Examining the potential for recession, rate cuts and rising inflation.
The emerging theme of 2024 seems to be focusing on the widely anticipated and predicted easing cycle by central banks, but when that begins is an economist’s best guess. The U.S. Federal Reserve and the Bank of Canada face the tough choice of forcing a recession amid slowing growth or reducing rates before they meet their inflation targets, which could cause further inflation. The most likely scenario appears to be a short, shallow recession and a possible reset for the markets as high interest rates force companies to reduce borrowing and spending.
However, underlying fundamentals appear to be healthy with a resilient U.S. consumer, a tight labour market and stable corporate balance sheets. Central banks may have to acknowledge that their blunt tools may not be suitable for every situation – and a short, shallow recession caused by maintaining higher interest rates may be preferable to another spike in inflation caused by lower rates feeding the healthy underlying fundamentals. The upside to a shallow recession could be a reset of market fundamentals like valuation, providing a tailwind for bonds.
Equities outlook
The story for equities is much the same as what was seen in 2023, because the same environment persists. A key difference that may unfold involves companies that were able to implement expense management policies that boosted valuations in the back half of 2023 and helped the balance sheet. In 2024, however, earnings growth is not likely to benefit from further expense management and may come under pressure from slowing growth, wage pressures and interest rates.
Slowing growth may present a significant hurdle despite wage pressure leveling off. The Federal Reserve Bank of Atlanta’s wage tracker, which peaked at 6.7 per cent in the summer of 2022, has now fallen to 5.2 per cent and will likely decline further in 2024. Interest costs, although high, don’t seem to be causing too many problems for many of the companies in the S&P 500 with strong balance sheets. So then, slowing growth may turn out to be the biggest threat. Flat to mildly negative earnings are expected across the first half of 2024.
It’s important to filter through the noise when it comes to valuations. In the face of weakening earnings, valuations in North America appear to be in line with long term averages. The S&P 500 looks moderately expensive compared to other indexes, but when you strip out the top 10 companies, the index is closer to 19 times trailing earnings, which is much more in line with fair value.
In an environment with slowing growth and fair to expensive valuations, it becomes more important to evaluate individual securities rather than taking an index-based approach. When looking back at the most recent earnings cycle in the S&P 500, companies with positive earnings surprises were rewarded more than average and those with negative surprises were penalized more than average. Security selection, based on solid fundamentals, strong earnings, pricing power and good management may be useful in the current market environment.
Fixed income outlook
Patience is a virtue and some of the longer-term fixed income strategies are playing out as mentioned in the last market update article. With interest rates rising to their possible peak over the last year, there have been some attractive yields for investors. Although rising yields affect the price of bonds negatively, now that we’re close to the top of the hiking cycle, coupon clipping is proving to be an effective strategy for investors. But what’s next? If rising yields bring down the price of bonds, then surely falling yields have the opposite effect?
Now may be the time when duration becomes your friend. Increasing the duration of a bond portfolio could help take advantage of a lowering yield scenario. The longer the duration of a bond, the higher the sensitivity to changes in yield. With the expected drop in central bank interest rates, it may be time to switch to phase two, recommended by the Manulife Capital Market Strategy team in their article, “Three phases of fixed income investing” which embraces duration. It’s been a tough road for fixed income investors. But it does appear as though patience is finally paying off.
Market movers
It wouldn’t be a U.S. election year without mentioning what a Republican or Democratic win would do to the financial markets, but there is an even bigger theme developing this year. According to Bloomberg Economics, voters in countries representing 41 per cent of the world’s population and 42 per cent of GDP will have a chance to elect new leaders this year. But for all of the pomp and circumstance, these events are usually headline driven with very little long term market movement. As indicated below, there’s not much difference when it comes down to the long-term averages.
This may be a great time to remind clients about disruptive versus destructive market events, with election years falling comfortably in the former. Short term market moving events should have little bearing on a long-term investment plan and portfolio.
For more information on the outlook for the rest of 2024, visit the Capital Markets and Strategy page.
