Navigating the Economy: A Look into 2024
Sifting through financial information online is becoming quite onerous with so many opinions out there, so we've consolidated what we believe to be informative and insightful into one Market Commentary.
In 2023, the U.S. economy (the biggest economy in the world and our largest trading partner) showed unexpected strength, demonstrating growth in the third quarter and inflation moving closer to the Federal Reserve's target. As we look ahead to 2024, concerns arise about potential vulnerabilities in a slowing economy. The US Federal Reserve, after raising rates over the past two years, is considering the end of its tightening cycle, with a cautious stance on rate cuts.
Corporate America experienced robust earnings growth last year, driven by factors such as increased revenues and cost-cutting measures. However, expectations for substantial earnings growth in 2024 may face challenges due to a potential economic slowdown and weakening pricing power. The labor market, returning to normal levels after a 50-year low, indicates signs of wage moderation, which should ease inflationary pressures.
On the global stage, economies took diverse paths in 2023, with challenges faced by Canada, the Eurozone, UK, and China. Bond markets saw some volatility, but bond yields remained elevated, offering some potential opportunities. U.S. equities rebounded in 2023, particularly for the 10 largest companies, signaling a potential market mispricing. Under these conditions, active management should be a value-add for identifying opportunities in 2024.
International equities performed well in 2023, presenting opportunities outside the U.S. Investors are always encouraged to diversify globally for better valuations and income. Regardless of economic conditions, alternative assets can also provide consistent outcomes in terms of alpha, income, and diversification, offering low correlations and enhanced returns.
The US Federal Reserve's policy tightening has increased yields on cash products (GIC’s, Cash Deposits, Savings, etc), but it's important to consider historical trends that caution against prolonged cash-like holdings. Historically, deploying capital into long-term assets after peak interest rates has shown better performance. Striking the right balance between liquidity and long-term assets will be crucial for optimizing returns.
I recently came across an economic & market update from J.P. Morgan Asset Management that I would like to share. This commentary, and its many supporting charts, are presented by Dr. David Kelly, and they highlight the major themes and concerns impacting investors today.
From JP Morgan’s Dr. David Kelly:
At the start of last year, many investors and economists worried that 2023 would be a challenging year for the economy and markets. Instead, 2023 turned out to be a year of surprising resilience. Growth accelerated to 5.2% during the third quarter while inflation has continued to slide towards the Fed’s 2% target. Looking ahead, the economy should slow in 2024 but a soft-landing still looks possible. However, with fading tailwinds from the consumer and business spending, slow momentum does leave the economy vulnerable to any kind of shock.
Meanwhile, after hiking rates by a cumulative 5.25% points over the last two years, the last of the Fed’s rate hikes is likely behind us. At its December meeting, the Fed kept rates unchanged and forward guidance indicated that rates are at their peak. That said, the Fed is still firmly pushing back against any notion of early rate cuts, raising the risk that rates will stay higher for longer. Ultimately, this will depend on whether or not the U.S. economy falls into a recession.
Despite Fed tightening, equity markets saw impressive gains last year with relatively low volatility. The same cannot be said for bond markets, however, which grappled with elevated interest rate volatility and supply imbalances. As investors look forward to 2024, geopolitical uncertainty remains elevated. However, valuations outside of the largest stocks look attractive, fixed income offers strong asymmetric returns and investors can look outside of public markets to alternatives to help fine-tune portfolios for their desired outcomes in alpha, diversification and income. 2024 could be another year of surprises, but leaning into active management and stepping out of cash should help investors take advantage of the changing investment climate.
The Guide to the Markets, now in its 20th year, is constructed to try to address these kinds of questions. However, it is important to do this concisely. There are over 60 pages in the Guide, but that is far too many for any conversation about the markets.
So, what we do here is boil it down to just 11 slides. In particular, we assess the performance of this past year for the markets and economy, considering trends in growth, jobs and inflation in the U.S, and how these trends are shaping the outlook for monetary policy. This is followed by comments on growth from around the globe. Finally, we consider the implications of all of this for those investing across asset classes and highlight the importance stepping out of cash and actively engaging with opportunities in alternative assets.
The U.S. economy saw impressive resilience last year, with the first three quarters showing above trend real GDP growth. Easing inflation and improved prospects for growth have helped fuel optimism for a soft landing. However, a quick look across each sector of the economy tells us that economic momentum in the year ahead is set to be moderate, at best.
Business spending held up better than expected last year despite tighter lending standards, supported by increased spending on intellectual property with greater emphasis on building and integrating artificial intelligence capabilities. Tailwinds from AI spending as well as federal government support for semi-conductor manufacturing should persist in 2024. However, increased caution among lenders and slowing corporate profits could still constrain growth in capital expenditures.
