Strong equity market performance in 2023 came as a surprise to most investors. The S&P 500 defied fears of an economic recession, contracting leading economic indicators, tightening financial conditions, slowing EPS and an inverted yield curve. It ended up 26.50% on the year. A large part of this equity performance can be attributed to the deceleration in the rate of inflation, which pulled forward investor bets on an end to the Federal Reserve’s interest rate hiking cycle and a pivot to rate cuts. By December 31st 2023 the market was pricing in 6.3 rate cuts of 25 bps each by the end of 2024. This implied a Fed funds rate of 3.75% by the end of 2024.
Like equity markets, the economy maintained strong momentum coming into this year. Fourth quarter 2023 real GDP growth, paced by a strong consumer and solid government spending, was 3.3% on an annualized quarter-over-quarter basis, suggesting top-line nominal growth close to 6%. The Conference Board’s Consumer Confidence Index, echoing ongoing labor market strength amid three months of rebounding job openings, registered its strongest reading since December 2021. S&P Global’s US Composite PMI Output Index, furthermore, exhibited greater-than expected expansion in both services and manufacturing, and capital goods orders surprised to the upside, confirming strong ISM survey readings. Construction spending also ran ahead of estimates, and leading economic indicators have turned less negative. Topping it all off, January nonfarm payrolls revealed a massive reacceleration in hiring, with over 350,000 jobs added.
So, evidence is mounting that we have achieved an economic soft landing. But there is an important catch-22 at play which seems to have flown under the radar. Can a strong economy and a tight labor market allow inflation to continue its downward trajectory? We believe that investors were treated to the answer to this question in the recent core CPI data which showed that inflation rose 0.4% MoM and 3.9% YoY (see chart). Albeit backward looking, this upside surprise (economists had forecast a rate of 3.7%) ought to serve as a warning to investors that are banking on interest rate cuts. 3.9% remains well above the Fed’s 2% target, and the disinflation that began in autumn of 2022 (and corresponded to the trough of the 2022 market drawdown) is not guaranteed to follow a consistent path down back to 2%.
Source: Bloomberg
Combined with a hot labor market and strong economic growth, the Fed’s fight against inflation is not over. As a result, rate cuts may need to be delayed until inflation can truly be said to be under control. Indeed, expectations for rate cuts have been tempered significantly this year, even before the high inflation print. As of February 14th 2024, expectations for the Fed funds rate at the end of 2024 stand at 4.36%. Compared to pricing at the beginning of the year when the market expected 6.30 rate cuts of 25bps each by December, it now expects only 3.88 rate cuts of 25 bps each by December.
Implied Fed Funds rate as of December 31st 2023:
Source: Bloomberg
Implied Fed Funds rate as of February 14th 2024:
Source: Bloomberg
For its part, the bond market has been digesting what is likely to be a higher-for-longer interest rate regime. The 10-year yield has risen from 3.9% at the beginning of the year to 4.3% today and the 2-year breakeven rate (2-year forward inflation expectations as priced by the market) has spiked from 2% at the beginning of the year to 2.6% today. However, equity markets appear to have shrugged off these significant shifts in inflation and interest rate dynamics. As of February 14th, the S&P 500 is up nearly 5% year to date and is hovering above 5000, just off all-time highs.
We are of the opinion that the 2023 “no recession surprise” and the “Fed pivot to rate cuts” is largely priced into current US equity valuations. Now, the market’s apathy towards a higher-for-longer cost of capital gives rise to valuation and economic pressures - and thus to downside potential in equity markets. We are not bearish, economic activity has proven resilient and return to 2022 inflation numbers is unlikely. That said, we do not anticipate a repeat of 2023’s +20% returns from US equities in 2024, and if markets fail to adequately digest a higher for longer interest rate regime, we could see downside risk when investors belatedly realize that rate cuts will be delayed because of “sticky” inflation. We are therefore remaining defensive in our equity portfolios. We are using buffered ETFs that have downside protection and upside caps in order to remain invested in equities and participate in the economy’s growth, but protect ourselves on the downside. We are also staying selective, especially in the US, and prefer large caps with strong balance sheets and high brand relevancy over smaller cyclical companies.
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