News and Insights Economic & Market Perspective: February 2024

Following unprecedented market turbulence in 2022, the conclusion of 2023 resulted in positive outcomes for both the stock and bond markets. Investors, initially bracing for a recession, were pleasantly surprised by a resilient economy, robust consumer spending, strong employment trends and favorable inflation data.

Despite low expectations by investors heading into 2023, stocks had an impressive year—the S&P 500® Index gained 26.3%, the Dow Jones Industrial Average surpassed 37,000, and the Nasdaq Composite soared 44%, fueled by companies with exposure to artificial intelligence. The year-end rally, marking the S&P 500’s longest winning streak since January 2004, provided a welcome boost to various assets. Higher bond yields, which initially concerned money managers, didn’t dampen the rally. In October, the 10-year Treasury yield hit 5% for the first time in 16 years, before retreating to 3.88% by year-end.

Despite challenges such as the U.S. Federal Reserve (Fed) raising interest rates, a regional banking crisis and geopolitical tensions, the markets defied predictions, hinting that the worst of these challenges are behind us. As we step into 2024, the world’s financial markets will keenly observe how these narratives unfold amid the ever-changing global economics, geopolitics and the U.S. presidential election.

Equities Rock and Roll

From the end of July through late October, the U.S. stock market experienced a 10% correction, despite improving economic conditions. However, a robust rally ensued after softer inflation data in the October Consumer Price Index (CPI) and dovish remarks from the Fed fueled investor confidence in a potential soft landing of the economy. In the fourth quarter, the S&P 500 surged 11.7%, and the Russell 2000® Index gained a notable 14%, driven by a substantial 12.2% increase in December. Examining the Russell 1000® Growth and Russell 1000® Value indexes, growth outperformed by 4% in the fourth quarter and by an impressive 31% for the year.

Equity investors navigated substantial volatility in the last two years, enduring a significant market selloff in 2022 followed by a robust yet turbulent rebound in 2023. Even with a strong 2023, the S&P 500 was up just 1.7%, and the Nasdaq was down 1.2% on an annualized basis for the combined last two years. It is worth noting, however, that the S&P 500 continued to shine in the first month of 2024, and on January 19, finished at 4,839.81 to set an all-time closing high, surpassing the previous mark of 4,796.56 from January 3, 2022.

A notable development in 2023 was the focus on the Magnificent Seven (Apple, Microsoft, Alphabet, Amazon, NVIDIA, Tesla and Meta Platforms), which contributed approximately 62% to the S&P 500’s returns through December 31, 2023, a shift from nearly 100% in late October. In fact, the equally weighted S&P 500 was down through October, but a strong rally in November and December lifted the index so that it was up 13.8% for the year. This suggests a broadening of equity market performance.

Many investors anticipate this trend continuing into 2024, supported by compelling arguments. Notably, valuations for the equally weighted S&P 500 and S&P Small Cap 600 appear more attractive, with forward earnings multiples of 16.2x and 14.4x, respectively—both below their 10-year historical averages. In contrast, the S&P 500 currently trades at 19.7x, notably exceeding its 10-year historical average of 17.9x.

10-Year Treasury Yield Does a Round Trip

As the fourth quarter of 2023 approached, the Bloomberg U.S. Aggregate Index faced the prospect of marking its third consecutive negative year, an unprecedented occurrence. However, a “relief” rally in November and December propelled the index to a positive return of 6.8%, concluding the year 5.5% higher. Similar positive outcomes were observed in the Bloomberg U.S. Corporate Index, which returned 8.5% for the year.

By contrast, 2-year bond returns have less favorable results—the Bloomberg Aggregate Index and the Bloomberg Corporate Index declined by 8.2% and 8.5%, respectively. Despite a modest gain of 3% in long-term Treasuries in 2023, it remains one of the poorest-performing asset classes for the two-year period, during which it was down 26%. Notably, amid significant interest rate volatility, the 10-Year Treasury yield commenced and concluded the year nearly unchanged, at 3.875% and 3.879%, respectively, with the yield curve action concentrated at the short end. The only weakness that could be spotted was in West Texas Intermediate Crude Oil futures, which fell 21.1% in the fourth quarter and 10.7% overall for the year.

Has the Fed Tamed Inflation without Hurting Employment?

Recently, economists have introduced the term “immaculate disinflation.” This unofficial term is used to depict a scenario where inflation subsides without triggering a surge in unemployment. It has also become synonymous with a soft landing.

Traditionally, accomplishing this has been challenging due to the well-studied “sacrifice ratio,” which suggests that reducing inflation incurs economic costs, typically seen as higher unemployment. In brief, the ratio is essentially the cost of combating inflation.

On the inflation front, utilizing the Fed’s preferred measure of core personal consumption expenditures (PCE), the annualized inflation rate dropped to 2.9% in December. Core PCE, which peaked 18 months ago, has declined as swiftly as it surged, challenging the notion of inflation being “sticky”—the idea that it falls more slowly than it rises. Non-core PCE and the CPI registered 2.6% and 3.4%, respectively, in December, rapidly approaching the Fed’s 2% target rate for inflation. This suggests that the Fed is making progress toward achieving its mandate of price stability in the coming months.

Turning to employment, the Fed’s secondary mandate, the unemployment rate, has consistently stayed below 4.0% since the initiation of interest rate hikes in March 2022. December’s unemployment rate held steady at 3.7%, resulting in an average rate of 3.6% for 2023, mirroring the 2022 average. This unprecedented 23-month streak below 4% indicates a persistently tight labor market. Some economists and investors speculate that the Fed has orchestrated a soft landing or immaculate disinflation by meeting both mandates. However, Fed officials exercise caution, awaiting inflation to sustain the central bank’s 2% target, recognizing that achieving this without a substantial rise in unemployment would be viewed as a near miracle by Fed Chair Jerome Powell and his colleagues.