Consumers have remained resilient, supported by a tight labor market and rising real wages. That said, there are some signs of weakness. While revolving credit as a share of disposable income does not look overextended, delinquencies are rising, and younger households are showing signs of increased financial stress. As labor market conditions continue to loosen and lending standards remain tight, consumer spending should grow at a slower pace from here.
The housing market appears to have stabilized, albeit at low levels, as tight housing supply and steadying mortgage rates are signaling that the worst is behind us. Trade should be a mild drag on the economy as a still strong dollar and sluggish global growth weigh on exports. Meanwhile, government spending growth should slow as gridlock in Washington limits further stimulus.
Overall, the U.S. economy should continue to grow at a moderate but slowing pace from here. That said, a slower-moving economy will be increasingly sensitive to shocks. Whether it be the U.S. election, higher policy rates, significant geopolitical tension or something else entirely, risks remain that could still push the economy into recession in 2024.
After a red-hot labor market sent wages higher and brought unemployment all the way down from a height of 14.7% at the onset of the pandemic to its 50-year low of 3.5%, the labor market is now getting back to normal. Unemployment remains at 3.7% as of November, despite swift declines in job openings, and has hovered between 3.4% and 4% since December 2021. However, cooling labor market conditions are evident in private sector wages, which have moderated from a peak of 5.9% year-over-year in March 2022 to 4.0% in November. While this is still above its long-term average, wage pressures are receding with quits falling and business reeling back hiring efforts in the face of slowing consumer demand. It’s also worth noting that while strikes have made a lot of headlines in the last year, less than just 6% of the private sector workforce is represented by a union—and this is down from 20%+ in the 1980s.
On balance, we aren’t worried about wages contributing to higher inflation and in the absence of a recession, unemployment could remain stable as well. U.S. businesses still face structurally slower labor force growth than in prior decades with Census projections showing the population aged 18 to 64 will rise only 0.1% in 2024. Tight labor markets could encourage more immigration or further gains in labor force participation, but excess capacity may be limited.
Overall, a combination of subdued job growth and slowing wages should give the Federal Reserve further confidence that inflation is sustainably coming down.
Resilience in the U.S. economy has also been shared by Corporate America with earnings growth surprising to the upside last year. Revenues were the largest contributor to earnings, with consumer strength and pricing power allowing companies to boost sales. Margins, however, have detracted from earnings as companies grappled with higher input and labor costs. Still, companies have been active in defending margins by cutting costs and adopting more efficient digital capabilities, helping margins stage an impressive recovery in the third quarter.
Looking to 2024 and 2025, expectations for double-digit earnings growth seem too optimistic as defending profit margins will become increasingly difficult in an environment of slowing economic growth and waning pricing power. However, high-quality companies with strong balance sheets, ample cash balances and sustainable earnings should perform well relative to the broader index.
After inflation reached 50-year highs in 2022, the inflation heatwave met a cold front in 2023 with headline CPI easing to 3.1% year-over-year in November, well below the 9.1% peak reached in June 2022. While this is still above the Fed’s target, the underlying components of inflation provide us with confidence that this downtrend has room to run.
Core goods prices trended lower in 2023 as supply chain distortions related to the pandemic and Russia’s invasion of Ukraine continued to fade. Meanwhile, the more volatile components, mainly energy and food prices, also provided an important source of disinflation amidst slowing demand. Absent any supply shocks or unexpected surge in demand, these categories should continue their descent in the coming months. Lastly, shelter inflation, which accounts for a third of the CPI bucket, is predictably falling as the rollover in market rents gradually flows through the data.
The remaining problem for inflation, therefore, is core services prices outside of housing, which the Fed has honed in on when referencing persistent inflation. However, as we show above, inflation in this measure is mostly just “transportation services,” which includes things like auto insurance and auto repair costs. Going forward, the rollover in vehicle and auto part prices should feed though to this category, and combined with easing wage pressures and cooling consumer demand, services inflation should fall further in the year ahead.
Overall, inflation made impressive progress towards more normal levels in 2023. While we are not quite back to the Fed’s target yet, 2% inflation by the middle of 2024 looks in reach, and this should give the Fed assurance that inflation is under control as they debate easing policy.
The Federal Reserve has hiked rates by a cumulative 5.25% since the beginning of 2022 to combat inflation. However, with inflation steadily trending back towards their 2% target and labor market conditions easing, the July rate hike was likely the last of this cycle. At their December meeting, the Fed voted to leave the federal funds rate unchanged at a target range of 5.25% to 5.50%, as widely telegraphed. Forward guidance acknowledged the progress made in cooling both inflation and labor markets but maintained a hawkish bias, likely in an attempt to temper dovish market expectations.
