2024 Outlook: Déjà Vu All Over Again

Executive Summary

While forecasting is always tricky, below is a summary of our market perspectives that may shape opportunities and influence asset allocation decisions:

• Despite 2023’s acceleration, we expect the US economy to slow in 2024. Outside the US, we see most major economies slowing as well, with elevated recession risks in the eurozone and the UK.
• Disinflation should continue, but much of the “immaculate disinflation” seen this year has run its course, making the final leg down to the Fed’s 2% inflation target more challenging.
• In our view, the end of this expansion’s interest rate hiking cycle occurred in July. Rate cuts are likely to begin in mid-2024.
• While many investors have taken comfort in money market funds lately, shifting back toward strategic asset allocations now will allow them to take advantage of attractive yields.
• Interest rates are likely to fall in either a “soft landing” or a “hard landing” scenario.  High-quality intermediate duration bonds look attractive, as do agency mortgage-backed securities. Municipal bonds currently offer higher after-tax yields than money market funds.
• We see attractive risk-adjusted returns in a number of areas across private credit. Real estate debt, direct middle market lending, bank capital solutions, and asset-based lending all stand out in this environment.
• Our base case for equity returns is primarily driven by around 4% EPS growth. We find more value in some of the Big Tech names than in others and we’re cautious on the sector overall due to elevated valuations and earnings expectations. Instead, we favor healthcare, consumer staples, and energy. Private equity remains a pillar for long-term investment portfolios.

’Tis the (Outlook) Season

Wall Street’s annual outlook season is an odd one. Although we all expect the unexpected in the coming year, we do our best to outsmart the universe—or at least our fellow investors.

Last year’s outlook season was especially notable for having one of the narrowest, most specific consensus forecasts we’ve ever seen. Across Wall Street, everyone was nervous, repeating two prevailing narratives: a tale of a recession foretold and a tale of two halves. The near unanimous call was for market caution in the first half, followed by clearer skies in the second half.

This year, consensus is not quite so narrow. Yet the tone still feels similar. A general malaise fills the air, along with a bias toward a conservative asset allocation and quality securities to withstand a slowdown. As we enter the fray with our outlook, we’re mindful of what others are saying and—much like Yogi Berra—feeling a sense of déjà vu.

Global Economic Outlook

United States

The global economy is downshifting. And yet, US economic activity still grew faster in 2023 than in 2022. Real GDP growth is tracking toward 2.4% (versus 1.9% in 2022), materially above what economists would deem the “potential” rate of growth. Meanwhile, inflation slowed from a 6.2% to a 3.4% run-rate over the course of the year. In late 2022, if presented with the possibility of such resilient economic growth and immaculate disinflation, most economists would have considered it highly unlikely. They thought that a more severe hit to growth and the labor market would be needed to bring inflation down. Or that higher inflation would inevitably ensue amid such brisk activity.

Yet as we enter 2024, more cracks are beginning to show. Notably, the US consumer—the engine of growth that accounts for the majority of US GDP—seems increasingly strained. In fact, while overall GDP accelerated in 2023, consumer spending chugged along more slowly year-over-year, a trend we expect to intensify next year. It’s hard to see it reaccelerating given a labor market near full employment, which leaves less room for hiring to inflate the aggregate paycheck. What’s more, much of the excess savings from the pandemic has now been spent, especially at the lower end of the income spectrum. Data from the San Francisco Fed suggests around $350 billion remained at the end of October, down from $2.1 trillion in August 2021 (Display).

Consumer credit quality also appears to be retreating from its cyclical high. Credit card delinquency rates have increased to around 3%, the highest level since 2012, according to Federal Reserve data. Likewise, data from the Federal Reserve Bank of New York and Equifax shows auto loan delinquencies have approached the level where they peaked last cycle.

Finally, many retailers have recently commented on consumers trading down. For instance, Walmart, who has been taking market share from other retailers in general merchandise categories, noted their customers appear to be making trade-offs to afford the things they want. Similarly, Home Depot highlighted that instead of undertaking larger projects, consumers are focusing on smaller ones. With that said, demand for travel experiences and services remains strong.

