Thought to ponder…
“after the laws of physics, everything else is opinion“
Astrophysics for People in a Hurry
Neil deGrasse Tyson
The View from 30,000 feet
Last week was a continuation of the major themes that have marked the fourth quarter: A softening of the labor markets, a downshifting in the trajectory of growth, a slowdown in inflationary pressures and a Federal Reserve that is coming around to the view that they have crested the top in rates and may be looking towards beginning normalization in the new year. These themes have opened the door for risk assets to appreciate in anticipation that the coming slowdown will resemble a gradual decline towards the mean (soft-landing), versus the more typical non-linear decent through the mean that has more typically been associated with interest rate hiking cycles (hard-landing).
This week we provide our outlook for 2024, which doesn’t focus one case as the primary possibility, but rather outlines what we see as the possible outcomes and probabilities for each. We believe it will be very difficult to forecast the exact route, because the outcomes will ultimately depend on variables that interact with each other based on the strength of feedback loops that are created. As the economy progresses through the new year, we anticipate the exact glide path will become clearer, and as that happens the probabilities will begin to shift towards one of the potential scenarios.
Inflation, employment, growth and Fed rhetoric all feeding the soft-landing story
Focus Point Leading Market Indicator signals Neutral Conditions
2024 Outlook – Scenarios and Probability Estimates
What to watch in 2024 for hints of which scenario is unfolding
Inflation, employment, growth and Fed rhetoric all feeding the soft-landing story
PCE, the Fed’s preferred measure for inflation, surprised to the downside with the headline number measuring flat month-over-month, and the year-over-year now below the Fed’s most recent Summary of Economic Projections.
Headline CPE YoY 3.0%
Core CPE 3.5%
Continuing Jobless Claims hit 1927k, extending to the highest level since the interrupting the downward trend, and up 200k over the last 6 weeks, the second highest 6 week rise since the pandemic.
ISM Purchasing Manager Survey Employment component surprised to the downside hitting the second lowest level since the post-pandemic recovery began.
The Atlanta Fed GDPNow forecast is now projecting 1.19% GDP growth for the Q4 and Conference Board’s Coincident Index measured 1.28% YoY, touching its lowest level post-pandemic, signaling a sharp cooling of activity in Q4.
Fed President Waller, who had previously been known to be a hawk, ignited a rally with is speech titled, “Something Appears to be Giving”, which is in stark contrast to his speech in October, titled “Something’s Got to Give”.
Fed’s getting their wish list – cooling growth and a tightening labor market
Focus Point Leading Market Indicator signals Neutral Conditions
QUANTITATIVE VIEW
The Focus Point Leading Market Indicator (LMI), signaled Neutral Conditions for December, as looser financial conditions, tighter credits spreads and resilient earnings - versus expectations - combined with strengthening technicals to nudge the model forward.
QUALITATIVE VIEW
With rates restrictive, growth and employment both deteriorating, and market expectations for the Fed to embark on an aggressive rate cutting campaign in 2024, financial markets are primed for disappointment if the growth slowdown trickles into earnings, or the Fed doesn’t deliver on expectations.
High frequency data signaling risk environment strong, in spite of deteriorating fundamental data
2024 Outlook – Scenarios and Probability Estimates
SURPRISE RESILIENCY PROBABILITY 10%
Economy plows ahead at higher than potential, spurred by rising real wages, higher interest payments on freshly minted debt filtering through to debt holders, as well as continued fiscal spending driven by post-pandemic congressional measures and election year antics. Economic strength allows companies to exceed earnings expectations, as margins improve due to disinflation in cost structures. A better-than-expected economy supports the labor market and is paired with steady disinflation in goods that spreads to services, allowing the Fed to slowly easy, supporting multiple expansion.
SOFT-LANDING PROBABILITY 40%
The Goldilocks scenario. Disinflation in housing and autos, as well as goods in general, continues to feed disinflationary pressures. Oil prices stay under control, causing stability on the energy side of prices. As inflation comes down, real rates drift higher, compelling the Fed to lower rates to recalibrate the policy environment from becoming even more restrictive. Growth slows to slightly below trend and the labor market continues to rebalance at a controlled pace. The balance between lower rates and relative stability in the employment market allows companies to achieve earnings projections, supporting equity appreciation
STICKY INFLATION PROBABILITY 10%
Inflation either levels off in an area slightly above the Fed’s comfort level or reaccelerates. The Fed contemplates hiking rates further, causing rates to drift higher and igniting losses on the fixed income side of portfolios. Equities begin to feel the lagging effect of higher rates as more companies and consumers are forced to refinance at higher rates. Companies and consumers with the strongest Balance Sheets are relatively unaffected, allowing spending to be sustained and because spending is in nominal dollars, earnings are maintained, while lower income groups and companies with we Balance Sheets flounder.
