2024 Market Outlook

We can sum up 2023 as the year in which “the” recession didn’t happen. Investors entered the year widely anticipating an economic contraction on the heels of all major markets selling off in 2022. The Federal Reserve (Fed) aggressively raised interest rates throughout the past two years with the understanding that a recession could be an unavoidable consequence of controlling inflation. However, the U.S. economy remains resilient, and inflation has steadily retreated closer towards the Fed’s target level. Throughout 2023, expectations increased that the Fed could successfully pull off the unlikely ‘soft economic landing’, and the result of such optimism was reflected through broad market gains.

In early December, at the final policy meeting of 2023, the Fed surprised markets by signaling an earlier than anticipated policy shift to a more accommodative position. Chairman Powell indicated in his remarks that the balance of risks shifted in favor of achieving sustainably lower inflation and introduced the prospect of interest rate cuts in 2024. Many view this pivot in narrative from the Fed as bringing the Fed one step closer to successfully averting the long-awaited economic setback that has yet to materialize.

While there are plenty of reasons to be optimistic about this outlook, and the long-term prospects for both the stock and fixed income markets, we remain mindful of the possible scenarios that may materialize throughout the year. Notably, if the economy begins to reaccelerate over the next several months it could lead to renewed urgency by the Fed to control inflation, hindering expectations for interest rate cuts and could result in near-term market volatility.

Throughout the last two years, investors have been fixated on inflation and the interest rate policy of the Fed. We highlight the relationship between inflation trends and market returns below as many support that this inverse correlation will continue. We also want to acknowledge that there are a wide range of potential outcomes this year that could force monetary policy action by the Fed. As it relates to investment strategy, we reiterate the importance of first creating a target portfolio that is aligned with your objectives and purpose for wealth, and second, sticking with that strategy until your personal situation changes. The Fed will ultimately pivot in response to changing inflation data; however, investors with a well thought out, long-term strategy should not be forced into a reactionary position with their portfolios.

Q4 MARKET RETURNS

Index Returns [1]:

Major Asset Class Returns

* Source: 2023 Total Return as of 12/29/23, Bloomberg

INFLATION, THE FEDERAL RESERVE, AND THE S&P 500 INDEX

The Fed has been hyper focused on reducing inflation and investors have been watching closely. Specifically, over the past two years we have observed a significant negative correlation between the trend in inflation and stock market returns. We created the graph below to simplify this interplay.  The graph has two main components: Inflation (represented by the year-over-year Consumer Price Index, CPI, and shaded in yellow) and the S&P 500 index (tracked with the blue line). The period is over two years, from January 2022 through December 2023, which we have broken down into four segments.[2]

* Source: Bloomberg CPI; S&P 500 daily pricing as of 12/29/23; ECON data

The first segment of the graph (1^st shaded area in light gray) covers the first half of 2022. This is a significant point in time as the Fed first acknowledged that the drastic rise in inflation was not transitory and then embarked on the most aggressive cycle of raising interest rates in history. Over the next six months, CPI grew to 9.1% while the S&P 500 index declined approximately 24% from its all-time high value set at the start of the year.

The second segment of the graph covers nearly 13 months, from June 2022 to July 2023. During this time, the CPI inflation rate fell drastically from 9.1% to 3.2% and investors responded favorably, driving the S&P 500 index up roughly 26%. The declining rate of inflation and overall strength of the economy for the most part supported investor’s optimism that a recession could be entirely avoided. Ultimately, by July 2023 the Fed increased rates 11 times, bringing the Fed funds interest rate to a target range of 5.25% – 5.50%, where it remains today.

The third segment of the graph (2nd shaded area in light gray) covers a three-month period, from August 2023 through October 2023. Inflation, which had been steadily declining, crept back up during the summer and the future path of interest rates became uncertain. This led to increased market volatility and growing concern that the Fed would be forced to maintain restrictive interest rate levels for longer and push the economy closer towards a recession. The S&P 500 index fell roughly 10% during this time. The final segment of the chart brings us to the end of 2023. Market sentiment shifted to bullish during the fourth quarter of 2023 as the Fed held interest rates steady, economic growth persisted and inflation eased slightly. Optimism was further sparked on December 13^th, when the Fed indicated that it would pivot from raising interest rates to lowering interest rates in 2024. The S&P 500 index generated a return of 15% from mid-October through year end and finished 2023 up a total of 26%, bringing the index within a few basis points of its all-time high from roughly two years ago.

THE IMPACT TO FIXED INCOME MARKETS

With the Fed indicating a policy pivot, bonds quickly repriced their expectation of the Fed’s interest rate path going forward and rallied to end the year. A combination of declining interest rates and tightening credit spreads supported the positive move in the Bloomberg US Aggregate Bond Index. All fixed income markets had positive returns in 2023, with those segments most exposed to duration performing best.