Turning to labor, non-farm payrolls continue to hold up well. As we look at unemployment heading into next year, we see a chance that the economy triggers the Sahm rule, a historically reliable recession indicator.¹ In November, unemployment measured 3.7%, three-tenths of a percent below the threshold set by the rule (Display). However, despite having created it, Claudia Sahm has written about why the rule may give a false signal this time around given that consumption growth and economic growth have remained strong.

Another concerning labor market trend? Initial and continuing claims figures. Fortunately, both data points are still quite low, but they’ve been rising year over year for much of 2023 (Display). In past economic cycles, that’s tended to be fairly reliable warning signal.

Monetary policy remains tight, though that is somewhat offset by the federal government continuing to run unprecedented budget deficits. Today’s level has never been seen before in the US, outside of a recession or a war. Yet, longer-term rates have recently moved sharply off their highs—despite short-term rates staying elevated—notably easing financial conditions.

Finally, as we’ve previously discussed, regulatory constraints along with banks tightening their lending standards have provided less fuel for both economic growth and inflation. Investors are stepping into the breach left by traditional lenders, though, so this may be less of a headwind than first appears.

We expect inflation will continue to ease from here—goods prices have been deflating and most services prices remain steady. Instead, housing (which operates on a roughly 18-month lag) has largely been driving inflation overall. With house prices now much flatter and unlikely to return to their trajectory from mid-2020 through mid-2022, the inflation picture continues to improve. The main question is whether current policy and the inability of consumers to spend another $1 trillion out of excess savings is enough to support the path back to the Fed’s 2% target—or if more of an impact on the labor market via higher unemployment will be required.

Given that economic backdrop, we expect interest rates to move modestly lower in 2024. Thus far, rates spiked in response to the Fed’s hiking cycle, slowing the economy and impacting stock and bond prices. Yet some of the most acute damage came in September and October this year. That’s when the term premium—the additional compensation investors seek for bearing macroeconomic uncertainty—increased by almost a full percentage point, raising the 10-year Treasury yield to 5% and other long-term rates along with it. It has since settled back down but remains a key source of uncertainty in 2024 and beyond (Display).

Given economic tightening and dissipating inflation, it appears the Fed finally has rates above the neutral level where inflation holds steady. But it’s hard to pinpoint just how far above that level we are (it’s likely in the 3%–3.5% range). That suggests that if the Fed aims to manage the admirable soft landing we’re headed for, they’d likely need to begin cutting rates sometime mid-next year. As of mid-December, their latest forecasts reflect that. However, should the economy weaken rapidly, they’d likely make cuts earlier and even more aggressively for support.

We believe a viable path remains for the economy to stay on track, even as it slows in 2024. Yet the risk of a recession is worth considering, as it would have significant ramifications for stocks, bonds, and other assets. If the Fed hiking cycle did truly end this past July, that could suggest the countdown is on. Recessions have generally trailed the final hike of a cycle by an average of 18 months, although the range is wide.

Gauging the probability of a recession is challenging. To put an upper and lower boundary on the odds, we come at it in two ways. First, for the floor, we look at the historical 12-month forward odds when the economy is not already in a recession. That puts the chance of a recession at around 15%. Note that those periods also include months at the outset of economic expansions when there’s significant slack and monetary and fiscal policy are both firmly stimulative. For that reason, we’d expect the current probability of recession to be meaningfully higher.

On the flip side, we estimate the so-called “ceiling” by using our more detailed recession model, which is based on a number of key macroeconomic variables that have been predictive in the past. These suggest there’s north of an 80% chance of a recession in the next 12 months. Today we believe this is more of a ceiling than an unbiased estimate for a few reasons:

• This type of model can be prone to overconfidence, though we’ve kept ours simple to minimize this risk.
• The model accounts for economic activity using manufacturing (where a longer data history is available) rather than services (which now account for around two-thirds of the economy). Those two sectors have diverged in 2023, with manufacturing arguably in a recession while services still run strong (Display).
• Post-pandemic aggregate economic data has been warped by bullwhip effects emerging in different parts of the economy at different times.

The actual odds of a recession lie somewhere between those two levels. Given that range, our perspective on the economic backdrop, and the views of our US economics team and other senior investment professionals, we’d put the chances of a US recession in the ballpark of 1-in-3 next year.

