News & Insights

Expectations for rate cuts in 2024 have moderated since the beginning of the year. Based on the CME FedWatch Tool, the current expectation is for three 0.25% rate cuts in 2024 with the first cut occurring in June. This is down from expectations at the start of the year for six rate cuts with the first reduction occurring in March. One might expect the revisions since the start of the year would spell trouble for equities, but stronger than expected economic data has helped propel the market while calming fears regarding an imminent recession. 

Real GDP increased 2.5% in 2023 and economists tracked by Bloomberg now expect real GDP to grow more than 2% in 2024, reflecting the view that the risks of a near term recession are remote. Regardless, the Fed appears ready to step in upon signs of a meaningful downturn in the economy while fiscal policy also remains stimulative, helping support risk appetite. 

The S&P 500 closed above 5,000 for the first time in history on February 9. The index has risen more than 50% since the end of 2019. The Russell 2000 index of smaller companies has only slightly underperformed the S&P over the past month. The persistent rally finally broadened out.  

Valuations are stretching, though. According to FactSet Earnings Insight, authored by John Butters, the S&P’s estimated forward P/E ratio has risen to 20.3, above the 5-year average of 18.9. With three quarters of the S&P having reported fourth quarter earnings, the composite Q4 growth rate for earnings stands at 2.9%. That modestly lags consumer price inflation over the same period, meaning the purchasing power of corporate earnings remains in modest decline. Markets look ahead, suggesting improved earnings growth will be necessary to justify the optimism baked into current valuations. 

Last year the market rebounded from what was a challenging 2022. Investor sentiment going into 2023 was decidedly negative, as the Federal Reserve’s aggressive rate hiking campaign to quell inflation led market participants to broadly anticipate a recession that still has not arrived. Instead, the economy proved more resilient than many expected while the Federal Reserve’s campaign against inflation showed progress. Falling inflation coupled with the anticipation of easier Fed policy has raised investors’ spirits heading into 2024. The possibility of inflation returning to more normal levels while the economy remains healthy has increased hopes for a “soft landing,” something that historically has been difficult to achieve. 

Recent data on inflation has been encouraging, trending toward the Federal Reserve’s customary 2% target. The consumer price index for December showed headline inflation increased 3.4% on an annual basis, an acceleration from 3.1% growth the prior month. That is the wrong direction, but in more encouraging news, the core consumer price index, which excludes volatile food and energy prices, fell to a 3.9% annual increase in December, a modest tick lower from 4.0% growth in November. The Fed’s preferred inflation measure, the core PCE price index, rose 3.2% in November versus the prior year, down from 3.4% in October. Notably, the November PCE inflation data took the core six-month annualized rate of inflation down to 1.9%. 

Markets have rallied since late October on the increasing belief the Federal Reserve has completed its rate hiking campaign intended to quell inflation. The Fed last raised rates in July to a range of 5.25%-5.50%, reaching 22-year highs. As inflation comes down investors are looking ahead to multiple rate cuts in 2024 with markets pricing in the likelihood of the first rate cut coming in March and five more rate reductions later in the year. Propelled by this belief, the S&P 500 has advanced more than 14% since just before Halloween, achieving new highs for the year and the highest levels since late 2021. The yield on the 10-year Treasury has also retreated from approximately 5% in late October to under 4%, helping support equities and other risk assets. As one sign of the risk-on environment, bitcoin is up more than 20% since late October.

Since late October, the stock market has rallied off multi-month lows and is now back near its 2023 highs, giving something extra for investors to cheer about as we head into this holiday season. Third quarter earnings are largely in the books, with Q3 2023 marking the first quarter of year-over-year earnings growth since Q3 2022 according to Earnings Insight by FactSet’s John Butters. The recent rally has returned S&P 500 valuations to approximately their five-year average of 18. That feels a little rich considering what has happened to interest rates over the last five years.

Investors in long-term bonds feel like they are repeating a bad song while investors in stocks are likely not doing as well as the media headlines assume.

In 2022, the Federal Reserve began its campaign to tame inflation by increasing the Federal Funds rate from zero to 4.25% by year end. The 10-year Treasury followed, ending at a yield of 3.88%, up from about 1.5% at the start of the year. Because the price of a bond moves opposite to yields, this dramatic increase in rates led to double-digit losses for bond investors.

After a bit of a reprieve in 2023, bond investors are feeling the pain again. The 10-year Treasury yield fell to 3.25% in April but has since steadily increased to about 4.8%, as the Fed has further increased the Federal Funds rate to 5.25%. With inflation still above the Fed’s 2% target and economic growth strong, it isn’t likely that bond investors will escape another year of losses.

As we head into the fall, 2023 has left egg on the face of most forecasters. The seemingly inevitable recession on the heels of a turbulent 2022 hasn’t materialized. The economy continues to grow, inflation is abating, and the stock market has had a remarkable year. Interest rate increases haven’t torpedoed the employment market. Government, consumers, and the market have coalesced around a “soft landing” narrative. However, as always, there are risks.

Since March 2022, the Federal Reserve has executed eleven separate increases to the Federal Funds rate, bringing it to a range of 5.25% to 5.5%. This rapid pace of increases is having the desired impact on inflation and a red-hot labor market.

Long-term interest rates were choppy with no clear trend in 2023 through the end of July but broke to the upside in August. The 30-year Treasury’s yield recently surpassed its 5-year high of 4.2%, with the 10-year also nudging above 4%. Long-term rates have not traded above these levels for an extended period since the financial crisis of 2008-09. It will be interesting to see whether investors treat this like a ceiling for rates or keep allowing them to rise.

Basic supply and demand for government debt may force a new equilibrium at higher rates, meaning lower bond prices, as the U.S. fiscal deficit will balloon to more than $1.5 trillion in the government’s fiscal year that ends in October. Deficits as a fraction of GDP have averaged 3.6% since 1973. This year’s deficit is likely to be more than 6% of GDP. That is a lot of supply.

Since early 2020 the economy has undergone a series of shocks. First came the Covid-19 pandemic, which continues to impact the economy more than three years later. Next came the war in Ukraine, impacting global oil and wheat markets.

Most recently the emergence of Generative Artificial Intelligence (GAI) is a technological development that some have said could be as profoundly positive as the invention of the internet, mobile devices and cloud computing. Only time will tell if GAI lives up to the hype, but these shocks have brought tremendous volatility to the economy and financial markets.

Unprecedented monetary and fiscal support in response to the pandemic has brought elevated inflation. Since March 2022, the Federal Reserve has been pursuing monetary tightening, resulting in the fastest pace of rate hikes in U.S. history, eleven separate increases bringing the federal funds rate to a range of 5.25%-5.5%. The Fed is attempting a soft landing for the economy, raising rates just enough to slow growth without causing a recession.

The U.S. economy is still feeling the after-effects of the Covid emergency more than three years after it began. In the early going, consumers hoarded items they feared would be in short supply like toilet paper and cleaning products. Demand for many types of services like travel and dining collapsed. In the next phase, component shortages caused prices of many goods to surge. Then, as Covid restrictions eased and demand returned, labor shortages led to further price increases. The war in Ukraine exacerbated growth and price challenges.

The government played a role as spending levels and easy monetary conditions were left in place for too long even as the worst of the crisis had clearly passed. The Federal Reserve was caught flat-footed, assuming the nascent surge in inflation two years ago to be “transitory.”  It has spent the last year and a half making up for its initial failure, raising short-term interest rates from around zero to 5.00%.