14 January 2024

On December 13, just weeks after warning it was premature to think the Federal Reserve would begin lowering interest rates, the US central bank gave the green light to at least three cuts in 2024. To be sure, consistent communication has never been a strong point of Chairman Jerome Powell’s premiership. Nonetheless, financial markets rightly are celebrating the Fed’s reversal. The central bank’s medium term forecast features a consistent decline in inflation towards the 2% target, GDP growth near the 2% long-term trend (after dipping modestly to a still respectable 1.4% this year), and the unemployment rate holding steady near 4% in coming years.

What’s not to like? Actually, several of the most bullish features of the Fed’s forecast have received less attention than they deserve. Indeed, the central bank’s engineering of a “soft landing” is unprecedented. During the past 70 years, there has been no economic cycle during which inflation has accelerated meaningfully, and the unemployment rate has remained persistently below 4%, that has not ended in recession.

As practitioners of the “dismal science”, economists are trained to ask “what can go wrong?”. In this case, however, I will also consider what could go right; that is, what could produce an even more bullish outcome than Chairman Powell and his colleagues are envisioning.

Financial markets have entered the “sweet spot” of the economic cycle: recession avoided, inflation declining and monetary policy easing. As an economist, of course, I will consider numerous short- and medium-term risks. However, setbacks are likely to prove temporary. I establish S&P 500 targets of 5,000 and 5,750 over the next 12 to 24 months respectively.

What Could Go Wrong?

Economic Growth Risks Remain to the Downside

The bullish investment outlook is based upon the market’s (and Fed’s) view the economy has dodged a recession, and GDP will grow nearly 2% annually over the medium term. To be sure, the US economy proved surprisingly resilient in 2023. Indeed, GDP growth significantly outpaced G7 rivals last year (Chart above).

But, what factors led to this outperformance? Most importantly, unlike other countries (Germany in particular), US consumer spending held up remarkably well, despite rising food and energy prices. However, I expect the post-Covid spending spree to fade in 2024. Likewise, the US economy benefited from generous government outlays last year. Similarly, I anticipate the impact of American fiscal policy to be more neutral in the New Year. And, the external sector contributed positively to US growth last year, as exports expanded and import volumes declined. With global growth remaining tepid in 2024, the boost from foreign sources will also diminish this year.

Overall, near-term economic risks remain to the downside. I project 2024 US GDP growth of 1%, but I agree that economic activity should revert to the 2% long-term trend by 2025. As a result, I believe S&P 500 EPS growth of 5% this year will prove disappointing, but I expect a 15% recovery in 2025.

Inflation: Could Be Stickier than Expected

Like the Fed, I am optimistic US inflation will decline further. However, I anticipate the easiest phase of the disinflationary process is over (reflecting more stable food and energy prices), and price growth may prove to be a bit stickier than expected. In particular, of course, labour market conditions remain tight. Like the low unemployment rate, the closely-watched unemployment/openings ratio has barely budged as the Fed tightened policy — remaining near historically low levels (Chart above).

Nevertheless, wage growth has moderated in response to higher interest rates during the past two years (Chart above). However, more recent data, including the recently-released December labour market report, indicate pay gains have remained steady near 4% in recent months. Compensation growth will need to moderate further towards 3% to achieve the Fed’s 2% inflation target, which may require a bit more time and higher unemployment. Similarly, recent CPI reports appear to confirm inflation has been sticky in the past six months or so: holding steady around 3% during the interval.

Overall, I expect US inflation to decline towards 2.50-2.75% by the end of the year, with further declines below 2.5% in 2025: further progress, but the low hanging fruit has been enjoyed already.

Monetary Policy: Markets to be Disappointed

As usual, with the Fed opening the gate for monetary easing, the financial markets have rushed through! Reflecting my concern that inflation may prove a bit stubborn, I project three interest rate reductions this year (similar to the Fed’s forecast), while markets are anticipating at least six (Chart above). I believe a March rate cut is unlikely. As the Chart above also highlights, however, the gap between my projection and current market pricing narrows during the course of 2025.

Equally importantly, the US central bank (as well as the International Monetary Fund) estimates the so-called “natural” Fed funds rate to be 2.5% — the sustainable interest rate after the 2% inflation target is achieved in the medium term. In other words, inflation-adjusted bond yields should return to the low levels (0% to 0.5%) enjoyed in the years prior to the pandemic (Chart above).

Such an outcome is even more optimistic than financial markets are considering at present, and would be very bullish for asset prices. On the other hand, as I anticipate America’s unstable fiscal position will remain unaddressed prior to the upcoming election (and probably beyond), I believe the equilibrium Fed funds rate may be closer to 3.25-3.5%. As a result, I expect US 10-year Treasury yields to spend a lot of time in the 3.5%-4% range during the next 12-24 months. (I will address this issue in more detail in future blogs.)

Valuation: Markets Priced for Perfection

These differences in interest rate projections are critical as markets are priced for perfection. As the S&P 500 now enjoys a 22X PE ratio, there’s little scope for multiple expansion. Rather, if the pace of monetary easing is slower than expected, the PE ratio is likely to decline towards 19X over the next 24 months. In addition, the lofty stock valuations make bonds an attractive investment alternative. Indeed, for much of the past 20 years, equity earnings yields have exceeded bond yields. But, that’s no longer the case (Chart above).

With PE multiples contracting, the direction of equity markets will be led by earnings growth. However, as I anticipate 2024 GDP and EPS growth to be below consensus forecasts, financial markets may be disappointed both by earnings as well as the pace of monetary easing in 2024. However, with economic activity improving and interest rates declining further in 2025, any market setbacks should be short-lived.

What Could Go Right?

Even though the “soft landing” is already an historical achievement, the US economy could potentially continue to exceed expectations. What could produce this bullish outcome? The US economy’s supply-side performance has contributed to its resilience in recent years. In particular, the labour force has expanded 1.5% annually during the past two years — twice the pace of the past decade.

This remarkable trend has helped contain inflation and wage growth, despite rapid job creation and low unemployment. It’s worth noting, especially given the currently heated debate on immigration, foreign-born workers have accounted for 60% of America’s labour force growth in recent years — even though this cohort accounts for just 15% of the population (Chart above). As the overall labour force participation rate remains below pre-Covid levels, these benefits may not have run their course yet.

As in other advanced economies, American productivity growth has faltered since the Global Financial crisis (Chart above). However, stronger business investment, which has expanded at a robust 5% annual rate during the past three years, could contribute to improved output per hour. And, it’s been done before — note the acceleration in productivity performance during the Naughties (as the internet, etc. took hold). Indeed, AI may have this potential. To be sure, efficiency gains remain tepid at present. But, does the 2.4% surge in US productivity in Q3 2023 signal the dawn of something new? Rising productivity growth — leading to higher wages, spending, and standards of living — could be the cornerstone of the next bull market.