Even if the economy were to go into a recession, though, we expect it would be a mild one. The downside is mitigated by the absence of any significant imbalances in the real economy or financial system, a still generally healthy consumer, and an inventory cycle already well underway in a number of industries.

Finally, we can’t talk about the US in 2024 without mentioning the presidential election. Here, it’s vital to remember that for the markets overall, the party in the White House has not had a historically meaningful impact. Under the surface, though, dividing lines can emerge based on policy headwinds or tailwinds for various sectors.

When assessing potential candidates and policy differentials at this point, the path for fiscal policy matters most in our view. Yet there’s very little daylight between major candidates in that regard—we’d expect significant deficits to continue under any of them. The main question is whether deficits are driven by spending or tax cuts. That said, major provisions of the 2017 Tax Cuts and Jobs Act are set to sunset in two years, including a halving of the estate tax exclusion. Given the lead time required to change estate plans, we’d recommend clients speak with their financial and tax advisors to begin preparing now.

Around the World

Looking overseas, Continental Europe faces a tougher backdrop than the US. While no recession has been declared yet, year-over-year GDP growth in the European Union has been trending down over the past several quarters and was flat in Q3. Meanwhile the eurozone Composite PMI, which is available monthly, has spent the second half of 2023 in contractionary territory. With euro inflation cooling similarly to dollar inflation, the ECB could be in position to cut rates in 2024. It appears they’re more likely to need to do so defensively than the Fed is.

In the UK, inflation remains elevated at over 4%. GDP growth continues to be weak, but steady and slightly positive. The Bank of England will have their work cut out for them in 2024 to bring inflation down further, though more tightening would likely tip the economy into recession.

China remains a regional hot button. Their economic growth was weaker than expected in 2023 despite ending their COVID lockdowns. That said, they still managed around 5% growth—higher than other large economies. Their overgrown property sector and elevated levels of local government financing vehicle (LGFV) debt will be an ongoing headwind not just in 2024, but likely for years to come. The government’s challenge will be the continued reorientation of the economy around domestic consumption even as the population shrinks.

We expected Japan to be a standout in 2023, and it was. After years of struggling to generate inflation, price changes settled into a 3%–4% range for most of the year. Real GDP growth started the year strong at 2.0% year over year but was more moderate in the back half (ticking in at 1.2% in Q3). We expect Japan to continue to march to the beat of its own drum to a large extent in 2024. The most notable economic change in 2023 was the BOJ’s allowance of a rise in 10-year yields after years of suppression. Rates rose from 25 bps a year ago to around 90 bps today. We’ll watch for any further changes to interest rate policy in 2024, as they could have an impact on global capital flows, especially if Japanese investors are no longer starved for positive real yields.

Latin America could be worth watching in 2024, too. While it’s not a monolith, the central banks have generally been ahead of the curve on rate hikes. Inflation also looks to be trending toward target in many of them. That could position their economies and assets attractively, unless the US dollar goes on another wild run, though it would take a meaningful economic acceleration and further US rate hikes for that to happen.

Asset Allocation Implications

Fixed Income

It’s not often we say this, but our bond portfolio managers are the most excited investors in the firm right now. That sentiment holds across varying forms of debt.

For clients who have stayed in high levels of cash to this point, now is the time to consider deploying it elsewhere. If you’re worried that you’ve already missed the boat in moving to intermediate duration bonds because of the sharp rally in the past two months, you haven’t. There’s still time. But as you can see, when longer-term bonds move, they move.

Furthermore, don’t be fooled by the headline yield for money market funds. At over 5%, it may seem attractive, but the after-tax return is still lower than short- or intermediate-duration municipal bonds due to the latter’s preferential tax treatment (Display).

Investment-grade credit looks quite compelling, for both municipal and taxable bonds. The interest rate backdrop still presents risks but appears rewarding overall. Those risks include a reacceleration in inflation, continued Fed hikes due to persistent economic resilience, and a rise in the term premium. All in, those seem manageable relative to the prospects for bonds in a stable or weakening economy. For instance, high-quality intermediate duration municipal bonds offer a mid-single-digit yield and could achieve a high-single-digit total return if longer-term interest rates fall the way our economics team expects.

The fundamentals remain strong for high-quality credit and, in several areas, the compensation for credit risk still looks quite healthy relative to fundamentals. We’d single out agency mortgage-backed securities (MBS) in particular.

