U.S. Outlook: One Thing Leads to Another

Looking ahead to 2024, we view the best-case scenario as a continued roll-through, with possible recession-level weakness in services being offset by stability and/or recovery in segments which have already taken their hits. However, we think recession risk in a traditional sense, via a formal declaration by the National Bureau of Economic Research (NBER)—the official recession arbiters since the late-1970s—is still a distinct possibility.

As shown below, the Leading Economic Index (LEI) from The Conference Board has been in a steady decline for 19 consecutive months and as of the end of October 2023, was down nearly 8% year-over-year. Per the recession bars in the chart, such steep declines have typically only occurred during recessions. As shown in the accompanying table below, the distance between LEI peaks and recession starts has averaged 11 months; but importantly, the range is quite wide: only three months of separation in 1960 and 21 months of separation in 2006-2007. Where you can also see a wide range is in the S&P 500^® performance column above. This is a great example of the appropriate admonition about averages: analysis of an average leads to average analysis.

We've recently received a number of questions about whether the recent steepening of the yield curve means recession risk is waning. The reality is that steepenings are signals of easier monetary conditions ahead—typically in response to recession. To use a weather analogy, inversions tend to be the recession "watch" while steepenings tend to be the recession "warning."

In this unique cycle, the strength in consumer spending had its roots in massive monetary and fiscal stimulus, which contributed to elevated "excess savings." But more recent resilience of consumer spending amid the decline in savings and a more challenging macro backdrop has largely been driven by confidence in the labor market.

As shown in the first chart below, there has been a complete rolling-over in excess savings. At the same time, per the second chart below, the spread between real disposable personal income and personal consumption expenditures has been negative (meaning spending is exceeding income) since last June.

As shown in the light blue line in the chart above, since the July Fed rate hike, the S&P 500 has tracked in the weaker part of the historic range; though with the latest rally, it's sitting closer to the average. It highlights that there are always myriad influences on market behavior—not just Fed policy.

The table above also shows a very wide span (from 59 days to 874 days) in terms of the period between the Fed's final rate hike in a cycle and the subsequent initial rate cut. This brings up the expectation, based on the fed funds futures curve, shown below via the blue line, that rate cuts could begin by the mid-point of 2024.

Along the lines of the admonition "be careful what you wish for," it may be the case that if the Fed is cutting rates by mid-2024, it's because of further deterioration in the economy—specifically the labor market. In fact, one of our key expectations for the year to come is that the Fed will begin to shift its focus from the inflation side of its dual mandate to the employment side of its dual mandate.

As shown via the orange line (inverted) in the chart above, what's unique about this cycle's hefty deficit is that it's been accompanied by a still-low unemployment rate. As you can see historically, loftier budget deficits were typically accompanied by higher unemployment rates, as fiscal spending was combatting weak economic growth/recessions. Today, there is a yawning gap between the two, suggesting less flexibility in terms of fiscal firepower to combat a recession.

As shown below, during nearly the entire span of the three-decade period preceding the Great Moderation era, bond yields and stock prices were inversely correlated, which reversed and remained mostly positive for more than two decades prior to the pandemic. This is not an unnavigable environment, it's just different from what many investors got used to during the Great Moderation.

One way that might manifest is via higher debt servicing costs for companies in a higher-for-longer rate environment. Investors had enjoyed a secular decline in interest rates and bond yields leading up to the pandemic, which changed rather abruptly in 2022 when global central banks started aggressively hiking interest rates to combat inflation, leading to that year's bear market.

The low interest rate ship has sailed for now, which means the cost of capital has risen sharply. As shown in the chart below, that quick rise should start to take a toll on corporations when it comes to the interest owed on their debt (historically, there is about an 18-month lag between a move in Treasury rates and companies' effective interest rates)—especially those that either didn't term out their debt when rates were low or have debt coming due in the next year. Importantly, it's likely more of a simmering problem over time vs. the bottom falling out all at once.

