Summary, Last Quarter:
Last quarter saw a “Santa Claus Rally” as investors became more optimistic that the Federal Reserve (“the Fed”) finished raising interest rates, thereby ending their restrictive monetary policy and becoming more supportive. That rally helped finish a strong year in both the bond and stock markets, something we haven’t seen in some time. 2023 was all about inflation and whether the Fed could tame it—thereby orchestrating a “soft landing”—or if they would be too aggressive and push the economy into a recession. Ultimately, that recession never showed up.
Our Commentary:
While the recession didn’t show up in 2023, the game isn’t over yet. The Fed did an admirable job by taking a methodical approach to interest rates, staying disciplined to their “transitory inflation” thesis, and avoiding the urge to crush inflation. So far, so good. 2024 appears to be a year of playing a game of “chicken”: the Fed expects inflation to cool given the current level of interet rates, and if it does, they can slowly decrease rates. This anticipated drop in inflation and subsequent drop in interest rates is the general market expectation for 2024.
Our expectation is that the economy will slow down but will not fall into a recession. However, a recession is possible. If a recession does materialize, it would likely be a short and shallow one. The current unemployment rate is 3.7% (U.S. Bureau of Labor Statistics), which is below the Fed’s 4% “full employment” target. In addition, core PCE—the Fed’s preferred measure of inflation—has come down from more than 5% to closer to 3%. That is still above the Fed’s 2% target, but it’s on the right trajectory. If the trend continues, as it appears it should, the Fed can watch inflation come down, unemployment get closer to their 4% target, and the economy return to a normal state.
Shifting our focus to the financial markets, it is unlikely that the stock market will have a year like it had in 2023, when the S&P 500 returned over 20%. However, we think the market will finish higher than where it started 2024. Valuations appear to be fair to slightly overvalued as we start the year, and expectations are that earnings growth will slow. Thus, we think 2024 will be a single-digit return year for the S&P 500. The looming presidential election adds more uncertainty to the mix, and the stock market generally doesn’t like uncertainty. Barring a recession, we expect a volatile year with lower returns than we have seen in recent years.
Believe it or not, the bond market is the more exciting financial market at the start of 2024 as the interest rate story plays out. Short-term bonds have enjoyed a rare moment in the sun as they are outperforming long-term bonds. That dynamic—known as an “inverted yield curve”—can’t continue forever. Economically speaking, this dynamic makes no sense: why would anyone buy long-term bonds if they can get a better return from less-risky, short-term bonds? Hence, as inflation subsides, the Fed is expected to lower interest rates, which will lead short-term interest rates to decrease in 2024. And as rates decrease, bond prices increase. Thus, we think bonds should have a strong year in 2024. This is a welcome change, because bonds have been an afterthought to equities for quite some time.
Until next quarter,
Leelyn Smith Investment Committee
Bond Disclosure:
Fixed income securities carry interest rate risk. Fixed income securities also carry inflation risk and credit and default risks. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
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