Each December, as an office, we get together and make predictions (more aptly referred to as “guesses”) about the coming year. Last year, the consensus prediction in our office (sample size of 5 people) was for US stocks to post a total return of +1% for the S&P 500. Needless to say, we were a little too pessimistic. The S&P 500 is currently up about 19% for the year as of December 8th after some stellar performance in November.
We also predicted that interest rates would be lower than where they are today. Our consensus office prediction called for a yield of 3.1% for the 10-year Treasury bond. At the time of this writing, the 10-year yield is closer to 4.2%.
Candidly, I was surprised to see rates rise as much as they did throughout 2023, and I was even more surprised to see stocks rally through the rate hikes. Stocks performed better than expected because corporate earnings remained strong, inflation came down, and nothing meaningful “broke” in the economy from the higher rates. The unemployment rate has remained relatively low, we didn’t get a recession, nor did we get a further escalation of geo-political events overseas (yet).
So, what about 2024?
When making predictions about the market and economy, I’m reminded of the classic Mark Twain quote: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. “ – Mark Twain
There are a lot of things that we don’t know and only a few things that we feel confident about. Let’s start with what we think we know and contrast that with what we don’t know.
#1. What we think we know: Short term interest rates have likely peaked. The Federal Reserve gives guidance of their projected path of interest rates although they don’t say exactly when they will increase or decrease rates with certainty. They’ve indicated on their own forecasts that they expect the path for interest rates to be lower in 2024. The consensus view is that the Fed Funds rate will decline to somewhere near 4% by year end.
We don’t know: Several things. For starters, what happens with longer-term rates (such as mortgages)? Longer term rates are driven more by supply and demand (and growth expectations) in the broad economy than by Fed policy. The Feds may decide to decrease shorter-term rates as expected, but longer-term rates may stay stubbornly high. This wouldn’t be good for financing real estate or “big ticket” items such as cars and boats and could be a headwind to the consumer.
We also don’t know the context of WHY rates would fall. The only rational reason for rates to decline would be a slowing economy. Without a slowing economy, any decline in rates runs the risk that inflation surges again. Rates could fall faster than expected if the economic data deteriorates quickly, or rates could stay stubbornly high if the economy remains hot.
What that means: On the surface, lower interest rates are good for stocks… but long-term rates matter more than short term rates when it comes to stock and bond performance, and we can’t be entirely certain that interest rates will come down much from the current levels.
Prediction: Despite the uncertainty, it’s somewhat odd for interest rates to become completely uncoupled (i.e. short term rates falling while long-term rates rise). The most likely outcome from my perspective is that we see an economic slowdown in 2024 which will lead to lower rates across the board, which should be good for bonds. It could also be good for stocks unless the falling rates are triggered by a deep recession.
#2. What we think we know: Is it too early to say that inflation was indeed transitory? In 2021, we were in the camp that inflation concerns would be short-lived. We are still in that camp. Admittedly, the inflation numbers reached heights that I didn’t anticipate, but inflation is now back to near 3%; slightly below the long-term average. In other words, the inflation fears appear to be in the rear-view mirror after a relatively short time frame (see chart above).
We don’t know: If rates fall will inflation flare up again? Could we get a commodity price shock unexpectedly (e.g. gas prices spike over conflict in the Middle East). Perhaps consumers continue to ignore higher rates and the spending accelerates in 2024 (seems unlikely, but it’s possible).
What that means: At the moment, it sure looks like the Federal Reserve has accomplished their goal of getting inflation down without causing massive pain to the economy. As long as inflation remains subdued, there is less pressure on the Federal Reserve to keep rates high. We are currently living in the “Goldilocks” scenario (although few would agree that this feels very “Goldilocks”) that the Fed was hoping for: a strong economy, low unemployment, and low inflation. Sure, housing is still out of whack and it’s expensive to finance a car purchase, but at this moment in time, it’s worth acknowledging that the Federal Reserve has pretty successfully nailed their objectives.
Prediction: Inflation will remain relatively subdued and the Fed will turn their focus to employment. As job losses increase (typical in an economic slowdown) the Fed will begin to position their policies to be a little more stimulative (i.e. lower rates) to the broad economy.
#3. What we think we know: We are in the late stages of the economic cycle. If points #1 and #2 are correct, then we should still anticipate a recession (or at least a slow economy) over the next year. A peak in rates and falling inflation are classic “late-stage indicators” of a coming slowdown. For reference, notice in the chart below how rates tend to peak 3-6 months before the gray shaded bars that indicate a recession. If rate cuts are on the horizon, then history would suggest that the economy may not be able to avoid a technical recession (defined as two consecutive quarters of a shrinking economy).
We don’t know: Not all economic slowdowns / recessions are bad for stocks. That sounds odd, but sometimes stocks rally before, during and after a recession. See chart below. In 1953 and 1960, the market (as measured by the S&P 500) was up 18% and 17% respectively during the recessions. In 1980 and 1990 the market was up before, during and after the start of the recessions. Recessions don’t always spell doom for stocks. We don’t know how much the economy will slow or if there will be a triggering event that causes fear.
What that means: For now, there is no reason to move toward extreme caution. While stocks look relatively expensive and it’s tempting to “cash out” while you can, stocks have a long history of surprising investors to the upside through concerning economic times.
Prediction: The upcoming year may not be a great year for stocks, but there isn’t reason for panic selling. We don’t know how long this current “Goldilocks-period” will last, and we don’t know how quickly interest rates may decline (which will have a huge impact on stock prices either way).
Regardless of what 2024 brings, we will try and help you both navigate the investment landscape and better understand your risks. As always, we appreciate your continued confidence and trust and wish you a very Merry Christmas.
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