Niels Bohr famously observed that "Prediction is very difficult, especially if it's about the future!" The sentiment is especially poignant when it comes to economic forecasting, as it's nearly impossible to get an accurate picture of the current state of the economy at any given moment. As a result, uncertainty about how the economy may unfold, even along the shortest time frames, is the default. However, given the ongoing debate around the various 'hard', 'soft', or 'no-landing' scenarios that have dominated the headlines due to the Federal Reserve's campaign to tame inflation, it's safe to say that economic uncertainty is especially elevated at the moment.
As has been the case for several quarters, the prevailing characteristic remains a "tale of 2 economies". While the manufacturing sector (which makes up 'only' 8% of the U.S. economy) contracted for the 12th consecutive month, the services sector (constituting about 78% of GDP) expanded for the 11th consecutive month, serving as a primary driver behind continued wage inflation as well as tightness in the labor market.
While there's certainly a chance that the Fed will achieve its 2% inflation target without a commensurate spike in unemployment, there are still plenty of threats on the horizon. Notably, banks face pressure on several fronts, including declining values of longer-term debt holdings impacting balance sheets, savers shifting out of savings accounts as they seek higher-yielding money market funds, and record-level office vacancy rates that hinder the refinancing of low-rate real-estate loans into higher-rate loans.
Consumers, meanwhile, have just about burned their way through their post-COVID savings, which was the main driver for GDP growth in 2023. With credit card balances and delinquencies spiking and student loan payments resuming, it's unlikely that consumers will be able to sustain their spending levels and ride to the rescue once again in 2024. Businesses are also feeling the pinch from higher interest rates, as November saw a rapid increase in the number of Chapter 11 commercial bankruptcies.
The labor market, while still remarkably resilient, has also started to show signs of stress. Since the Fed started raising rates in March 2022, job growth has steadily slowed; continuing claims for unemployment hit a 2-year high; the average work week is getting shorter; and job openings, 'quit rates', and wage growth for job switchers have all been falling.
The good news is that while there's little doubt that the economy is indeed slowing, there don't seem to be any "black swans" lurking around the corner, as was the case for 2008's severe recession. As a result, professional forecasters generally agree that there's less than a 50% chance of negative growth throughout 2024 and that unemployment could rise to a manageable 4.1%.
That said, plenty of factors can still impact the economy and markets, including the conflicts in Israel and Ukraine, increased tensions with China, a spiking debt-to-GDP ratio, and chances for a government shutdown. Moreover, historically extreme valuations in a small handful of mega-cap stocks that account for about 30% of the market weight in the S&P 500 (i.e., the Magnificent Seven) means that any sort of correction in those names could reverberate through the broader market.
The cumulative impact of the Federal Reserve's actions has resulted in it achieving its objective to slow demand in order to reduce inflation toward its target of 2%. Raising interest rates has led to not only tightening credit conditions (credit is harder to obtain and has been accompanied by a drop in the money supply) but also a loosening of the labor market (a rise in unemployment, a drop in the number of job openings, and a fall in the quits rate), a decline of the manufacturing sector, slowing demand for services, and a fall in inflation.
This quarter's review will cover the economy; the loosening of the labor market; the tightening credit conditions along with rising delinquencies; the resumption of student loan repayments; the outlook for inflation; the concerns over funding the huge Federal deficits; the outlook for interest rates; equity valuations and the outlook for markets; and an in-depth look at the world's 2nd largest economy, China.
The U.S. continues to be a tale of 2 economies. The manufacturing sector, which accounts for only about 8% of employment, has been in recession since November 2022 as the Fed's aggressive rate hikes cooled the interest-sensitive sectors of the economy (such as housing, autos, commercial real estate, manufacturing, and durable goods).
The November 2023 U.S. ISM Manufacturing PMI, which assesses the level of demand for products manufactured in the U.S., was 46.7, indicating contraction (below 50) for the 12th consecutive month.
On the other hand, services-sector spending, which is less sensitive to interest rates and constitutes about 78% of GDP, continues to be strong even as economic growth has slowed. Economic activity in the services sector, as indicated by the ISM Services PMI, expanded for the 11th straight month in November (52.7). Note that readings above 50 indicate expansion (see chart below).