Specifically, the Fed’s “dot plot” continued to suggest rates will remain higher for longer, with the median FOMC member expecting limited easing in 2024. However, there appears to be some diverging opinions amongst the committee pertaining to the future path for policy. Updates to the Summary of Economic Projections reflected confidence in a soft-landing scenario and the Fed appears to acknowledge that inflation has fallen faster than expected despite economic resilience.
Overall, the Fed is more likely than not at the end of its hiking cycle, which means investors are now more interested in the timing and extent of eventual rate cuts. If the economy remains afloat, the Fed may only deliver minor policy cuts. However, if the U.S. economy enters a recession, the Fed may be forced to cut rates more aggressively to try and stimulate the economy. Either way, it looks increasingly likely that rates will move lower in the year ahead, but they may still settle at a higher level compared to previous policy easing cycles.
Despite the negative headlines, the global economy proved to be more resilient than expected in 2023, but some countries clearly did better than others. The Eurozone, UK, Canada and China struggled, while the U.S., Japan and emerging markets outside of China were stronger, as evidenced by their composite PMIs remaining above 50 for much of last year.
In China, depressed consumer and business confidence continues to challenge growth, while the full effects of stimulus measures from policymakers have yet to be realized. China’s weakness also spilled over to Europe, which is similarly experiencing weak domestic 7 consumption and elevated manufacturer pessimism. Activity is now showing signs of stabilizing, albeit at low levels, and there is hope for a modest reacceleration in Europe as falling inflation boosts real incomes. Elsewhere, India continues to see strong growth, supported by its growing middle class and government support for private businesses and digitalization.
Global growth should be less divergent in 2024, with the US economy slowing down and China’s economy stabilizing. However, the key question is how much this gap will close – and whether it is more due to a U.S. slowdown or a pickup in overseas growth
In bond markets, volatility was a defining feature of 2023 as investors grappled with resilient economic data, a hawkish Fed and various technical factors. The yield on the 10-year Treasury climbed by nearly 170 bps basis points from early April to late October, before expectations for a soft landing and an end to tightening helped drive the yield lower by more than 70 bps in less than two months. Even with this move lower, current yields across the fixed income landscape still offer investors much better income and total return opportunities than existed a year ago.
Slide 37 shows yields across fixed income sectors relative to the last 10 years, and nearly all sectors are trading well above their 10-year median yields. Simply sticking with core fixed income provides attractive yields above 5%, while leaning into riskier asset classes like high yield can provide yields north of 8%. Moreover, with peak interest rates likely behind us, bonds also offer the potential for price appreciation in the event of lower rates, and diversification benefits as lower rates coincide with recession. This potential for asymmetric return in bonds may not last long, underscoring the importance of leaning into fixed income while yields are at these elevated levels.
After a very troubled year for investors in 2022, U.S. equities rallied strongly in 2023, largely recovering their losses in the prior year. This performance owes to a combination of better-than-expected consumer spending, resilient corporate profits and enthusiasm around the advancements in AI. However, equity market performance was not broad-based, with the largest stocks in the index by market-cap accounting for the majority of gains.
On the left, we show stock market performance since the 9 start of 2023, and the top 10 stocks have accounted for roughly 90% of price returns, leaving them 1.4 times more expensive than the broader market. Meanwhile, the remaining stocks are only up by low-single-digits and are trading cheap relative to the broader index.
Indeed, index concentration is not a new phenomenon as the weight of the top 10 stocks in the S&P 500 has been rising since 2016. The earnings contribution from those stocks, however, hasn’t kept pace and hardly budged last year despite strong asset price appreciation. The fact that the top 10 stocks now make up a third of the index but only account for a fifth of index earnings, suggests significant mispricing in the stock market.
In 2024, if economic growth remains positive and technological advancements yield significant productivity gains, markets could still perform well but gains should broaden out beyond the largest names. In environments like these, active management is best suited to identify those companies with sustainable, high-quality earnings that are being overlooked by the 9 markets.
Strong equity market performance in 2023 was not only a U.S. phenomenon as international equities also experienced impressive growth, with the MSCI All Country World Index climbing more than 10%. Taking a quick trip around the globe, Japanese equities had a very strong year, rising nearly 16% in dollar terms, as an improved interest rate backdrop and corporate governance reform propelled new enthusiasm from investors. Elsewhere, promising fiscal reforms and strong economic momentum bolstered the case for Indian equities, which similarly rose over 16%. In Europe, markets also saw strong performance in the first half of the year as the end of negative interest rates supported banks and economic activity stabilized 10 from Russia-induced energy shortages.
Looking ahead, while the global growth backdrop looks set to slow, there are still strong opportunities outside of the U.S. for long-term investors, and at better valuations. Indeed, international equities continue to trade at a steep discount of over 30% compared to U.S. equities, near 20-year lows. International equities also offer greater income, with dividend yields trading at a 1.8% spread above that of U.S. equities.
