2Q24 Market Outlook: Navigating the New Interest Rate Regime

April 2, 2024

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or [email protected]

Summary

As we have been writing since June 2020, we continue to believe that the U.S. will avoid recession in 2024, but economic uncertainty is growing. The economy is running at full capacity, household savings are diminishing, the labor market is slowing down, and the U.S. Treasury yield curve is still inverted.
Restrictive Federal Funds Rates are slowing down the economy, and the Fed will need to begin reducing rates later this year as inflation continues to move towards the target rate of 2%.
Amid mounting economic risks exacerbated by a tumultuous political campaign and continued geopolitical risks, we’re emphasizing the importance of security selection and diversification as the second quarter unfolds.

Lower Recession Risk Fuels Market Sentiment

Economic growth is proving resilient, inflation is falling, and corporate profits are increasing especially for the artificial intelligence mega-cap growth stocks. Those investors fearful of recession in 2023 are now being drawn into the market, and positive momentum can push the S&P 500® Index to further record highs. Exuberance about the surprising robustness of the U.S. economy is spilling over to investor enthusiasm.

The U.S. Labor Market: Resiliency Has Its Limits

Look behind the curtain, however, and cracks are becoming visible. The U.S. labor market is cooling, with job openings down about 25% as of mid-March from their early 2022 peak, and there are signs that lower-income households are coming under stress. Default rates on credit cards and auto loans are above pre-pandemic levels. In the corporate sector, high-yield default rates are picking up, and commercial real estate delinquencies continue to rise.

After the pandemic, corporations and households built strong defenses against the U.S. Federal Reserve (Fed) tightening, accumulating large cash reserves, and locking in low-interest rates on 30-year mortgages and longer-term corporate bonds. These defenses, however, are now weakening. The Fed can calibrate monetary policy so inflation settles near 2% and job growth cools from the average of 265,000 over the past three months to the near 100,000 per month needed to keep the unemployment rate from falling further.

The Fed’s dilemma is that delaying rate cuts and easing too slowly may create the risk of a recession while easing too quickly could trigger inflation.

When could the Fed start cutting rates?

We are concerned that the Fed’s overly cautious outlook for lower inflation will further delay rate cuts. This increases the likelihood that the soft landing currently priced by markets overshoots into a mild recession. We expect the Fed to start easing in the middle of the year. If Fed funds rate cuts are delayed to the end of the year, we will become more concerned about the longer-term outlook.

Could economic growth expectations disappoint markets?

Markets and forecasters anticipate a soft landing, where inflation slows, and growth cools without falling into recession. Just as last year’s investor pessimism was overdone, we worry that this year’s optimism could prove excessive.

The Soft-Landing Scenario

At the peak of the inflation problem in 2022, most economists thought a global recession was likely and needed to restore price stability. Instead, inflation fell rapidly in 2023 without meaningful damage to the business cycle—a soft economic landing. This disinflation occurred globally but was particularly evident in the United States, where price and wage pressures faded despite strong, above-trend economic growth.

High inflation is principally a consequence of too much demand for goods and services relative to their available supply. Therefore, high inflation can be brought back under control through weaker demand, increased supply, or both. Importantly, supply-side gains offer a relatively painless way for overheated economies to rebalance, and these appeared to drive roughly two-thirds of the disinflation in the United States in 2023.

What factors have helped inflation ease in the U.S.?

U.S. supply recovered in two ways. First, the supply of goods- which broke down globally during the pandemic due to factory closures, worker shortages, and shipping bottlenecks- now looks healed. Second, labor supply also recovered through a pickup in the participation rates of near-retirement age workers, disabled workers, and young women, as well as through a surge in net immigration. This recovery in labor supply helped tame wage inflation without a need for widespread layoffs-something that has never happened before in the post-World War history of the United States.

Regarding the outlook, the U.S. economy is now in a much better balance. Most industry estimates of the underlying inflation rate are back below 3%. We also see further disinflation in the pipeline as housing inflation moderates and becomes more in line with alternative, timelier rent measures in the coming months. We think 2%- 2.5% inflation is in sight for year-end 2024, which should allow the Fed to start gradually transitioning policy back to a more normal setting over time.

Upside inflation risks include:

Excessive investor exuberance to the prospect of lower interest rates.
An economy that is still running close to full capacity.
There is potential for further supply chain disruptions from the Ukraine and Gaza Strip wars.

Disinflation will continue based on an increased productivity boom from the increased use of AI and a more sustained recovery in labor supply. Notably, the Fed is committed to its inflation target, which should keep realized inflation and inflation expectations close to 2% over the medium term.

Asset-Class Outlook

2024 is off to the races again with strong equity market returns across Japan, Europe, and the United States. The Magnificent Seven stocks continue to outperform benchmark exposures within the U.S. market, but returns across these mega-caps are increasingly divergent. For example, Tesla (TSLA) is down 35% while NVIDIA (NVDA) is up 78% on the year through March 14. The Russell 2000® Index measures the performance of small-cap U.S. companies, which is flat in the year and remains 17% below its peak from 2022 as smaller companies bore the brunt of higher interest rates and generally show weaker profitability. Meanwhile, China continues holding the emerging markets back as its measured policy response and property market challenges have left many global investors on the sidelines.

Public equity valuation multiples are expensive, particularly in the United States, and corporate credit spreads are tight. Rich valuations dampen the outlook for risk assets. Government bonds, by contrast, look attractively priced, with U.S. Treasury yields continuing to trade well above expected inflation.

Portfolio Strategy

At the beginning of the second quarter of 2024, most of our portfolio strategies emphasize security selection and diversification to protect client outcomes across a wide range of potential scenarios in the year ahead.

Expensive valuation multiples constrain the equity market outlook, optimistic industry consensus earnings growth expectations, and overbought sentiment. We previously preferred High-Quality equities-profitable companies with solid balance sheets; however, that overweight was neutralized in February following a stretch of strong performance for these stocks. We continue to increase the breadth of our holdings to include overweight positions in information technology, industrial stocks, high-quality banks and commodity exposure.
Non-U.S. developed equities still trade at a steep discount to U.S. equities, but there is significant uncertainty around the ability of these markets to deliver differentiated earnings. China faces numerous structural challenges and weak consumer confidence and has thus far only offered a measured policy response to support its economy and markets.
Government bonds provide attractive value for investors as yields still trade well more than expected inflation. Markets are not currently weighing the possibility of adverse economic scenarios. Therefore, if developed market economies slow or slip into recession, we expect central banks to cut interest rates more aggressively than what is currently priced into forward curves. Short-term U.S. Treasuries are a preferred overweight exposure. We also see the potential for the curve to re-steepen if more aggressive rate cuts are delivered in the next few years.
U.S. High yield and U.S. investment grade spreads are very tight in an environment of elevated economic uncertainty, leading us to dampen our average strategic overweight to corporate credit.
The prospect of developed market central banks cutting interest rates in 2024 should be a significant tailwind for real estate. Real Estate Investment Trust (REIT) valuations continue to look attractive. Given the considerable uncertainty surrounding the macro-outlook, the defensive nature of infrastructure investments makes them a valuable lever for portfolio diversification—cushioning the portfolio in a market downturn while not giving up significant upside potential should a soft landing come to pass.
Oil prices might remain rangebound as the tug-of-war between softer growth and supply constraints from the OPEC+ oil-producing countries continues. Gold, trading near record highs, appears overvalued relative to current real yields.

Warm regards,
John P. Swift, CFA, CPA