While it is difficult to predict where rates will be at the end of 2024, we anticipate continued volatility in the fixed income markets early in the year as the market tries to anticipate the pace of interest rate cuts by the Fed. As the year progresses and this path becomes clearer, yields can be expected to decline across the yield curve in a bull steepening trend, where short-term rates decline more than long-term rates. Now could present an opportune time to lock in higher yields on bonds with the potential for capital appreciation by year end as interest rates potentially move lower.

FED PIVOT SCENARIOS – WHAT’S IN STORE FOR 2024

Looking ahead in 2024, we believe the market will be in a “wait and see” mode, searching for any validation that the Fed has gotten things right (or possibly wrong). With the S&P 500 index now trading near all-time high levels we anticipate increased volatility as investors react to the headlines. We see four scenarios to be mindful of in 2024 with varying implications to investors as the Fed continues its battle with inflation, while monitoring employment, and the overall strength of the economy.

The Fed is right on inflation (Soft Landing)

The growing optimism within the stock and bond markets rests on the Fed executing a ‘soft landing’, where rising interest rates successfully bring down inflation, without causing a drastic rise in unemployment and without GDP growth turning negative. For this to happen the U.S. consumer would need to remain in a strong financial position (supported by low unemployment and wage growth), GDP growth would hold steady, and the rate of inflation would continue to decelerate towards the Fed’s 2% target rate. Meanwhile, corporations would likely benefit from both the consumer spending and cheaper cost of capital (assuming the Fed lowers interest rates), which would ultimately drive earnings and support rising stock prices. While this outcome is a possibility, a perfectly executed ‘soft landing’ would not be necessary to support a bullish environment for stocks and bonds.

The Fed is right on inflation (Mild Recession)

The Fed may end up being correct with their outlook on inflation and guidance towards lower interest rates; however, it could be forced into action if the economy falls into a recession. The true impact to the economy from the Fed’s current restrictive policy is unknown and its possible the Fed will keep interest rates too high for too long. We expect this scenario would be a short-term negative for the stock and bond markets, as current expectations are for the U.S. economy to avoid a recession. However, while this is a possible outcome, we believe a reset to the economic cycle remains a long-term positive environment for investors.

The Fed is wrong on inflation (Interest Rates Stay Higher for Longer)

Another possible outcome is one where inflation remains at current levels or even slowly increases for a period of time in 2024. This would most likely be a result of an economy that is heating up. The Fed would likely update its expectations for interest rates to remain restrictive for as long as it takes to keep inflation trending back towards its target rate. A strong economy, with slightly higher than desired inflation rates, may result in more volatile markets over the short-term.

The Fed is wrong on inflation (Inflation Re-Accelerates)

We believe the least likely scenario, yet something investors will be monitoring closely, is where inflation accelerates higher in 2024 and the Fed is forced to re-pivot back to restrictive policy (such as raising interest rates further). Fed Chairman Jerome Powell has consistently stated for years that he is determined to avoid the decade-long inflation spiral that materialized during the 1970s. Knowing that this has been Powell’s main goal for several years, we do not believe that he willingly pivoted on the Fed’s stance if he had concerns that inflation would reaccelerate. The uncertainty of this environment would likely result in heightened levels of stock and bond market volatility, until inflation is brought back under control.

SUMMARY

For a third year in row, the Federal Reserve will be in the spotlight as it attempts to navigate the U.S. economy towards a soft landing while fulfilling its mandate to drive down inflation and achieve price stability. Throughout the past two years, the markets have inversely tracked inflation rates, and so it remains a question as to how long this trend will continue. The Fed has signaled a possible shift to be more accommodative with its monetary policy and has established expectations for interest rate cuts this year. Investors, however, are currently expecting the Fed to lower interest rates more than the Fed has indicated and this sets the market up for heightened volatility as expectations shift throughout the year.

While the Fed and the U.S. economy will gather significant headline attention, investors will also be keeping a close eye on geopolitical and political risks as well as stock price valuations and corporate earnings. On the heels of the market correction in 2022 and subsequent recovery in 2023, we expect that the markets will be searching for direction and experience choppy movements over the next several months.

Knowing that there are several possible Fed pivot scenarios this year it’s an important reminder that when building out an investment strategy we want to plan for market volatility and avoid having to react to current market conditions. When focused in on factors that can be controlled, such as investment allocation targets, cash flow needs and taxes, investors can comfortably stay committed to their investment strategies.

APPENDIX

Chart A: 2023 Total Return of Major Asset Class Indexes

1 – Source: Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index
2 – Bloomberg data; Consumer Price Index (CPI) as of 12/29/23

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