The sharp rise in longer-term rates poses 8 major risks to the economy, as listed below, including the burden of debt service. Interest on the Federal debt will become the 2nd largest category of government spending over the next year.
We turn now to examining credit market conditions.
Since the Federal Reserve started raising rates, lending growth has slowed (see chart below).
While private market lending activity is growing rapidly, it is not growing fast enough to replace bank credit and public credit markets, as it is growing much slower than global financing needs. While total global fixed-income assets are well over $100 trillion, private capital is only about $13 trillion. Since 2010, banks have increased lending by more than $5 trillion, as have investment grade markets, and high-yield markets have grown by about $500 billion; private credit assets grew by 'only' $1 trillion, and borrowing costs in private markets are much higher.
We turn now to discussing the loosening of the labor market.
A strong labor market has been supporting economic growth, though it is losing steam (at least it was until the strong job report released by the U.S. Department of Labor in November), as companies are now adding jobs at a slower pace, new and long-term unemployment claims are rising, wage growth has decelerated, there has been a decline in weekly hours worked, and the quits rate has fallen – all of which are leading to some pullback in consumer spending and likely slower economic growth.
However, there are several factors, as listed below, indicating that the upward pressure on wages has been reduced, which should lead to slower growth in wages and, thus, inflation.
Another factor contributing to a less tight labor market is that the labor force participation rates have been increasing significantly since 2020, shown below for women ages 25-54 (to a record 77.6% in October) and men ages 55-64 (the highest level in at least 20 years). Rising wages and technology improvements allowing more people to work from home likely explain the higher participation rates, which increase the supply of labor.
However, despite the increase in labor participation rates, employment costs unexpectedly accelerated in the 3rd quarter, heightening concerns that a still-strong labor market risks keeping inflation above the Federal Reserve's target.
The Employment Cost Index (ECI), a broad gauge of wages and benefits, increased 1.1% in the July-to-September period after rising 1% in the 2nd quarter. When compared with the previous year, there was a 4.3% increase in the ECI, representing the most modest year-over-year growth since 2021. However, this growth rate is considerably higher than the average observed in the pre-pandemic years. Moreover, the jobs report for November indicated a 0.4% rise in wages for the month.
A positive sign in the outlook for inflation is the sharp decline in oil prices.
The price of a barrel of West Texas Intermediate (WTI or NYMEX) crude oil had soared from its pandemic lows to just over $120 between March and June of 2022. However, by December 28, 2023, it had fallen to just about $73 – contributing to the sharp decline in inflation over that period. With that said, the Fed knows that energy prices are highly volatile. Thus, its focus is on the core CPI, which excludes both the volatile energy and food price components (more on that later).
We turn now to the housing sector, an important though much smaller part of the economy than it was historically.
Housing construction's contribution to the GDP is currently at its historical low, having dwindled to roughly one-third of its level 60 years ago. At the same time, mortgage rates are at very high levels. This surge in rates has significantly impacted the housing market, with existing home sales in October dropping to their lowest level in 13 years, suggesting that this year could mark the weakest performance since 1992. The downward trend persisted into November, with a further 7.7% decline, the 10th straight month of decreasing sales. Despite these challenges, the inventory of homes for sale remains low, indicating that the housing sector poses limited downside risks to the overall economy.
While economic growth is likely to slow, there are no excesses of the type that led to the 2008 financial crisis nor any excesses in inventories. Thus, it doesn't seem likely that we will see a severe recession (a 'hard' landing), though a mild one (a 'soft' landing) is certainly possible. And it is even possible there will not be a recession at all (no landing).
Having reviewed the positives and the concerns, and keeping in mind that everything we reviewed is well known by the markets (and thus incorporated into prices), what do professional economists forecast for the economy? The consensus forecast, from a survey of professional forecasters done by the Philadelphia Federal Reserve, should be considered 'the wisdom of crowds'.
The Federal Reserve Bank of Philadelphia released its 4th quarter 2023 Survey of Professional Forecasters on November 13, projecting that real GDP will grow 1.3% in 2024, down from its full-year 2023 forecast of 2.1%. The forecast does not include a single quarter of negative economic growth, let alone a recession, just a soft landing.
