Outlook: 1st Quarter 2024

Economy

One year ago, the consensus view called for a recession in 2023. Instead, the economy performed well, and it continues to grow at a respectable pace. However, the expansion remains uneven with some industries experiencing strong demand while others are in recession. These disparate outcomes, characterized by simultaneous patterns of boom and bust, are called rolling recessions and they have been working their way through the economy, industry by industry, for several years.

In the depths of the pandemic, service providers such as restaurants, hotels, and airlines were either closed entirely or had limited operations. In contrast, providers of goods such as furniture, sporting equipment, cars, and appliances enjoyed strong demand fueled by work from home lifestyles and government stimulus programs. Those trends have since reversed resulting in busy restaurants and long lines at airports as well as weakening demand for furniture and appliances.

Looking forward, we expect the economy to continue along its current path with disparate outcomes across industries. Employment markets remain resilient; however, the excess savings that were built up during the pandemic will eventually be depleted and the Federal Reserve continues to pursue a restrictive monetary policy. These opposing factors are expected to facilitate a path toward 2.0 percent growth that is consistent with our long-term trend.

Inflation

Inflation rates continue their downward trajectory and are now well below the 9.1 percent peak reached in June of 2022. Looking forward, we expect inflation to continue its decline as the Federal Reserve’s restrictive monetary policy further reduces price pressures.

We are making progress in reducing inflation, but it is not clear where it will settle on a long-term basis. In the years leading up to the pandemic, the Consumer Price Index increased at an annual rate of approximately 2.0 percent. However, in today’s world of high government debt levels and large federal deficits, it remains uncertain if the rate can return to that level without a meaningful downturn in the economy.

U.S. dollar

The U.S. dollar has fallen from its post pandemic high but remains elevated. Expectations for an eventual pivot in the Federal Reserve’s tightening policy have led to a decline in the value of our currency. In the coming year we expect the dollar to maintain a weakening bias as the upward pressure on inflation and interest rates subsides.

Asset class

Cash/Money Market Instruments

As we enter 2024, the Federal Reserve has left the Federal Funds rate unchanged for three consecutive meetings. Overall economic data, as well as commentaries from corporate management teams, indicate that the economy and labor market are exhibiting signs of slowing. In addition, inflation continues to decline, raising hopes for a soft landing. Despite the consensus view that we have reached a peak in the Federal Reserve’s policy rate, money market yields remain stable within the 5.25 to 5.50 percent range, but a continuation of soft economic readings may lead to lower rates in the coming year.

Intermediate Government/Credit Bonds

Rising optimism for a soft landing has resulted in a significant decline in bond yields. In fact, the yield on the 10-year Treasury has declined approximately 100 basis points since hitting a high of 4.99 percent on October 19. A combination of softening economic data, as well as signs that the labor market is cooling, have reinforced optimism that inflation can return to its 2.0 percent target without a recession.

Hopes for a pivot by the Federal Reserve have driven the sharp decline in Treasury yields. The market is currently pricing in 125 basis points of rate cuts in 2024 with the first easing occurring as soon as March. In addition to lower Treasury yields, credit spreads have contracted for both investment grade and high yield bonds, and they are currently at the lowest levels of the year. Spreads of 106 and 366 basis points reflect hopes that the Federal Reserve’s tightening cycle has concluded.

Tax-Exempt Municipal Bonds

Optimism related to a highly anticipated pivot in the Federal Reserve’s policy has also driven returns in tax-exempt municipal bonds. The Bloomberg Municipal Bond Index posted its sixth-best monthly return on record in November and its second-best for any November since 1981. With market expectations for the Federal Funds rate to decline to 4.0 percent by December 2024, we continue to focus our purchases in intermediate to longer-term bonds.

U.S. Equity

The S&P 500 Index generated a strong gain in the first eleven months of 2023. However, a closer look at the underlying constituents reveals that the market’s returns were bifurcated. The largest stocks in the Index were the drivers of the high returns as the eight positions with the largest weightings increased by an average of 96 percent. These stocks rose dramatically as most of them are expected to benefit from the proliferation of artificial intelligence. In contrast, many other stocks generated modest gains or declined as evidenced by the fact that strategies utilizing equal weights for index constituents significantly underperformed the traditional capitalization-weighted indexes.

