2024 Economic & Market Outlook:
Congress Passes the Baton to the Fed as Inflation Eases
2023 started with a bang. On the heels of a 4.25% increase in the federal funds rate in 2022, regional banks were hurting, leading to the failures of Silicon Valley, Signature, and First Republic. Congress got comparatively little done in 2023, with the biggest laws passed including one to temporarily suspend the federal debt limit and one to officially end the COVID national emergency declaration from 2020.
The Federal Reserve was busy at work most of the year, maintaining their quantitative tightening program and higher interest rate policy to quash rising prices. Annualized inflation crept lower toward 3%, while energy and used car prices fell (Bureau of Labor Statistics). All year long, investors have scrutinized every quote, publication, and nuance from the Federal Reserve, trying to figure out if Fed policies will help or hurt their investments.
Stock Market Commentary
All Hail the Magnificent Seven
While stocks were broadly up this year, the superstars of 2023 were the aptly named the “magnificent seven” companies (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia, and Tesla) which stood at the forefront of artificial intelligence technology. These big cap technology stocks each gained 49% or more in 2023, pushing the technology-dominant NASDAQ Composite Price Index to have its best year since 1999, with a 43.4% annual gain (Money.net).
Featured Image 1; Source: Stockcharts.com
Most stocks didn’t do as well – or at least until mid-November, when markets anticipated the Federal Reserve pivoting its policy stance from monetary tightening to monetary easing. In fact, an equal-weighted S&P 500 Index, which can be a fair representation of the stock performance of the average large company, was negative year-to-date just two months ago. Since then, it has climbed nearly 15%, indicating the first broad-based, healthy stock market rally of 2023.
International markets posted smaller gains in 2023. The MSCI Europe, Asia, and Far East Price Index rose 15.0% (MSCI) and the MSCI Emerging Markets Index increased 7.0% (MSCI), compared to the domestic and tech-heavy S&P 500’s Index’s gain of 24.2% (Yahoo Finance).
Much of this year’s gains were in anticipation of strong corporate earnings in 2024, not 2023. In fact, earnings among small cap Russell 2000 companies are expected to be down 11.5% in 2023 (Reuters), and earnings growth for the S&P 500 is expected to be just 0.6% for the year (Factset). This will set the bar high for stocks, especially large cap stocks (more on that below), in 2024, as anything less than stellar earnings growth may disappoint investors.
Looking for Opportunities in 2024 – Small Caps
While the much-loved “magnificent seven” stocks launched higher over the last year, many lesser known, smaller companies have shouldered immense selling pressure. In fact, both the small cap S&P 600 and Russell 2000 Indexes were both down nearly 30% from their 2021 peaks as late as October 2023. The more economically sensitive companies in these indexes have been sold off in anticipation of economic stress and have become quite undervalued, with the forward price-earnings ratio for the S&P 600 Index touching 2009 lows just two months ago (Yardeni Research). Meanwhile, the forward P/E ratio for the big cap S&P is 19.5, compared to its 2009 low of around 10, suggesting small caps are undervalued versus large caps.
Here’s the tricky part – you can’t time with valuations alone. In other words, different stocks can be undervalued or overvalued for long periods of time. And if the economy does dip into recession, history tells us that small cap stocks will likely underperform. Therefore, we’re going to be cautious and only invest in small caps when the risk-reward trade-off is in our favor.
Fed Policy Update – Inflation Conquered, But Why Wait This Long to Cut?
The Federal Reserve declared victory over inflation at its December meeting, opening the door to rate cuts in 2024 to move back to a neutral monetary policy stance. Their forecasts indicated three rate cuts in 2024 and four more in 2025. This will mark the end of the rate hike cycle that began in March of 2022.
Personally, I’m surprised the Fed didn’t start cutting rates earlier. In the chart below, you can see that the Fed historically starts cutting rates prior to inflation peaking. This time, they’re expected to begin cutting rates nearly two years after inflation, as measured by the annual change in the Consumer Price Index (green), peaked.
