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Do conditions favor a strong year in the markets?

January 19, 2024

Moderating growth and cooling inflation set the table for potentially strong returns for both stocks and bonds.

Contributors

Jacob Manoukian

U.S. Head of Investment Strategy

December’s message from the Federal Reserve – rate cuts seem in the cards for 2024 – ignited a strong rally for both stocks and bonds. In the end, total returns for U.S. stocks came in north of 25% for the 2023 calendar year, while a balanced portfolio of 60% stocks and 40% bonds returned 18%, well above the 5% return offered by Treasury bills.

Can the rally continue? In this article, we explore both the bear and bull cases for stock and bonds in 2024.

The macro and market outlook for 2024

Our recently published Outlook 2024 discussed our expectations for the year: continued economic growth and declining rates of inflation, along with lower cash rates, lower bond yields and higher equity prices. Investors can now choose among a range of compelling options across asset classes to design portfolios that can perform well in the near term, and achieve their goals over the long term.

The bullish case for stocks and bonds builds on what is seen as a favorable macro backdrop: moderating growth (strong enough to avoid recession but not so strong it would spur higher policy rates) coupled with steadily cooling inflation. In such an environment, corporate earnings could grow at a decent clip, propelling equities higher. For bonds, attractive starting yields offer the potential for strong forward-looking returns.

The bearish case builds on what is seen as an unfavorable macro backdrop: Inflation persists, delaying rate cuts, pushing bond yields higher (and prices lower), increasing the risk of recession and depressing corporate profits. We’re firmly in the bullish camp.

The threat of resurgent inflation

What could derail the bullish case for stocks and bonds this year? At this juncture, a resurgence in inflation would present the most unexpected, and potentially harmful, scenario for both asset classes. The latest data on prices suggest that inflation is settling into a 2%–3% year-over-year pace. That should allow the Federal Reserve and other global central banks to start lowering rates to more normalized levels. A rapid shift in the inflation outlook has caused longer-term bond yields to retreat to early 2023 levels (with the 10-year U.S. Treasury recently yielding 4%, for example) while stock markets are inching back toward all-time highs.

To be sure, both prices and the labor market are in a much better balance than they have been in recent years. At their peak, consumer prices were rising at a 9% pace, while the labor market, as proxied by the rate at which workers were voluntarily leaving their jobs, was as tight as it had ever been. Today, prices are only rising at a 3% pace, while the quits rate is back to where it was in 2019.

But it’s possible that the best news on inflation is behind us. Wage growth, as proxied by the Federal Reserve Bank of Atlanta’s wage tracker, seems to have stabilized at an above 5% pace, well past the 3%–4% pace that characterized the late 2010s. Supply chains, as measured by the New York Fed, are also tightening, which could put upward pressure on goods prices.

Wages seem to have stabilized at a higher level than in the 2010s

Line chart showing the 3-month moving average of median wage growth, from 2013 to 2023 in the United States.

Source: Federal Reserve Bank of Atlanta, Haver Analytics. Data as of October 31, 2023.

In the United States, home prices are once again on the rise. As the affordability of single-family homes reaches historical lows, more households are giving up on trying to buy a home. As a result, rent price growth may be at, or close to, a bottom.

Finally, oil prices are trading near their lowest levels of the past year. They’re unlikely to fall much further, in our view, given resilient global economic growth, OPEC’s commitment to limiting supply and the willingness of the U.S. government to replenish the Strategic Petroleum Reserve.

If inflation is not yet tamed, it could cause investors to revise their expectations for central bank policy. The result would likely be higher bond yields (and lower bond prices), and an increase in the risk that it could take a true recession to eradicate inflation. That would likely hurt equities, and lead to a year of cash outperformance.

A sweet spot for stocks?

We do think the bullish case for stocks and bonds is the more persuasive. Indeed, Wall Street analysts may underestimate the potential for stock gains. The most bullish forecast for the S&P 500 that we can find sees the index at of 5,400 by year end 2024, implying a price return from current levels of around 15%.

We think there is a reasonable chance that the equity market is entering a sweet spot in terms of inflation, earnings growth and monetary policy. If so, 15% would be a reasonable expectation for stock market appreciation.