We’d also highlight the value of active management (versus laddering) in bonds right now. For instance, while the Treasury yield curve is inverted, the municipal yield curve is U-shaped (Display). That’s allowing our managers to barbell short-term and long-term bonds, which each offer higher yields than intermediate-term bonds. In addition, in some shorter-term maturities, we’re finding Treasuries more attractive than the highest-quality municipal bonds and rotating into them (after doing the opposite several months ago). These are just two ways active management can deliver additional value for bond investors.

Private credit still seems extremely interesting for opportunistic investors right now. With traditional banks stepping back, other credit investors (like us) are able to fill the void. In commercial real estate (CRE) debt in particular, valuations have reset significantly lower due to high interest rates, placing the bargaining power firmly in lenders’ hands. That’s giving our clients a generational opportunity for attractive interest rates, asset coverage, and protective covenants.

What’s more, other private credit approaches—such as direct lending to middle market companies, buying existing loans from banks or other investors, and creating customized financing solutions—all stand out as banks step back and rebalance their loan books. We’d also note opportunities in asset-based lending for similar reasons. We’re seeing pretax private credit yields on individual deals ranging from the high-single-digits up into the high teens, depending on the risks.

If the economy weakens from here, bonds should benefit from lower interest rates despite being temporarily hurt by wider credit spreads. In other words, we’d expect bonds to be strong relative to stocks in that environment, but still not a panacea.

Equities

Amid a slowing economic backdrop, reasonable fundamental expectations, and valuations at the higher end of historical levels, it’s hard to get too excited about US stocks at the moment. That said, we wouldn’t count them out. Over the long run, their absolute expected returns still look favorable relative to other traditional assets. Plus, if the economy continues to grow and risk appetites hold steady or increase, stocks could surprise to the upside in the short run. Finally, stocks remain a core pillar of inflation protection and while we expect disinflation to persist, heightened levels of inflation will remain a real risk in 2024 and the decade that follows.

Fortunately, the third quarter of this year brought brighter news for stocks—the earnings recession that started in 4Q22 finally came to an end, and quarterly earnings per share rose to their highest level on record. Since stock valuations always come back to earnings, that earnings recession had been overshadowing upside surprises in economic growth.

In our base case for 2024, we expect modest earnings growth of around 4%, consistent with slow but positive economic growth. This is in line with strategists’ top-down EPS estimates but around 6% lower than bottom-up estimates from the aggregate of single-stock analysts. That’s actually quite normal. It suggests there’s no reason to worry about expectations being too high or to fret about expectations being too low.

At 19.4x 2024’s expected earnings, valuations for the S&P 500 in aggregate are certainly elevated relative to history. Yet most of that is fueled by the “Magnificent 7” stocks, which have led performance this year (partly on a reversal of a weak 2022 and partly on hopes for AI). On an equal-weighted basis, the S&P 500’s 15.9x 2024 multiple falls close to the middle of its historical range. Assuming valuations don’t budge from current levels, investors should expect equities to move in line with earnings growth by year-end (Display).

If you read market outlooks or watch financial news, you’ll likely hear numerous references to the narrowness of the equity risk premium. In other words, stocks’ incremental earnings yield— E/P, or the inverse of a P/E ratio—is not much higher than the yield on Treasury bonds. Usually, such a modest differential would suggest you aren’t being properly compensated for the risk of owning stocks.

The value investor resting deep in our investment teams’ souls would love for things to be that simple. Yet historically, the equity risk premium has had very little predictive power for stock returns, either on an absolute basis or relative to bonds. Any signal is usually drowned out by volatility’s noise. Most notably, the equity risk premium² was negative from at least the beginning of 1991 (when that data was first collected) until late 2002. This unfolded even as the market rose by 300% to its peak and had still strengthened by a healthy 130% at its post-bubble trough.

Along with valuation, we track sentiment. As previously mentioned, most investors are focused on quality today and few are willing to stick their necks out, as with last year. While we acknowledge meaningful risks, that also suggests there could be enough of a “wall of worry” for the market to climb from here.

