Shifting sands: The economy, the Fed, and market dynamics in 2024

The labor market is also showing signs of rebalancing. While overall jobs growth is undoubtedly solid, averaging 250,000 in the past three months as of May month end, surveys clearly indicate waning labor demand and deteriorating job security among employees. This trend is particularly evident among smaller businesses, where high input and wage costs have made it more difficult for them to hire new employees, leading many business owners to reconsider their hiring plans. At the same time that labor demand has been slowing, there has been a significant increase in labor supply due to a surge in immigration. As a result, new entrants into the job market are finding it increasingly difficult to secure employment.

Labor market tightness: Various measures
NFIB hiring plans, JOLTS quits rates, jobs-workers gap

… yet still a solid economy

It is important not to exaggerate the pockets of U.S. economic weakness. While lower-income households are showing strains, middle- and higher-income households, who are responsible for most consumer spending, remain in good shape. Indeed, most households were able to lock in low mortgage rates during the years before inflation began to surge and Fed policy was tightened. Coupled with gains from property and equity market exposure, broad household balance sheets have remained strong.

Corporate interest payments versus Federal funds rate
Quarterly, 1970–present

Equally, while small business confidence is struggling, large business confidence continues to move from strength to strength. Furthermore, as a record number of companies chose to issue/refinance their debt when rates were low in 2020 and 2021, interest payments by nonfinancial corporations, as a percentage of profits, have actually fallen to the lowest levels since 1957. With still-healthy profit margins, the prospect of mass job layoffs across the economy is highly unlikely.

Large versus small business optimism
Level, 2007–present

The Fed’s dilemma

From an inflation perspective, slightly cooler economic growth and an improved labor demand/supply balance should lead to a softening in wage growth. It is doubtful that there will be enough of a softening to bring inflation all the way down to the Fed’s 2% target, but potentially enough to unwind the fears surrounding the series of upside inflation surprises in 1Q24. Once inflation is moving sustainably toward the 2% target, the stage will be set for the Federal Reserve to finally start reducing rates.

Nevertheless, the timing of the first Fed rate cut remains a difficult question to answer. The uncertainty surrounding the “last mile” of progress for stubborn and sticky inflation undoubtedly complicates the Fed’s decision-making, as does the continuing strong U.S. jobs growth. Even with a slight downshift in economic activity and with the soft May inflation print, it is not obvious that the economy requires policy easing, and it is no wonder policymakers have been steadfast in communicating their patience with their current policy stance.

Although the timing remains uncertain, investors can derive three key insights regarding the Fed's outlook:

1. Recent consumer and labor market survey data suggest that the next policy move will be a cut, not a hike.
2. With just four FOMC meetings remaining in 2024 and inflation still above the Fed’s comfort zone, markets are unlikely to get more than two policy rate cuts this year.
3. While inflation is likely to decelerate, the economy’s underlying strength, geopolitical tensions and several structural drivers argue against a meaningful drop in inflation. This is shaping up to be a short and shallow cutting cycle, with rates very unlikely to approach the zero bound.

Although prospects for interest rate cuts were an important driver of the market rally in the first half of 2024, the set-up for equities remains positive even after most of those rate cuts have been priced out. Looking ahead, the rationale for the delay in Fed rate cuts is critical to the equity outlook.

Fed policymakers have shown that they won’t rush to cut rates, as continued resilient economic growth is preventing inflation from swiftly returning to its 2% target. That same economic strength, even if it is downshifting slightly, is driving the constructive backdrop for corporate earnings and giving investors good reason to remain invested in equities.

History suggests that long Fed pauses are positive for stocks. In fact, the 1995–1996 Fed pause was against a similar backdrop to the present day, with strong economic growth giving the central bank little reason to lower rates. During the time, when the Fed kept policy rates on hold, the S&P 500 rose 19.2%.