Consider: Since 1950, when inflation ranged between 2% and 3% (where we expect it to be next year), the average S&P 500 return was 15%.

Further: Analysts expect earnings growth to be close to 15% year-over-year by the end of 2024. If that is correct, valuations wouldn’t have to change for appreciation to match earnings growth. Remember, the S&P 500 is already emerging from its own earnings recession, and now margins are stabilizing while profits continue to grow.

And here’s the kicker. Since 1980, the lowest S&P 500 return when the Fed was lowering interest rates outside of a recession was over 20%, from December 2018 to October 2019. In the three other “soft landings” since 1980, S&P 500 returns were 47% (1984–1986), 35% (January 1995–February 1996) and 50% (March 1997–November 1998).

Equities tend to rally in soft landings, and bonds have gained in all but one cutting cycle since the 1960s

Table showing market moves during Federal Reserve cutting cycles, from 1960 to 2022.

Market moves during Federal Reserve cutting cycles, 1960-2020

This table shows market moves during Federal Reserve cutting cycles, from 1960 to 2022. For the period between November 1966 and April 1967, it was a soft landing, with a policy rate change of -225 basis points (bps), a 10Y Treasury change of -48 bps, and an S&P 500 return of 9.8%. For the period between August 1969 and February 1971, it was a recession, with a policy rate change of -700 bps, a 10Y Treasury change of -52 bps, and an S&P 500 return of 3.0%. For the period between May 1974 and April 1975, it was a recession, with a policy rate change of -775 bps, a 10Y Treasury change of 68 bps, and an S&P 500 return of -5.3%. For the period between May 1981 and December 1982, it was a recession, with a policy rate change of -1,150 bps, a 10Y Treasury change of -387 bps, and an S&P 500 return of 2.7%. For the period between August 1984 and August 1986, it was a soft landing, with a policy rate change of -587 bps, a 10Y Treasury change of -556 bps, and an S&P 500 return of 46.9%. For the period between February 1989 and September 1992, it was a recession, with a policy rate change of -643 bps, a 10Y Treasury change of -279 bps, and an S&P 500 return of 43.1%. For the period between February 1995 and January 1996, it was a soft landing, with a policy rate change of -75 bps, a 10Y Treasury change of -197 bps, and an S&P 500 return of 35.2%. For the period between March 1997 and November 1998, it was a soft landing, with a policy rate change of -75 bps, a 10Y Treasury change of -206 bps, and an S&P 500 return of 50.4%. For the period between May 2000 and June 2003, it was a recession, with a policy rate change of -525 bps, a 10Y Treasury change of -313 bps, and an S&P 500 return of -32.9%. For the period between June 2006 and December 2008, it was a recession, with a policy rate change of -400 bps, a 10Y Treasury change of -263 bps, and an S&P 500 return of -30.3%. For the period between December 2018 and October 2019, it was a soft landing, with a policy rate change of -75 bps, a 10Y Treasury change of -98 bps, and an S&P 500 return of 21.5%. For the period between October 2019 and March 2020, it was a recession, with a policy rate change of -150 bps, a 10Y Treasury change of -88 bps, and an S&P 500 return of -21.7%. The average change of policy rate was -448 bps, the 10Y Treasury average change was -202 bps, and the average S&P 500 return was 10.2%. The recession average change of policy rate was -620 bps, the 10Y Treasury recession average change was -188 bps, and the recession average S&P 500 return was -5.9%. The soft landing average change of policy rate was -207 bps, the 10Y Treasury soft landing average change was -221 bps, and the soft landing average S&P 500 return was 32.7%.

Source: Bloomberg Finance L.P., J.P. Morgan Private Bank. Analysis as of December 2023.

The bull case for bonds (especially relative to cash) is even simpler. In every Federal Reserve rate cutting cycle since 1960, bonds have outperformed cash.

Inflation risks could reemerge. It’s possible – but unlikely. Indeed, it may be that the biggest risk our clients face heading into 2024 isn’t recession, inflation, geopolitics or elections – it’s not being fully invested.

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