The following chart shows the mean probabilities of real GDP growth in 2024. It emphasizes the importance of thinking about forecasts not in terms of point estimates but as probabilities of a wide dispersion of possible outcomes (there are no clear crystal balls). With that in mind, the forecasters put the odds of a recession in 2024 as follows:
The forecast for unemployment is that it will rise from its current rate of 3.7% to 4.1% and will thus have no hard landing. But if unemployment doesn't rise, that would give the Fed more freedom to keep rates higher for longer, especially if inflation remains above its 2% target. And the forecast is for inflation to rise to 2.5% in 2024, remaining above target in 2025 at 2.3%.
The Federal Reserve released its Summary of Economic Projections in its December 2023 meeting, which included the 'dot plot' graphic indicating each Fed official's expectations for future interest rates. It displayed a wide range of estimates on how much the Fed should cut rates next year. The median forecast called for cuts of 75 basis points; 8 anticipated fewer reductions, while 5 expected deeper cuts.
My own view is that Jerome Powell, the current chair of the Fed, wants to be remembered like former Fed chair Paul Volcker (who slew the inflation dragon in the 1980s) and not former Fed chair Arthur Burns (who allowed inflation to spiral in the 1970s). Thus, the Fed would like to keep rates at current levels until there's overwhelming evidence that inflation is beaten back or the economy is turning.
Having discussed the economic outlook, we turn now to discussing the problems of unsustainable budget deficits and the implications of the rising debt-to-GDP ratio.
The huge fiscal deficits incurred by the Biden administration are leading to a dramatic increase in the size of the Treasury auctions. The Treasury Borrowing Advisory Committee forecasts that auctions will increase in 2024 on average by 23% across the yield curve. This dramatic growth in the supply of risk-free assets will pull dollars away from other fixed-income assets, including mortgages and corporate credit, as investors turn away from spread products toward Treasuries.
While the size of the auctions is increasing (the supply of bonds is rising), there have been 3 persistent sellers of Treasury securities (helping to explain the rise in interest rates until the November rally drove the yield on the 10-year note from a high of about 5% on October 19 to about 3.9% on December 15).
There are several additional reasons that may have contributed to the rise in rates from their lows (the 10-year yield was just 1.63% at the start of 2022). More importantly, they are reasons to be concerned about the future level of interest rates.
Having reviewed the issues, we turn now to what the future holds for interest rates.
As always, my crystal ball as to the future of U.S. interest rates remains cloudy. Many forecasters have called for a U.S. bond rally, believing that the Fed's tight monetary policy, with tightening credit standards in the banking system, will lead to a slowing economy, allowing inflation to fall toward the Fed's target of 2%. Providing further hope is that after growing rapidly in the post-COVID period, money supply growth (the fuel for inflation) has sharply declined and even turned negative.
However, there are risks that could lead to rates staying higher for longer or rising further. What can history tell us about future interest rates after episodes of rising inflation?
Rob Arnott and Omid Shakernia, authors of the study History Lessons: How 'Transitory' Is Inflation?, analyzed the behavior of inflation across 14 developed economies once a country's inflation rate surged past various thresholds and studied how long a burst of inflation typically lingered. Following is a summary of their findings:
Their findings led Arnott and Shakernia to conclude: "If history is a guide, inflation can take far longer to return to normal levels than most people realize."
While it is possible that the current phase of high inflation will be temporary (the CPI peaked at 9.1% in June 2022 and fell to 3.1% in November 2023, though the core year-over-year CPI increase was still 4.0%), it should not be taken as certainty, especially in light of the outlook for fiscal deficits.
What can historical yields and yield curves tell us about the future? 1-month Treasury bills have averaged a real yield of about 0.3%. To that, a forecast of long-term economic growth should be added, which, for the U.S., is about 1.8% (well below the longer-term average of about 2.5%). That puts the real yield for longer-term debt at about 2%.
However, an estimate for inflation must also be added. If you're an optimist, the floor should be 2% (the Fed's target), which would put the nominal longer-term yield at about 4%. If you are not as optimistic, and particularly if you are concerned about our inability to address the growing fiscal deficits and debt-to-GDP levels, you would forecast a higher figure, perhaps 3% or even higher. That would put the yield on longer-term debt above 5%. Another negative for rates could be an increasing risk premium demanded by foreign holders of dollar reserves. The risk that rates rise or fall is at least balanced at this point.