NOT SO SOFT-LANDING PROBABILITY 30%
The employment market deteriorates faster than expected, creating a feedback loop where consumers have less confidence and reduce spending, which leads to a markdown in corporate earnings. Falling earnings creates a repricing of equities lower. The softening labor market and falling assets prices tips the scale for the Fed from being focused on price stability to being focused on full employment, allowing them to quickly move into action, cutting rates by over 300 bps to try and get rates back in the neutral range to stabilize the markets. Equities respond to lower rates by rallying and ending the year on a higher note.
CRASH LANDING PROBABILITY 10%
The faster deterioration in the employment market is accompanied by asset price uncertainty related to commercial real estate and low-quality corporate debt. Uncertainty feeds on itself, creating lower consumer and corporate spending, larger than expected layoffs, forcing homeowners back on the market and increasing existing home inventories to levels where they are unable to clear and prices on the residential side begin to fall as well. Prompted by an icing over in the credit markets and falling asset prices, The Fed is forced to act aggressively, dropping interest rates below the neutral rate, cutting rates by as much as 400 bps and reinstating QE programs. This creates a dramatic pothole, characterized by a sharp selloff and then a V shaped rally.
Take aways from 2024 Outlook
Although the probabilities are roughly evenly split between financial markets that trend higher, on a relatively smooth course versus bumper outcomes with more variability, volatility and drawdowns, the upside/downside return disparity is tipped towards more pain to the downside in the negative outcomes. Said another way, we expect the drawdowns from the negatively weighted outcomes in the lower half to exceed the upside from outcomes in those that are positively weighted. However, we do anticipate that in the event of most negative outcome scenarios related to slowdowns, the policy response should ultimately drive higher returns for risk assets.
There are three main things to keep in mind that should make investors wary of the path of potential outcomes for 2024:
Rates are restrictive
The majority of data from historical analogs indicate that soft-landings when rates are restrictive are hard to come by
The Fed would rather risk a recession than risk a recurrence of inflation (what does Powell want his legacy to be?)
The investment implications include maintaining risk asset exposure but hedging or remaining nimble and aware of which way the data is trending. As data rolls in, the probabilities will migrate between scenarios and potential outcomes for asset values.
What to watch in 2024 for hints of which scenario is unfolding
The Fed has a dual mandate: Fully Employment (growth) and Price Stability (inflation), with a tacit third, and overarching, mandate of Financial Stability. Things to watch out for in the coming year are those things that drive the Fed’s mandates.
Labor Markets
Credit Conditions and Use of Credit
Consumer Spending
Depletion of Excess Savings
Housing
Commercial Real Estate
Corporate Credit Health
Oil Prices
Goods and Services Supply and Demand
Supply Chain Pressures
Other data and events that are likely to influence the markets in 2024
Demand for Government Bonds
Geopolitical Events
U.S. Election
Investment Themes
Wall Street expectations across the spectrum, driven partially by survey vs hard data divergence
Putting it all together
The risk asset rally of 2023 has been driven by a host of factors but there were two that stood out:
Excess consumer and corporate savings
The Artificial Intelligence investment theme and the Magnificent 7 effect
Going into 2024 the two main drivers of 2023 are unlikely to repeat.
Pandemic savings on consumer Balance Sheets peaked between $2.0t and $2.5t, and now probably stand at somewhere between $500b and $800b. Saving are being drawn down by $50b to $60b per month, with the lower income cohorts likely already exhausted.
Although AI will to be a continuing theme in 2024. The average return of the Magnificent 7 for 2023 currently stands at 101% though the close on Friday. It is very unlikely that there will be a repeat of this performance in 2024.
Although there are potential scenarios that provide for positive outcomes in 2024, it bears reiterating that restrictive rate environments have historically caused recessions, with very few instances where this was not the case. Although it has become fashionable to forecast a soft-landing, investors should be aware a soft-landing is betting against the odds based on how things have typically played out in the past.
The soft-landing narrative is predicated on the notion that the data that is currently falling towards the mean will level off near the mean with a little help from the Fed. Although this is always plausible, it is also plausible that the data falls through the mean, as it has done in the majority of past analogs. This is why we see Wall Street strategist falling on either side of the argument.