As we turn the page on a new calendar year, we look ahead to the 2024 Paris Olympics and exciting events like the relay races in track and field. A similar passing of torches (and batons) may be happening for markets this year as all eyes begin to focus on jobs as an indicator of the Fed’s victory (or defeat) in the race against inflation. Plentiful employment and stable prices could produce another successful year for markets, while a stumble for either jobs or inflation could leave investors disappointed.
We believe the economy has a reasonable chance of maintaining modest growth in 2024. Investors expect the Federal Reserve to provide a tailwind for the economy by way of gradual interest rate cuts. However, we are vigilantly watching for changes in forward-looking investment classes such as equity markets, which constantly adjust to predict moves in the economy and corporate profits. It’s quite possible that last year’s bull market in stocks may have already baked in some of the good economic news that investors are hoping to see in 2024. Under this scenario, we may see more modest performance for equities in 2024, though we continue to believe that equities will outpace inflation longer term.
Jay Powell takes down inflation
Before we look ahead to 2024, let’s take a quick look back at the Fed’s battle with inflation and implications for markets. Government stimulus payments and supply chain pressures coming out of the Covid pandemic fueled a round of inflation that peaked in mid-2022 with a 9% increase in the Consumer Price Index (CPI). After some initial delays, Jay Powell pushed through eleven rounds of interest rate hikes in an effort to slow the economy and arrest inflation, a move that appears to be paying off as the CPI is now around 3%.
With sentiment rising and inflation fading, investors embraced Jay Powell’s pivot away from restrictive policy and a move toward easing. Investors cheered for Powell and the Fed, and stocks staged a rally in late 2023 with broad equity markets up 26%. Excitement around artificial intelligence and a massive recovery in mega cap tech stocks boosted the S&P500 in 2023, but an equal-weighted approach that treats big and small companies the same was only about half as good with a 14% return (still well above historical averages).
Bonds, which have an inverse relationship to yields, also rallied in the fourth quarter as long-term bond yields fell amid fading inflation expectations. As we approached the end of 2023, the 10-year Treasury yield rose to approximately 5% in October, but fell sharply in December, which sent bond prices higher. While yields are slightly less attractive now, we continue to see high quality corporate bonds as a good inflation hedge, with yields between 4% and 5%.
Job market at a crossroads
Stocks and bonds appear to be sending a message of “mission accomplished” regarding inflation, but the next big hurdle could be changes in the job market. Historically, Fed efforts to tamp down inflation often go too far, triggering layoffs and rising unemployment. However, demand for workers remains high at this stage in the economic cycle, giving fully employed consumers the confidence to keep spending.
In a favorable scenario, companies may decide to keep employees and avoid an expensive and time-consuming process of short-term layoffs and recruiting in a tight labor pool. However, we could also see a downside situation in 2024 if higher borrowing costs trigger headcount reductions as a way to preserve corporate profits.
Watching the cycle, but positioning for the long term
We remain somewhat cautious on equity markets amid rising investor expectations of a soft landing for the economy and steady growth for company profits. When good news becomes mainstream, any unexpected disappointment may lead to a move away from risk assets. However, as we evaluate upside opportunities for stocks along with downside risk, we continue to favor owning equities as an attractive way to compound wealth over time.
Valuation is one factor that gives us a bit more comfort in stocks as we begin 2024. Stocks are trading about 10% above long-term averages, compared with a 20% premium in late 2021. This relative discount from valuations two years ago should help to soften the blow from any unforeseen challenges. Despite our mixed near-term views, we believe that stocks will continue to chase corporate profits through the business cycle, generating attractive long-term performance.
With inflation fading, we expect a passing of the torch this year as the job market becomes a prominent indicator of where the economy is headed. We favor a fully invested approach at this stage in the economic cycle by owning companies that are generating durable growth, remaining ever mindful of your long-term goals and objectives.
Michael Bailey, CFA
Director of Research
Michael Mussio, CFA, CFP®