January 29, 2024Scroll down
The CIO’s Take:
Taking in data on the progress of US economic growth and disinflation at the end of 2023, we continue to be pleasantly surprised at how little resistance the Fed has thus far faced in its quest for the elusive soft landing. With fourth-quarter GDP surpassing what we felt were reasonably bullish expectations and some measures of core PCE inflation actually creeping below the US central bank’s 2% target in the last couple months of the year, the path toward rate cuts with no recession—a combo that has historically corresponded with strong stock returns—is clearly illuminated. Mind you, we haven’t achieved that yet, and there are a number of risk factors at play, including conventional macroeconomic pitfalls (lagged effects of past rate hikes, for example) and exogenous shocks to the Fed’s game plan (imagine where developments in the Red Sea might take us). Stocks still look expensive, particularly in the US, and the number of rate cuts baked into futures still looks a little steep. All in all, that leaves us cautiously optimistic and looking to add risk where it’s most reasonably priced.
Economic growth remains red hot
For the last few quarters, we’ve often come back to the remarkable strength of the US economy as really the key piece of the puzzle in terms of how the Fed thinks about the decision as to when easing might begin. Along those lines, fourth-quarter GDP data released by the Commerce Department last Thursday left no doubt that America ended 2023 on a strong note. According to Thursday’s report, the US economy grew at a staggering 3.3% year-over-year rate in Q4, trouncing analysts’ consensus estimate for just 2% growth. Despite GDP being backward-looking, continued evidence of strong growth will be music to the Fed’s ears: another test of the “soft landing” hypothesis passed with flying colors. Anyone cheering the strong numbers should thank American consumers, whose spending remains the key driver of trends in GDP. Personal spending rose 2.8% in Q4, accounting for the lion’s share of growth going into the end of 2023 (see below), as areas like transportation, food services, and recreation saw a big boost in the final quarter of the year.
Consumer spending isn’t the only item to watch
There were other categories of note in the breakdown of Q4 growth. Alongside robust spending by consumers, the US government has been aggressively shelling out cash to prop up growth, with increased spending at both the federal and state level helping to support the economy’s expansion since fiscal stimulus ramped up amidst the pandemic. As we’ve mentioned elsewhere, that will put upward pressure on yields as prospective Treasury buyers fret the government’s fiscal position. In other areas, meanwhile, growth has been more subdued. Residential investment saw a rather modest increase of 1%, well below its early-2021 peak, as high interest rates and slow real income growth continued to weigh on the sector. Business investment also faces high rates, but managed to grow 1.9% for the quarter, lifted by significant outlays on information processing and industrial equipment; intellectual property investments likewise saw a moderate increase of 2.1%. Going forward, two aspects of GDP worth keeping an eye on: As uncertainty around Fed policy subsides and rate cuts inevitably begin—whenever that is—conditions for business spending should improve. On the flipside, a cooling labor market (e.g., last week’s jobless claims coming in a bit higher than expected) and effects of past tightening could catch up with consumer spending. That latter effect could explain a dip in GDP forecasts headed into the middle of this year (see above).
December sees Fed’s 2% target in sight
Of course, GDP growth is but one element of the soft landing narrative. The other key factor is inflation, and Thursday also brought data from the Bureau of Economic Analysis on the Fed’s preferred measure of rising prices: the personal consumption expenditures (PCE) price index. Headline PCE grew 2.6% year-over-year, in line with projections, while core PCE—the quantity on which Fed officials have focused most, stripping out volatile food and energy components—came close to a three-year low, clocking in at 2.9% year-over-year, well below the 3.2% observed in November, and also slightly below the consensus forecast of 3.0%. Versus the preceding month, core PCE rose only modestly, to the tune of 0.2%, and the six-month annualized value was below the Fed’s 2% target (see below).
Consistent with the story we told about Q4 GDP above, we also note that inflation-adjusted consumer spending surged by 0.5% in December, representing the largest back-to-back monthly increase in nearly a year, fueled by a notable rise in wages and salaries. Services inflation, excluding housing and energy, slowed to a 3.3% pace, the softest since early 2021. Purchases of durable goods like recreational items and cars largely drove spending in the last month of 2023. On an inflation-adjusted basis, spending on goods climbed by 1.1%, the most significant rise in nearly a year. Real disposable income advanced by a mere 0.1%, the smallest increase in three months and contributed to a drop in the saving rate to its lowest level in a year.
What does this mean for rate cuts?