Fed Officials and Investors Have Divergent Views on Rates

Anticipating a sustained easing in inflation, there’s a possibility that the Federal Open Market Committee (FOMC) will gradually start adjusting policy rates around mid-2024. The Fed’s current projection suggests three rate cuts for 2024, aiming for a year-end Federal Funds Rate ranging from 4.50% to 4.75%, down from the current target of 5.25% to 5.50%. Despite nearly two years of raising rates for price stability, the Fed seems to be signaling the end of that effort. Investors, however, anticipate a more aggressive approach, with six cuts totaling 1.25 percentage points, beginning as early as March 2024, creating a divergence from the Fed’s outlook. This disparity could introduce volatility to both equity and bond markets. Regardless, the Fed’s quantitative tightening, with a monthly removal of $95 billion, is expected to continue throughout 2024, withdrawing approximately $1 trillion from the economy in the next year.

Gross Domestic Product Is Resilient – No Recession Here

Following a robust 2.8% performance in 2023, including 3.3% growth in the fourth quarter, it is anticipated that the Gross Domestic Product (GDP) will ease to a 1.4% pace in 2024. The significant role of consumer spending, constituting 70% of GDP, adds importance to monitoring this indicator. Recent holiday shopping trends reflected modesty, with consumers displaying caution and actively seeking bargains. Several factors, such as reduced excess saving, stagnant wage growth, low saving rates and diminished pent-up demand, could contribute to a continued slowdown in consumer spending in 2024. Emerging indicators, including the resumption of student loan payments and a rise in subprime auto and credit card delinquencies, suggest potential stress for certain consumers. According to a Bloomberg economic forecast survey, the consensus points toward a lower GDP in 2024 compared to 2023, but this is in no way recessionary.

Housing Continues to Be “Frozen”

With housing affordability metrics hitting a 40-year low in 2023 and 75% of mortgages secured at 4% or below, the U.S. housing market is essentially stagnant or frozen. Since 2020, housing affordability has plummeted by 47%, reaching levels near the lowest on record since 1986. Real residential investment experienced a notable 12% decline at a seasonally adjusted annual rate over the past six quarters. Despite a 6% rise in home values in 2023, resulting in nearly all-time highs due to tight supply and historically low vacancies, the market faces vulnerability in 2024 if mortgage rates, which dropped from above 8% to around 6% by year-end, don’t return to 3%.

Commercial Real Estate Troubles Loom

The office sector has transformed due to widespread work-from-home and hybrid office policies. Companies, reevaluating space needs, are downsizing, leading to reduced demand and lower rent rates. Concurrently, small and regional banks lending in commercial real estate tighten standards amid rising interest rates. A substantial volume of commercial mortgages, with maturity approaching, will have to refinance at significantly higher rates. It is estimated that $1.2 trillion of commercial loans will need to be refinanced this year and next. This convergence presents a perfect storm, foreseeing lower valuations, increased loan defaults and potential foreclosures.

Supply Chains Continue to Adjust

In the last year, with the alleviation of inventory constraints and reduced shipping costs, supply-chain focus has transitioned from short-term tactics to long-term strategies emphasizing cost reduction and resilience. Legislation like the CHIPS and Science Act and the Inflation Reduction Act, both of which were enacted in 2022, incentivizes specific strategic industries—such as semiconductors and renewables—to bring production onshore. Consequently, there has been a noticeable increase in business investment in high-tech manufacturing structures over the past year. Looking ahead, global supply-chain adaptations are anticipated to proceed cautiously, especially now that companies have a better appreciation of how quickly supply-chain disruptions can squeeze their operating margins.

Geopolitics Are Plentiful

On the global front, persistent trade tensions with China, the ongoing Russia-Ukraine conflict and instability in the Middle East carried over from 2023 and are likely to contribute to ongoing uncertainties and risks in 2024. Although the direct impact on the U.S. economy has been limited, the overarching concern lies in the potential for a supply shock in essential commodities or goods—such as energy, food or semiconductors—leading to substantial market disruption. The upcoming U.S. presidential election in November may exert a more significant influence on geopolitics than recent cycles, given the current backdrop of heightened political tensions in the U.S.

Summary and Outlook

In 2023, the financial markets defied initial expectations, with both stock and bond markets experiencing positive outcomes by year-end. Despite concerns of a recession, a resilient economy, robust consumer spending and favorable inflation data led to impressive stock market gains, marked by the S&P 500’s longest winning streak since 2004. Equities faced challenges but navigated volatility, with a notable focus on the Magnificent Seven tech giants contributing to market performance. The 10-year Treasury yield ended where it started the year, with positive returns in the fourth quarter, but 2-year bond returns reflected less favorable results. Amid these developments, the Federal Reserve’s efforts to tame inflation without harming employment prompted discussions of a potential soft landing.

Looking ahead to 2024, there are diverging views between Fed officials and investors regarding policy rates. While the FOMC anticipates a gradual normalization with three rate cuts, investors are betting on a more aggressive approach, potentially adding volatility to both equity and bond markets. The GDP has been resilient, with a projected slowdown in 2024 but no signs of a recession. However, challenges persisted in the housing market, characterized by affordability concerns and a “frozen” state. Commercial real estate faced troubles due to changes in the office sector and refinancing challenges. Meanwhile, supply chains continued to adjust, with a focus on long-term strategies, and geopolitics remained a source of uncertainty, particularly with trade tensions and conflicts influencing market dynamics as the world approached the 2024 U.S. presidential election.

With these key issues in mind, investors should continue to expect a sustained period of uncertainty in the financial markets and economy.