Stocks finished mixed Friday as they ended another up week. Bond yields seem to be stabilizing around 3.9%, at least for the moment. Short-term, momentum continues to be on the side of equity bulls. But soon the tailwind of corporate stock buybacks will end until the conclusion of year-end earnings season. Investors will shift from riding the wave of momentum to focusing on the economic outlook for 2024.
As I see it, there is an inherent conflict within markets today. Fed Funds futures markets indicate that consensus expectations are for a first rate cut in March, and 150 basis points of cumulative cuts next year. The Federal Reserve members, based on last week’s dot plots, are pricing in just three rate cuts next year. Markets overwhelmingly today believe a soft landing is the likely economic outcome rather than a recession. Which leads to the obvious question. Why would the Fed see the need to cut rates by 150 basis points if growth continues at a pace similar to today unless inflation falls to or through its 2% target?
While the Fed claims to be apolitical, next year is an election year. While the Fed doesn’t want to take sides, it usually acts to accommodate incumbents within reason. In addition, as inflation falls, the real cost to borrow rises without any changes in nominal rates. Both points argue for more decreases than Fed officials currently project.
But history may tell another story. Clearly, the lessons of the 1970s are on the minds of everyone within the Fed. Defeating inflation isn’t hard. Invoke enough economic pressure and rates go down. Keeping inflation down is another story. Slowly cutting the Fed Funds rate back to something considered normal in a 2% inflation environment is one thing. But the Fed does not want to stimulate above trendline growth that could retrigger inflation.
Ultimately, whether the first cut happens in March or June will make little long-term economic difference. For the Fed, given that all signs suggest the current battle against inflation is mostly accomplished, attention will turn more to sustaining growth. But, not to be repetitive, the Fed is data dependent and therefore backwards looking. Christmas season is turning out OK. The key is how much spending power the consumer has left. The excess savings built up during the pandemic will be exhausted soon if they haven’t been exhausted already. The good news is that most Americans who can work and want to work have jobs. And wages are rising as fast or faster than inflation. The bad news is that the price increases of the past 2-3 years aren’t going away. Most Americans today are getting less bang for the buck than previously. That hasn’t shown yet but as excess savings evaporate, it will.
This all sits against a backdrop of record equity prices and a 10-year bond yield that has returned to levels last seen in mid-summer. The equity rally of the first half of 2023 was squashed between August and October by a spike in long-term interest rates. As that reversed, stocks rallied. Against that backdrop earnings expectations barely budged. Corporations almost always beat expectations each quarter, but managements subsequently push analysts to lower future expectations setting up a yin and yang scenario that leads to rather flat expectations.
Thus, looking forward, with inflation receding and growth rates likely to moderate, there is little reason to expect another spike in interest rates. If a recession ensues, long rates can fall further. But so will earnings expectations. Stocks rarely perform well at the start of a recession. While it is still a toss-up whether a soft landing or a recession is near at hand, there is little reason to expect bond yields to be a near-term headwind for equities. Longer term, assuming 2% inflation and growth somewhat near 2% are likely baseline assumptions, long rates should stay reasonably close to where they are today. Short-term rates will fall as the Fed moves from restrictive to neutral monetary policy. At some point, perhaps later in 2024, the Fed will stop liquidating its balance sheet. Growth of 2% cannot be sustained long-term against a backdrop of declining money supply.
While the interest rate outlook is neutral-to-positive for stocks, the key, therefore, is earnings. If the U.S. economy slips into recession, earnings forecasts are too high. Earnings never rise in a recession. Period. The adjustment process would lead to a meaningful correction in the first half of 2024. But what if there is a soft landing? The answer depends on how soft. If growth slips to something close to zero, there still will be downward adjustments to earnings. One must remember that when it comes to earnings, we live in a nominal world. Inflation lifts prices and revenues. When both inflation and growth rates fall simultaneously, it exerts enormous pressure on margins. That’s when layoffs start. I’m not talking about massive job cuts but rather hiring freezes and selective surgical cuts to reduce margin pressure.
The bottom line is that economic headwinds in the first half of 2024 could well stop the current rally in its tracks. The fall swoon in the stock market actually was fed by an economy that was too hot pushing interest rates well above expectations. Any correction in the first half of 2024 will likely be the opposite. Rates won’t be the villain. Earnings expectations will provide the headwind.
So, what should one do? Unless one was remarkably nimble selling stocks at the start of August and buying exactly at the end of October, the relatively brief and shallow correction wasn’t a great trading opportunity. On the other hand, chasing a rally late (e.g. buying at the end of July) wasn’t very profitable either. For long-term investors, trying to time short term spikes and corrections is a waste of time. We may have a shallow recession in 2024 but it won’t be one that should impact the long-term value of good businesses. With that said, price always matters. Markets overall today are at record price levels without the tailwind of record earnings or mispriced bond yields. There are few bargains out there. You will notice that over the past two months, shares of the Magnificent Seven that led the market throughout 2023 have largely stalled and moved sideways. Some of the best gainers the past two months have been stocks that got whacked the most in 2023 up to October. For some, the rally was real. For others, it will prove to be a dead cat bounce. Some of the stocks that got beaten up earlier this year got beaten up for the wrong reasons. Less than 1% of Americans are taking the newer diet pills. Yet markets have beaten up stocks of companies that sell snacks and sweets. I am hardly convinced that Americans are ready to give up their Doritos just as I was convinced a few years ago that they weren’t ready to give up their hamburgers for some ground up pea concoction. Similarly, while owning central business district office space is a dicey proposition at the moment, all commercial real estate isn’t bad. There is still increasing need for data centers and distribution space, for instance. Investors who act first before they think provide others good opportunities as reality replaces hype.
Bottom line, I can’t predict when the present momentum will fade. But I suspect it will be soon. Markets need to reassess how much pressure there will be on earnings, especially early in 2024. Beyond that, however, skies should clear. The Fed will be moderating rates throughout the year and growth prospects will brighten. We can’t ignore that 2024 will be an election year. One should probably assume it will be a Biden-Trump battle unless or until something happens to change that. If it is Biden versus Trump the one truth is that there is little to be learned about either candidate that we don’t already know. The air will be acrid for sure over the next year but the economic impact will be determined more by the makeup of the next Congress than by who is elected President. A Biden win combined with a Democratic control of Congress would mean much more spending, higher deficits, and possibly higher taxes. Total Republican domination would still lead to higher spending, but taxes would stay where they are or be cut. But the most likely outcome is something similar to today with legislative gridlock. Should that happen, actions of the Fed and individual corporations will matter much more than what happens on Capitol Hill.
Today Billie Eilish is 22. Brad Pitt turns 60. Steven Spielberg is 77. Finally, Keith Richards is 80, testimony to longevity associated with a good healthy lifestyle.
James M. Meyer, CFA 610-260-2220