All of this is important because strong GDP growth in the absence of good progress on inflation would mean the Fed has every incentive to keep rates high while a robust economy offers the luxury of time to let restrictive policy cool prices down. That’s why signs of a strong economy in the last few months have sometimes been received by markets as pushing back the timeline for easing. If, on the other hand, the economy is strong while inflation comes down to the Fed’s target? The very definition of a soft landing. Indeed, at last month’s FOMC press conference, Fed chair Powell made it explicit that the central bank “…would want to be reducing restriction on the economy before you get to 2%” to avoid overshooting. As such, once again, we do see last week’s data on GDP and PCE inflation as combining to increase the likelihood of rate cuts sometime toward mid-2024. What might get in the way of that? Bumps in the road over that last mile of disinflation could range from accelerating inflation in insurance costs and home prices to spikes from geopolitical events, including the Red Sea shipping situation highlighted in last week’s Perspectives.
New year brings new highs for US stocks
Of course, whether reading the favorable macro developments above should send us rushing out to load up on risk assets depends on how much of the good news is already in prices. That’s a question we’ve asked ourselves every time the market rallied since the Fed began hiking in 2022, and it’s a question that’s become increasingly relevant in 2024. Indeed, less than a month into the new year, the S&P 500 has already blown way past last December’s year-ahead Wall Street forecasts highlighted in our final Perspectives of 2023. There, we noted that the median sell-side strategist predicted around a 2% return for the full year. As of last Friday, and despite a rocky start to the year in early January, the S&P 500 had risen by over 3%, hitting an all-time high, while the NASDAQ was up nearly 5%, year-to-date. Not surprisingly, given expectations for rate cuts have fueled investors’ enthusiasm, a big chunk of those gains have been concentrated in stocks more sensitive to interest rates: think high-flying growth stocks—including the same tech companies at the heart of the AI rally in early 2023—as well as homebuilders and commercial real estate firms. Defensive stocks, including those in the Health Care, Utilities, and Consumer Staples sectors have likewise underperformed.
Looking more closely at valuations
As stocks have risen in such short order, valuations have naturally expanded, though all else equal, equities still appear less expensive than at the start of 2022. But “all else equal” assumes quite a lot. In reality, as stock prices fluctuate, there are plenty of other things happening in financial markets that lend some perspective to where equities currently trade. Take the bond market, for example. Higher bond yields typically correspond to lower stock valuations, as interest costs rise, growth slows, and investors substitute risky residual claims in equities for much lower-risk fixed income securities. One metric closely related to the equity risk premium we’ve highlighted before is the so-called “excess earnings yield”: the difference between the earnings yield on risky stocks and the yield on Treasuries, assumed to be virtually risk free. Below, we plot Professor Robert Shiller’s version, based on his popular cyclically adjusted P/E (CAPE) ratio, also profiled in 2023’s year-end edition of Perspectives.
On the face of it, stocks are expensive today, with excess earnings yield falling to levels rarely breached since the dot-com bubble of the late-1990s. In the plot above, we’ve superimposed stocks subsequent 10-year returns, which suggest expensive stocks—i.e., a low excess earnings yield—often predict lower long-run returns on equities. In that sense, one possible implication of the chart is that investors might want to temper expectations for how stocks might perform in the medium to longer term, despite some good momentum to start 2024.
US stocks pricing in a Fed pivot
One final thing we’ll note: The above analysis is for US stocks, whose recent outperformance jibes with rising optimism that we’re on the verge of Fed easing. The conclusion we draw is that much of that good news is, in fact, priced in. While rate cuts at some point this year look like a good bet, there’s still uncertainty as to whether a soft landing will come to pass. Investors willing to stake their portfolio on a wager in the affirmative might earn a little extra return as markets more fully bake that outcome in, though such a venture isn’t without downside risk if eighteen months of Fed tightening hit the economy harder than expected on a bit of a lag. Along those lines, we’ll close here by reiterating another message we delivered at the end of last year, considering the case for spreading one’s chips out on some other countries with potentially better odds. Specifically, we note that in other parts of the world—especially China, but also across many of the emerging markets—cheaper valuations suggest to us that less of the good news is already priced in, offering more upside in the event the Fed does pull off an easy touchdown, and also perhaps more margin for error if there are a few unexpected bumps on the way back to 2% inflation. As such, a month on from our assessment at the end of December, with more positive news and further appreciation of US stocks under our belt, we still see diversifying a little further into EM as a sensible play from a tactical perspective.