That expectation would be satisfied in 2024 if the consensus is correct in expecting double-digit earnings growth for both the S&P 500 and Russell 2000—a significant improvement relative to 2023. We have some skepticism about the lofty expectations; and indeed, excitement waned a bit as third quarter 2023 earnings season came to a close. As shown in the chart below, 2024 estimates been lowered; but an actual economic contraction would mean estimates are still too high.

That said, the hefty "swing factor" for small caps may be enticing for investors looking for opportunities down the capitalization spectrum. As LSEG I/B/E/S estimates show, the estimated earnings growth rate for the Russell 2000 is expected to improve from -11% in 2023 to +31% in 2024; one reason there may be attractive opportunities in the small-cap universe.

Important caveat: there is a stark difference in multiples between the Russell 2000 and the S&P 600, which underscores our continued emphasis on quality. Unlike the Russell 2000, the S&P 600 is constructed with a profitability filter. For our stock pickers out there, the S&P 600 represents a higher-quality "source" of ideas in 2024.

Small caps have historically outperformed when unemployment was high and the economy was transitioning out of recession ("early cycle"). Today, the unemployment rate is still quite low, and the economy is still showing signs of being "late cycle." For investors interested in small caps offering a value bias, we encourage heightened discipline and a factor focus around profitability, profit margin strength, and high interest coverage.

To be sure, the Mag7 scores quite well on a variety of quality metrics we favor—notably, high interest coverage and strong cash positions; supporting the notion that even in a weaker growth/higher rate environment, the Mag7 cohort can still do well. If we do see a harder landing, however—and if it occurs earlier in the year—there may be more potential upside in segments of the market that lagged in 2023; likely manifesting in the form of rotation out of the Mag7.

One theme we believe will shift from 2023 to 2024 is around artificial intelligence (AI). AI has both captured investors' hearts and minds, and contributed to the outperformance of both the Mag7 and technology stocks more broadly; but it's been in conjunction with narrow market performance. We believe a theme in 2024 will be less about AI's "creators" and more about AI's "adopters"—across the spectrum of industries and sectors—as companies increasingly focus their capital spending on productivity-enhancing investments.

On that note, we're often asked what period in history does the current cycle most resemble. There are several facets of the late-1960s cycle that ring familiar. It's a comparison our friend Nancy Lazar, the chief economist of Piper Sandler Macro, believes rings familiar as well. Nancy was a recent guest on our new podcast—On Investing, hosted by me (Liz Ann) and Kathy Jones—and you can hear many of her thoughts here: This Week's CPI Data and the State of the Economy | Charles Schwab

In a nutshell, rate cuts by the Fed into late 1967 helped reaccelerate real GDP and push the unemployment rate down. But it also reignited inflation, forcing an aggressive tightening cycle which triggered the 1970 recession and sharply higher unemployment. The Fed then compounded the error by easing aggressively, even though core inflation remained elevated, setting off the 1970s' era of stagflation. We have no doubt this is a scenario Jerome Powell's Fed would like to avoid.

Best-case scenario for the economy in 2024 is for rolling recessions to morph into more durable rolling recoveries. Once the economic path is clearer, we expect less bifurcation within the market (i.e., less violent swings in leadership) as the year unfolds. That should bode well for groups that have failed to participate in the advance since the bear market low in October 2022.

Our outlook does provide some runway to the upside to equities, but possibly with the necessity of some economic pain nearer-term, in the interest of less-tight monetary policy. Heading into 2024, another short-term concern is around investor complacency, witnessed in attitudinal sentiment indicators showing elevated optimism amid extremely low volatility. As was the case in 2023, short-term market swings often move contrary to extremes of sentiment.

Specifically, for investors who have sector and asset classes exposures within portfolios that are now stretched both to the upside (e.g., Mag7) and downside (e.g., smaller cap stocks), periodic rebalancing is prudent in the interest of "adding low and trimming high" and staying in gear with the market's eventual mean reversions. We also (always) remind investors of the benefits of diversification—both within and across asset classes—especially if, as we expect, the investing backdrop will be characterized by wider global dispersion in term of both inflation and growth patterns.