Solid economic growth is also supporting a broadening out of risk appetite and earnings growth, adding an additional positive dimension to equity markets. Last year, the equity market’s stellar performance was primarily driven by the Magnificent Seven. While the AI craze and delivery of strong earnings means that investors are still willing to pay higher multiples for those companies, investors are also seeing an improvement in earnings across a variety of other companies and sectors. Today, there is a growing opportunity set, including non-tech sectors of the U.S., as well as in international markets, which have meaningfully less stretched valuations than the Magnificent Seven and, therefore, have the potential for above average market returns.

For the downside risk to this positive equity outlook, look no further than the same rationale for Federal Reserve policy decisions. Higher rates are usually a positive for equities, provided they are associated with strong economic growth. However, if the Fed were to need to raise rates because they had lost control of inflation, the result could be detrimental for broad investment markets. Conversely, if the Fed reduces rates due to recession concerns, deteriorating earnings growth would likely weigh on equities. The most favorable scenario for risk assets is the currently anticipated path of easing policy, even if rate cuts are postponed.

Despite the significant repricing in rate expectations so far in 2024, fixed income has continued to deliver positive performance. This is predominantly because the macro resilience narrative is still very much intact, and the yield generated from fixed income today is markedly higher than a few years ago.

Credit spreads are currently near historic lows and are unlikely to narrow further. However, provided recession is avoided, a gradual rise in defaults is more probable than a sudden spike, meaning spreads are unlikely to widen significantly from their current levels. Additionally, it is noteworthy that despite recent macro volatility, spreads have remained within a relatively tight range. This suggests an attractive “stability” element to credit which should continue even amidst ongoing debates about interest rates.

Albeit delayed, the continued prospect of rate cuts remains a critical support for the fixed income market. Despite the Q1 upside surprises in inflation, there has been significant improvement over the past year, and concerns about a second wave of inflation appear overstated. Fed Chair Jerome Powell shares this view, having indicated that the threshold for further rate hikes is quite high. Just as bond yields trended higher as inflation surged, yields should now trend lower given inflation deceleration and the anticipation of forthcoming Fed rate cuts.

Certainly, the most bearish scenario for credit from here would be recession. Defaults would spike, leading to a significant widening in spread levels—unless the Fed responded proactively to weaker growth and reverted to balance sheet expansion. Any further hesitation from the Fed to cut rates will also likely lead to higher yields and more negative outcome for fixed income—but it would create a more attractive opportunity for investors to position for eventual cuts. On balance, however, the most probable scenario for fixed income in the second half of 2024 is a market that is poised to benefit both from an attractive yield and a duration tailwind.

The still robust macro backdrop, even without imminent rate cuts should provide an almost perfect set-up for a risk-on environment. However, the potential for further equity gains may be somewhat limited from here. With valuations so stretched, a soft economic landing is a necessary backdrop to support further gains. There is no room for either economic disappointment or hawkish inflation surprises.

Within equities, exposure to large-cap technology and AI means that the U.S. remains the favored region. International developed market equities have started to show more appeal, with valuations relatively less stretched, central bank paths somewhat more assured, and cyclical economic upturns underway. However, the sustainability of any outperformance is still in question given the limited nature of their economic recoveries. Small caps have seen occasional flickers of strength, yet their relatively high share of floating rate debt implies that small caps cannot stage a sustained recovery unless rate cuts materialize promptly and the economic growth backdrop strengthens. Investors should also consider strong opportunities outside the U.S., with segments of the Latin America and Asia emerging market complex likely to show strong gains, although China continues to be pressured by its weak macro performance.

Fixed income has continued to deliver even in the face of repriced Fed rate expectations. Yet, with the rate debate heating up as concerns about the U.S. fiscal position collide with sticky inflation fears, bond market volatility will likely rise in the second half of 2024. Treasury yields appear to be rangebound and so asset allocation duration positions reflect the limited risk/reward. On the other hand, given the strong economic performance, credit retains a positive outlook.

Aside from traditional equities and fixed income, the sticky inflation environment argues strongly for exposure to alternatives. Commodities and hedge funds will also provide important diversification benefits in the current environment.