The reason for my surprise is that the effects of monetary policy are seen with a lag of up to 18 months. In other words, the last interest rate hike in July 2023 may take until early 2025 to be fully baked into economic growth and inflation. Even Chairman Jerome Powell recently acknowledged that policy lags when asked about waiting until inflation touches 2% to cut rates. His quote was:
“The reason you wouldn’t wait to get to 2% to cut rates is that would be too late . . . You don’t overshoot.”
He talks about “overshooting,” meaning that if monetary policy is kept tight for too long, it causes deflation and economic stress. Even though I don’t think overshooting is too likely, the fact that the Fed waited so long after inflation peaked to cut rates does increase the risk that past monetary measures will strain the economy in 2024.
Economic Update – Currently Healthy, But Pandemic Stimulus Wearing Off
We’re looking at a degree of uncertainty in 2024. On one hand, we see falling inflation, interest rates, and low unemployment as economic tailwinds. On the other, leading economic indicators such as business confidence surveys, new manufacturing order flow, and rapidly contracting private job openings suggest some stress in the economy. These indicators, however, have generally been flagging red since mid-2022, and their lead time to an economic contraction is usually around seven months, not a year and a half.
So, what’s going on? Is the risk of recession, which we’ve been discussing for over a year now, gone? We don’t think so, but it has likely been delayed primarily by a factor we may not have given enough credit in the past – massive fiscal spending. We had some of the largest government stimulus in history during the pandemic, which contributed to huge buildups in consumer savings. With the rising cost of living, these funds have been dipped into; estimates by the San Francisco Federal Reserve indicate that these savings are only now becoming depleted. Absent these savings, higher prices would have likely choked out most consumers in 2023, causing a drop in aggregate demand for goods and services (the textbook definition of what causes a recession).
The 2020 and 2021 COVID fiscal stimulus measures were followed by more stimulus in the forms of the Inflation Reduction Act, the CHIPS Act, extended student loan moratoriums, and big cost-of-living adjustments for Social Security recipients. All of this has led to record year-over-year deficits, which act to spur the economy.
Again, the temporary surge in fiscal spending has likely delayed, not cancelled, a cyclical economic slowdown, and there’s evidence of strain beginning to show – especially on consumers with poor credit.
For one, credit card delinquencies are beginning to climb. This is especially the case with credit cards issued by smaller banks (blue in the graph below), which tend to issue more cards for less creditworthy individuals. Small-bank delinquency rates are at multi-decade highs.
Subprime auto delinquencies have also reached their highest level in 30 years, as lower income and less creditworthy borrowers shoulder higher car prices and payments. Loan interest rates for poor credit score borrowers are especially punishing, nearing 20% (NerdWallet).
Still, these statistics are for subprime borrowers, which according to Experian make up less than a third of Americans. Delinquency rates (credit card, mortgage, car loan) for higher credit score (and likely higher income) borrowers are still close to historic lows, or as a recent article described, “pristine.”
Significant financial stress for most Americans has most likely been contained by the lasting effects of fiscal stimulus over the last four years. This tailwind is going away in 2024, making it more important for less restrictive monetary policy to pick up the slack. As of now, economic turmoil doesn’t appear imminent, but policymakers face the potentially difficult task of keeping it that way in 2024.
Final Thoughts for 2024 – New Market Leaders & Election Chaos
The biggest gains this year were concentrated in the large cap “magnificent seven” technology stocks. As of early-January, the average trailing price-earnings multiple for these stocks is a staggering 49.9 (Money.net, table on right). I’m concerned that even good earnings in 2024 might not be enough to satiate investor expectations, so we’re avoiding large overweights to these stocks in 2024. We predict that different sectors will likely lead this year., including financials, which stand to profit more as the yield curve un-inverts, and dividend paying stocks, which perform best when long-term interest rates are falling.
Finally, there’s the election. At this point, it seems that each party is trying to take the other’s candidate off the ballot; this is likely only a prelude to how heated and contested this election will get. We hesitate to infer causation to one party’s victory to good or bad stock market performance; however, if history repeats, democrats tend to create favorable policies for technology companies, and republicans do the same for energy companies.
Whatever 2024 brings, we’ll be ready. As always, we welcome any questions and feedback about our outlook and remain gracious that you choose Union Bridge Capital as a partner in your financial life.