Combine this attractive entry point with structural tailwinds, attractive relative fundamentals and a weakening dollar, and the year ahead could be a much more favorable environment for U.S. based investors investing oversees looking to diversify and add exposure to important global secular trends and themes.
Regardless of what happens to the economic backdrop, investors are still looking for consistent outcomes across alpha, income and diversification. The challenge is that you can’t get all those outcomes from the same assets. However, when you expand the opportunity set outside of public markets, investors can leverage a range of different alternative assets to reach their desired outcomes. Indeed, as we show on the above slide, alternative assets can offer low correlations to public markets, diversified income streams and enhanced long-run returns.
For instance, real assets shown towards the left, such as real estate, infrastructure and transport, tend to be less correlated to a traditional 60/40 portfolio while providing robust income. Private equity and venture capital, towards the right, provide much higher total returns but come with higher correlations to public markets and little-to-no income generation.
The classic 60/40 stock-bond portfolio still looks attractive, but adding a sleeve of alternatives can help long-term investors achieve strategic goals through higher alpha, better diversification and enhanced income.
Policy tightening from the Fed has pushed yields on cash-like instruments to their most attractive levels in over a decade. With yields north of 5% and minimal risk, many investors have decided to allocate more heavily to cash.
However, history shows that staying parked in cash after the peak in interest rates usually leaves money on the table. In the last six rate hiking cycles, the U.S. Aggregate Bond Index outperformed cash over each of the 12-month periods following the peak in CD rates, while the S&P 500 12 and a 60/40 stock-bond portfolio outperformed in 5 of these periods.
This is not to say that investors should abandon cash altogether, as liquidity is an important allocation in any portfolio. However, there is an opportunity cost in holding onto too much cash, and investors should put long-term money in long-term assets. Following a peak in interest rates there has always been a better asset than cash to deploy capital.
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Your portfolio
Of course, I try my absolute best to ensure my human outlook does not spill into your investment strategy.
“If the consensus on Wall/Bay Street is often wrong – and evidence from 2023 does little to dispel that notion – then in the year ahead investors are facing either the mother of all rallies or a selloff for the ages. That’s because most investment outlooks from major banks, advisors and asset managers envisage the same middle-of-the-road scenario in 2024: They see interest rates finally starting to bite, a benign economic slowdown, and a central bank pivot to easier policies setting the stage for a late-year rebound.” – Bloomberg
As a strategic asset allocator (decisions made based on past outcomes) versus a tactical asset allocator (decisions made based on future outlook), my belief is that future short-term outcomes are not yet known, and that past outcomes are a matter of fact.
Based on this framework, we make systematic determinations for portfolio shifts every quarter. The end result of these determinations was to reduce your overall equity/stock holdings in July of 2021, then increase them in July of 2022, and then reduce them again in July of 2023. Note that no change was determined for the quarter ending January 15th, 2024.
A graphical representation of what I describe above, contrasted against the S&P 500 index (just one of several market factors) over the past 4+ years, can be found below, whereby green dots represent a shift into equity, and red dots represent a shift out.
From a historical perspective, you may find that this strategy has yielded results that had your portfolio overperform in 2020, underperform in 2021 (shifting out as stocks went up), and overperform in 2022 (despite the down year) and 2023.
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We continue to monitor any potential new holdings on an almost daily basis, and continue to evaluate your existing holdings to determine if the reasons we bought them in the first place remain true today.
I hope you find this both interesting and informative in keeping pace with the events of today’s financial world.
This publication contains the opinions of the writer. The information contained herein was obtained from sources believed to be reliable, but no representation or warranty, express or implied, is made by the writer, Designed Securities Ltd. or any other person as to its accuracy, completeness or correctness. This publication is not an offer to sell or a solicitation of an offer to buy any securities. The information in this publication is intended for informational purposes only and is not intended to constitute investment, financial, legal, tax or accounting advice. Many factors unknown to us may affect the applicability of any statement or comment made in this publication to your particular circumstances. Hence, you should not rely on the information in this publication for investment, financial, legal, tax or accounting advice. You should consult your financial advisor or other professionals before acting on any information in this communication.
Embark Wealth is an investments trade name of Designed Securities Ltd (DSL). DSL is regulated by the Canadian Investment Regulatory Organization (www.ciro.ca) and Member of the Canadian Investor Protection Fund (www.cipf.ca ). Investment products are provided by Designed Securities Ltd. and include, but are not limited to, mutual funds, stocks, and bonds. Adam Schacter is registered to provide investment advice and solutions to clients residing in the provinces of British Columbia, Alberta, Manitoba, Ontario, Quebec, and Nova Scotia.