers in the world. It is especially difficult now to fully realize the benefits of a global supply network when piracy is disrupting one of the world’s critical sea lanes.
We believe that inflation will continue to abate in 2024, although at a slower downward rate and with the possibility of a few monthly reversals along the way. The easy work is behind us. Nevertheless, the longer-term measures of inflation continue on a downward trend. Year-over-year CPI for “all items” was 3.4%, and the core measure for “all items less food and energy” was 3.9%, a new low for this cycle. Inflation is currently running hotter for services over goods. The improvement in supply chains over the past 18 months has primarily benefited pricing for goods, but services comprise the greater part of the US economy.
- Fed rate increases are over
- Debate over timing and extent of future cuts
- Fed still shrinking its balance sheet
The Fed Open Market Committee met on December 12 and 13, and they will meet again on January 30 and 31. At their last meeting for 2023, they once again held steady on their target for overnight interest rates. They have now been on hold since September of last year. Taking into account their own actions and remarks, it is only reasonable to assume that this period of rising rates and monetary tightening is over. The upper bound of the overnight target remains at 5.50%, up from virtually zero post-pandemic, and the highest it has been for most of this century.
The Fed continues to reduce its bond holdings, which has the effect of reducing liquidity in the economy at a rate of $95 billion per month. This process is referred to as “quantitative tightening.” However, it is now anticipated that this additional tool for monetary constraint may start to wind down over the first half of 2024.
The 10-year Treasury note currently yields 4.15%, after dipping below 4% earlier this year. The yield curve continues to be inverted, and rates have proven to be quite volatile this year as markets attempt to anticipate when the Fed may begin to cut interest rates and by how much. Markets appear to be anticipating an initial rate cut in March and a total reduction of 1.25% for the year. Those assumptions look aggressive to us, but we certainly believe that the Fed’s next move will be to cut interest rates and that those cuts will begin in the first half of 2024. We anticipate that there will be meaningful reductions in short-term rates this year and next. We believe that short-term rates may settle in the 3.0% range by the time the Fed completes this next phase and that the yield curve will return to a positive slope during that process.
- S&P 500 sets new high
- Bond market anticipating lower rates
The S&P 500 reached a new high on January 26 and is up over 2% so far in 2024. That index was up over 20% over the past year. The index remains richly priced with a price/earnings multiple above 26. That being said, there does appear to be some momentum in the market’s recent moves, and some recent sessions have displayed signs of a market attempting to “spread out” its gains. So much of last year’s gains were concentrated in a short list of technology mega-cap stocks, and a significant part of current gains are being concentrated in the stocks of companies positioned to benefit from the development of Artificial Intelligence (AI). Some parts of the market not associated with technology are more attractively priced, so skillful stock pickers may find opportunities in sectors that were neglected in 2023. These include energy, healthcare, and consumer staples. However, it should also be pointed out that valuation alone is not a very good indicator for timing. To the extent that fundamentals still matter to stock values, the market would benefit greatly from an improvement in corporate earnings. A strong US economy would support such an improvement. Analysts project earnings growth for the S&P 500 at 12.2% for 2024. That projection includes a low of -1.7% for the energy sector and a high of 18.2% for healthcare. It should be noted that analysts’ projections are often optimistic at the beginning of the year.Bond markets have been volatile, with the 10-year Treasury yield fluctuating between 3.91 and 4.15%. Bond markets are trying to anticipate both the scope and the timing of Fed interest rate cuts in 2024. Investors have recently become accustomed to a market that rewards cash—many short-term rates are above 5%, however, long-term investors may wish to rotate into intermediate bonds in order to lock in some of the currently attractive rates available on those bonds. When the Fed does cut rates, the reduction in yield will be at the short end of the yield curve and rates on cash will fall in lockstep with those cuts.
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GDP – Bureau of Economic Analysis
Employment & Inflation – Bureau of Labor Statistics
Interest Rates – Federal Reserve
P/E S&P 500 – multpl.com
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