In the coming year, we are watching for an inflection in earnings growth that can serve as a catalyst to higher stock prices. Profits, in aggregate, plateaued in the last two years, but in 2024 they are projected to return to an upward trajectory and rise approximately eight to ten percent. That provides a positive backdrop, but the market may struggle to generate unusually large gains given today’s high equity valuations. Currently, the market is trading at a multiple of approximately 19x forward earnings, which represents a premium to the long-term average of 16x.

In the coming year, we are also watching for greater symmetry in the returns of each market segment. The economy has settled into a soft landing characterized by an uneven expansion. Some industries are benefiting from strong demand while others are struggling, but demand patterns will eventually normalize. In anticipation of that trend, we expect less dispersion in returns relative to the extremes we experienced in 2023.

International Equity

International equities followed domestic markets higher this year fueled by strong performance in Europe and Japan. Given those results, coupled with weakness in China, the developed markets have outperformed stocks in the emerging world this year.

As we progress into 2024, we expect foreign stocks to continue following the lead of the U.S. markets. Many of the drivers of domestic markets are similar across the international landscape including falling inflation, expectations for central bank rate cuts, and uneven economic expansions. In addition, the U.S. dollar has steadily increased and acted as a headwind to returns in foreign stocks. In the coming months, we expect the dollar’s ascent to stall, improving the return potential for international equities.

Commodity

Consistent with their historical pattern, commodities have been volatile in the post pandemic environment. As a group, commodities have declined this year with falling prices across many constituents of the energy, metals, and agricultural segments. Amongst the widely followed natural resources, oil prices are well below the recent highs, but gold has been an outlier with strong gains year-to-date through the end of November.

In the coming year we expect ongoing volatility in commodity prices with a mixed outlook. The slowing pace of economic growth and tight monetary policy should reduce price levels over time. However, the extent of the declines may be tempered by supply constraints related to the wars in the Middle East and Ukraine as well as a low level of investment in production capacity for some commodities. On a longer-term basis, we remain constructive, given ongoing supply headwinds across many of these markets.

Potential opportunities & risks

Opportunities

New opportunities/new markets—The outbreak of COVID-19 presented a unique set of challenges. It also provided businesses with an opportunity to differentiate and develop new markets. According to some estimates, technology has been pulled forward two to three years and new products and services are in high demand.

Despite a push for a return to the workplace, many people are resisting that pressure and continue to advocate for flexible work policies. The ongoing demand for remote work opportunities increases the demand for technologies that can facilitate a world of geographically distanced employees. In addition, a shortage of labor is leading companies to invest in technology with the goal of boosting productivity, automating processes, and adapting to the lack of labor supply.

The emergence of new technologies such as artificial intelligence—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes such as the growth of artificial intelligence, Big Data, quantum technologies, and cloud computing.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance, and transfers of cash. We are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards, as well as the emergence of cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, buy-now-pay-later arrangements, and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and developing economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry with opportunities for new entrants while creating risks for the firms that currently dominate this space.

Risks

Recession—The unprecedented tightening of monetary policy since March of 2022 has increased the risk of a recession. The Federal Reserve reversed course from an aggressive stimulus policy during the pandemic, to a tightening stance in a short period of time. This is notable as monetary policy works with a lag of about one year, so we have yet to feel the impact of recent hikes. Accordingly, it is possible the central bank has tightened too aggressively, resulting in a hard landing for the economy and a recession in 2024.

Inflation—Given the unparalleled amount of fiscal and monetary stimulus in previous years, persistent federal budget deficits coupled with high government debt, the wars in Ukraine and the Middle East, reduced investment in production capacity for some commodities, the trend towards deglobalization, and a shortage of labor, there is a risk that inflation may continue to decline but remain above the average of the last thirty years.

Rising Government Debt— Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt has increased approximately 45 percent since the end of 2019 and that trend shows no sign of reversing course with persistent budget deficits. While the short-term implications of higher debt levels are manageable, the long-term impact may be substantial as rising interest costs burden taxpayers.

Deglobalization—Rising geopolitical tensions across many parts of the world have resulted in a reversal of the globalization trend we have enjoyed since the fall of the Berlin Wall. A renewed priority to secure access to commodities and other vital product inputs, along with a race to establish global dominance in certain technologies, have led to a reversal of the free trade movement. We expect this development to be coupled with a sustained increase in geopolitical tensions, upward pressure on inflation, and a rising cost structure for some industries.

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans, and competitive practices.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring the wars in Ukraine and the Middle East along with the relationship between the West and China.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.

Originally posted on December 18, 2023