Those investors concerned about the future direction of interest rates and inflation should consider increasing their allocation to Treasury Inflation-Protected Securities (TIPS); it is now a particularly attractive time, as real yields are well above 2%. As of December 17, the yields on 5-, 10-, and 20-year TIPS were 1.74%, 1.69%, and 1.76%, respectively. Another option for those willing to accept some economic cycle (credit) risk and their illiquidity is to invest in private credit funds (such as Cliffwater's Corporate Lending Fund, CCLFX), which invest in floating-rate loans that are senior, secured, and sponsored by private equity firms. CCLFX has a duration of only about 1 month, a yield to maturity of about 12%, and a distribution rate of 11%.
We turn now to additional risks investors should be aware of that could have significant negative impacts on the economy and markets.
Each of these headwinds creates risks to the economy. Should any of them, let alone all of them, appear, the risk of recession would increase, with significantly negative implications for the already huge budget deficit.
We now turn to another potential headwind: economic, social, and geopolitical problems for the world's 2nd-largest economy.
China is by far the largest exporter and is the top trading partner for 120 countries. Thus, it is critical to the global economy. 8 areas of concern are discussed below.
In summary, given the problems facing China, it doesn't seem likely that its economy will provide a boost to world economic growth. And while the economic outlook is troublesome, depressed equity prices already reflect that. The trailing 12-month P/E of the iShares MSCI China ETF (MCHI) is under 10 (9.6 on December 17).
We turn now to the outlook for equities.
While the S&P 500's return through December 17 was about 24%, the performance of the Magnificent 7 was responsible for the vast majority of the returns. That performance has been greatly impacted by investors' fascination with the AI' story'. However, history provides cautionary warnings about sky-high valuations driven by 'stories'.
As the table below demonstrates, with an average P/E of 50, the valuations of the Magnificent 7 are now reminiscent of the high valuations of the Nifty 50 and the dotcom stocks just prior to their crashing. While not a forecast of a crash, it is a warning that, at the very least, these stocks, which currently make up about 30% of the total market cap of the S&P 500, are at historically extreme valuations. Fortunately, the rest of the market has valuations that are much closer to their historical averages.
While investors have many reasons to be less than optimistic as most central banks around the globe continue to engage in more restrictive monetary policy to fight inflation, valuations generally already reflect that concern. As of December 17, Yahoo Finance showed that Vanguard's U.S. Total Stock Market ETF (VTI) had a trailing 12-month price-to-earnings (P/E) ratio of 22.1 (about its average over the last 40 years). Excluding the Magnificent 7 would lower that figure significantly. In contrast, Vanguard's Total International ETF (VXUS) had a P/E of 12.5, well below its historical average (for example, from 1996-2023, the MSCI EAFE Index had an average P/E of about 21). Similarly, its Emerging Markets Stock Index ETF (VWO) had a P/E of just 11.2.
Value stocks are trading as if we are already in a serious recession. As examples, Avantis' U.S. Small-Cap Value ETF (AVUV) was trading at just 7.6 times earnings; its International Small-Cap Value ETF (AVDV) was also trading at a multiple of 7.3; and its Emerging Markets Value ETF (AVES) was trading at a multiple of just 7.6. On the other hand, the large growth stocks are trading at historically very high valuations. For example, the Vanguard Growth ETF (VUG) was trading at a P/E of 37.1. And note that over the last quarter, the P/Es of the 3 value ETFs have gotten cheaper, while the P/E of VUG rose almost 25%!
Don't let recency bias keep you from investing in asset classes that have performed relatively poorly, such as international stocks (relative to U.S. stocks) and U.S. small and value stocks (relative to U.S. large and growth stocks). Their valuations are now trading at historically large discounts, increasing the odds that they will outperform going forward.
Another favorable development for international equities is that in the eurozone and Japanese equity markets, earnings growth and dividends accounted for more than 60% of returns this year compared with only 40% in the U.S – returns in the U.S. have been driven primarily by multiple expansions (enthusiasm for the AI story), leading to a large increase in valuations of tech names, while the impact on earnings has yet to show up to the same extent.
Remember that for stocks, it doesn't matter to markets whether the future news is good or bad, only whether it is better or worse than expected. The markets appear to be anticipating the worst possible outcomes, at least for value stocks, as valuations are near levels reached at the depth of the Great Recession.
