Will 2024 Repeat, Rhyme, or Rattle Investors?
Michael Arone
Chief Investment Strategist, Managing Director at State Street Global Advisors
"Enthusiasm is common. Endurance is rare." – Angela Duckworth
Investors fell victim to the behavioral bias of extrapolation in 2023. After a historically poor 2022, they anticipated an equally bad, and possibly worse, new year. With expectations at rock bottom, most economists forecast a recession. Instead, years of easy monetary policy and tremendous fiscal spending supported the economy and led to an unexpected stock market rally, one that investors believe will continue in 2024. But is their optimism misplaced?
2023: A Magnificent Year
Notwithstanding a still difficult environment for bonds, stocks and diversified investment portfolios performed solidly in 2023. The S&P 500 Index has soared by more than 19% and the 60/40 portfolio has returned a commendable 11%.1
Plenty of bad news could have derailed both the economy and markets. The Federal Reserve (Fed) and other central banks continued to raise rates throughout the first seven months of 2023. Several US bank failures were the collateral damage from more restrictive monetary policy. Dysfunction in Washington, combined with the US’ deteriorating fiscal health, routinely stoked investors’ fears. US companies suffered through an earnings recession — three consecutive quarters of negative year-over-year earnings growth. And, despite considerable progress made on lowering inflation, it still remains too high.
Bigger picture, China’s disappointing emergence from COVID-19 restrictions led to a weaker than expected European economy. In the battle for world supremacy, elevated tensions between the US and China persist. There’s still no resolution in the Russia-Ukraine war. And the Israel-Hamas war risks entangling additional countries into a wider Middle East conflict.
Yet, years of seemingly endless easy monetary policy and massive fiscal spending, especially in response to the pandemic, combined with historically low investor expectations to start the year, created the perfect environment for a resilient economy and an unexpected rally. Rather than contracting as most economists anticipated, the US economy expanded in every quarter of 2023, culminating in a robust annual increase of 4.9% in third quarter GDP.2 Bolstered by the strongest labor market in more than 50 years, the consumer continued to be the engine of exceptional US economic growth.
The Economy’s Resilience Should Be No Surprise
More than a decade of ultra-low interest rates enabled consumers and businesses to lock in cheap financing costs on growing debt obligations. Now, after 11 Fed rate hikes, they are able to earn a competitive return of 5% or more from money market investments. This differential between low financing costs on debt and practically risk-free income from money market investments has allowed the economy to weather the impacts from higher interest rates better than the Fed or anyone else thought possible.
Further aiding the economy’s resilience, consumers and businesses lined their pockets with extraordinary government stimulus funds, incentives and tax breaks enacted to combat the negative effects of the pandemic. Beginning with the CARES Act in March 2020 and ending with the Inflation Reduction Act in August 2022, the US government signed into law more than $6 trillion in fiscal stimulus legislation that’s been positively flowing through the US economy.?
To investors’ relief, inflation cooled considerably as benefits from fiscal spending faded, monetary policy tightened, and global supply chains were restored. Softening economic data and shrinking inflation have convinced market participants that the Fed’s tightening cycle is over and that a soft landing is probable. In fact, the Fed has raised rates just once since June 2023 and stood pat in three out of the last four FOMC meetings.
According to FactSet, the earnings recession ended in the third quarter. Year-over-year earnings for S&P 500 companies are on pace to grow by 4.3%, marking the first quarter of earnings growth since the third quarter of 2022.3 And S&P 500 companies continue to be highly profitable. After bottoming early in 2023, net profit margins expanded to 12.1% ?year-over-year in the third quarter — above the previous quarter, one year ago, and the five-year average.?
But will lofty investor expectations for future earnings growth, cooling inflation, and an end to the Fed’s tightening cycle be enough to sustain the rally?
Soft Landing or Hard Lesson?
As investors begin 2024, healthy skepticism has transformed into dangerous confidence. Market participants are certain that the rare soft landing is in reach. Convinced that inflation will continue to move toward the average 2% target, investors believe the Fed’s tightening campaign has ended — without a recession or a capital markets catastrophe.
Investors are confident that their willingness to pay a higher price for future earnings in 2023 will be rewarded in 2024 when S&P 500 companies are forecast to grow their earnings by 11%.? But they are underestimating the risks to the economy as it transitions from monetary and fiscal policy aided resilience to durable organic expansion. Not to mention the potential for increased market volatility in a contentious US presidential election year.
Regrettably, 2023’s caution has turned into 2024’s courage. The economy and market were able to beat incredibly low expectations in 2023, but they were supported by the long and variable impacts from years of easy monetary policy and massive fiscal stimulus. In 2024, investor expectations are much higher. And the monetary and fiscal policy crutches have been removed from an economy that may not be able to stand on its own two feet.
With the range of possible market outcomes wider than normal, risks are firmly skewed to the downside. As a result, investors should consider these three strategies when constructing investment portfolios for 2024:
Footnotes
1 FactSet as of November 17, 2023.
2 U.S. Bureau of Economic Analysis, October 26, 2023.
3 Earnings Insight and FactSet as of November 17, 2023.
? Earnings Insight and FactSet as of November 17, 2023.
? FactSet as of November 17, 2023.
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Glossary
CARES Act
The Coronavirus Aid, Relief, and Economic Security (CARES) Act (2020), signed into law on March 27, 2020, was implemented to address issues related to the onset of the COVID-19 Pandemic. The purpose of the act was to provide direct economic assistance to workers, families, small businesses, and industries by providing $2.2 trillion for economic stimulus. The spending primarily included $300 billion in one-time cash payments, $260 billion in increased unemployment benefits, the $669 billion for providing forgivable loans to small businesses, $500 billion in loans for corporations, and $339.8 billion to state and local governments.
Earnings Recession
It is a situation in which earnings have decline for at least two consecutive quarters. In the financial sector, during an earnings recession, companies’ profits decline year-over-year for two or more quarters in a row.
Federal Open Market Committee (FOMC)
The FOMC is the branch of the Federal Reserve System that determines the direction of monetary policy in the United States by directing open market operations. The committee consists of 12 members, including seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four of the remaining 11 Reserve Bank presidents, who serve on a rotating basis.
Inflation Reduction Act
The Inflation Reduction Act, passed in 2022, aimed to curb inflation by possibly reducing the federal government budget deficit, lowering prescription drug prices, and investing in domestic energy production while promoting clean energy. It achieved these goals by investing in domestic energy production and manufacturing, and reduce carbon emissions by roughly 40 percent by 2030. The bill also allowed Medicare to negotiate for prescription drug prices and extend the expanded Affordable Care Act program for three years, through 2025.
S&P 500 Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
Soft Landing
A soft landing is a gradual slowdown in economic growth that avoids a recession. A soft landing is the goal of a central bank when it seeks to raise interest rates just enough to stop an economy from overheating and experiencing high inflation, without causing a severe downturn.
Risk Disclosure
The views expressed in this material are the views of Michael Arone through the period ended November 20, 2023 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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