We turn now to the outlook for corporate profits. What will happen to them, given what seems likely to be a slowdown in economic activity while labor markets remain tight (which could put pressure on wages and hurt profit margins)?
In 2022, the earnings of the S&P 500 companies were $219.49. The December 15, 2023, forecast from FactSet called for an increase of just 0.6% to about $221. With the S&P 500 at about 4,700, that's a P/E of about 21. According to FactSet, analysts are expecting earnings growth in 2024 of 11.5%. That would put calendar 2024 earnings at about $246 – a forward-looking P/E of about 19. Keeping in mind that corporate earnings have historically grown in line with the growth in GDP, that creates an enigma – either the stock market is right, or the bond market is right.
The bond market's inverted yield curve, with 1-month Treasuries yielding about 5.5% and the 10-year Treasury yielding about 3.9% (as of December 17), indicates that the bond market is expecting the Federal Reserve to cut rates several times due to slowing inflation and/or a weakening economy. In 2024, the Philly Fed Survey of Professional Forecasters expects the economy to grow by just 1.3% and inflation to increase by 2.5%. That's a total increase in GDP of just 3.8%, which is inconsistent with a forecast of 11.5% in earnings growth – unless there is a dramatic increase in productivity, perhaps from AI.
On the other hand, it's also possible that corporate profits get squeezed because of wage pressures and a slower economy. Should that occur, equities, at least the high-priced growth stocks, could come under significant pressure as earnings fall short of forecast. While my crystal ball remains cloudy, historically, the bond market has been a superior predictor to the stock market – one logical explanation being that the bond market is dominated by sophisticated institutional investors, while the stock market can be more influenced by naive retail investors who tend to trade more on 'noise' and emotions and are subject to recency bias.
It's important to recognize a possible challenge for stocks: the likelihood of reduced buyback activity due to concerns about a recession, the newly imposed tax on buybacks, and increased capital costs. These 3 factors collectively enhance the importance of free cash flow for companies.
First, be prepared for volatility, especially if Congress is unable to avoid a shutdown of the government, trade tensions increase, or geopolitical risks increase. The surge in deficit spending amid economic growth is poised to ignite intense discussions on Capitol Hill regarding the country's fiscal strategies. This comes as legislators confront the possibility of a government shutdown early next year and decisions concerning the expiration of tax cuts worth trillions of dollars.
As of December 28, the VIX (a measure of the market's volatility) was trading at about 12.5, well below its historical average.
Given all the uncertainty investors are facing, it is surprising to me that it is trading at such a low level. Perhaps investors are overconfident of a soft landing?
For those investors concerned about volatility and downside risk, there are 2 ways to address those issues. The first is to reduce exposure to stocks and longer-term bonds and bonds with significant credit risks while increasing their exposure to shorter-term, relatively safe credit risks. By raising interest rates dramatically, the Fed has made that alternative more attractive than it has been in years. For example, for those concerned about inflation, the yield on 5-year TIPS has increased from about –1.6% at the start of 2021 to about 1.7% on December 17, 2023.
Another way to address the risks is to diversify exposure to risk assets to include other unique sources of risk that have historically shown minimal or no correlation with the cyclical risks associated with stocks or the inflation risks tied to traditional bonds, even though they have still offered risk premiums. The following are alternative assets that may provide diversification benefits. Alternative funds carry their own risks; therefore, investors should consult with their financial advisors about their own circumstances prior to making any adjustments to their portfolio.
Larry Swedroe is the Head of Financial and Economic Research for Buckingham Strategic Wealth, an independent Registered Investment Advisory firm in St. Louis, MO, and an independent member of the BAM ALLIANCE. which provides an evidence-based approach to private wealth management for near- and current retirees, He is also Director of Research for BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. Previously, Larry was vice chairman of Prudential Home Mortgage.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has since authored seven more books, and co-authored eight additional books. His latest work, “Your Complete Guide to a Successful & Secure Retirement,” was co-authored with Kevin Grogan and published in January 2019. Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television shows airing on NBC, CNBC, CNN and Bloomberg Personal Finance. Larry is a prolific writer, contributing regularly to multiple outlets, including Advisor Perspectives and The Evidence-Based Investor.
Larry holds an MBA in finance and investment from New York University, and a bachelor’s degree in finance from Baruch College in New York.
Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third-party data and may become outdated or otherwise superseded without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-23-603
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