Within stocks, we almost always favor quality. It’s part of our DNA as long-term investors and it has historically been a source of excess returns in the market. However, when everyone else professes how much they like it too, we become slightly concerned. Given today’s late-cycle economic backdrop, quality stands out because it has held up the best of any factor in past cycles.

To express that “quality” view, many investors are focusing on tech stocks. And while that sector is home to numerous high-quality companies, we’re a little more cautious there.³ All three technology industry groups—hardware, software, and semiconductors—are trading above the 90th percentile of their historical valuations versus the rest of the market. Even more importantly, the expectations baked into earnings are extremely high and operating margins are forecasted to come in close to a record high of 25.6%. That’s projected to rise to over 29% next year and almost 31% the following year. We’re techno-optimists by nature and see further margin growth in the sector over time. But these estimates are enormous. That means we have lofty valuations on top of lofty expectations in a sector that has had a strong recent run. Caution is warranted.

Instead, we’d favor other homes for quality that have been more beaten up lately, like healthcare and consumer staples. Much of the recent suffering in both sectors has been driven by the excitement around GLP-1 drugs, which combat chronic conditions and obesity. In the wake of those sectors’ shakeups, our portfolio managers have recently found attractive values in the medical device space.

Moving away from quality, two cyclical sectors bear mentioning. Energy once again looks attractive and could be a hedge for geopolitical risk, an unexpectedly strong economy, or a rebound in inflation. Separately, inside financials, banks recently traded at their cheapest relative valuation to the rest of the market on record.

In addition, two rate-sensitive industries—real estate and utilities—have been hit by the rate surge over the past two years. We are starting to find value in publicly traded real estate. But when we think about it from a portfolio construction standpoint, expressing a view on rates via bonds will have more of an impact on balanced portfolios than doing so via equity sector selection. And expressing that view in both ways makes investors vulnerable to a “double whammy” if rates rise.

Outside the US, we don’t see any evidence for broad-based geographic calls at the moment. To a certain extent, Latin America seems attractive, screening as relatively cheap versus other regions. Meanwhile, India looks quite expensive. It has one of the best secular stories in terms of demographics, but valuations already reflect a healthy dose of optimism, and the country still faces challenges in realizing its economic potential.

China comes up in many of our client conversations. As discussed, the economy needs to rebalance from a property orientation to being driven by services and manufacturing, a process that will likely take a number of years. That said, EPS growth and economic growth have not been closely connected in China historically. In 2024, we anticipate that Chinese EPS growth will outpace that of developed markets. Meanwhile, valuations are quite low. While that combination is tempting, we still lack enough conviction to overweight amid the geopolitical risks and secular challenges.

What about factors? We’ve already discussed quality. The momentum factor also tends to acquit itself well at this phase of the cycle. We’re cautious on growth given our view on the technology sector. Value could be attractive, but we have low conviction there. And small caps have hovered at significant discounts to large caps for an extended period now—that provides some support for a positive view if momentum turns. But our attraction rests primarily on small caps’ ability to generate alpha in key areas, especially internationally, rather than our expectations for the group as a whole.

Moving one degree away from stocks, volatility appears cheap, especially in the face of a relatively narrow consensus. Meaningful upside and downside risks to the economy and markets also work in volatility’s favor. Currently, the VIX index is trading at its lowest level since before the pandemic, suggesting that hedges that involve buying volatility should be compelling.

Finally, while we’ve focused mainly on public equities here (as they more easily lend themselves to a one-year horizon), we reiterate the important role private equity plays in a portfolio. Those investments should be systematically built up over several years, via a steady stream of vintages. Ideally, each vintage year would deploy capital over a roughly three-year horizon while returning principal and capital gains over nearly a decade.

Right now, our private equity investment teams are finding two especially attractive opportunities. First, many institutional investors’ private equity allocations currently exceed their targets. As a result, they aren’t taking on new vintages, leaving room for us to allocate to some high-quality managers who tend to be difficult to access. Second, the sell-off in growth stocks over the past two years—combined with the shortage of funding for early- and growth-stage companies—is creating a chance to invest in the next generation of venture and growth companies at the most attractive valuations we’ve seen in a decade.

Luck Is When Preparation Meets Opportunity

Going into 2024, predicting what will happen next remains as difficult as ever. We prefer to simply have a base case in mind while preparing for a range of outcomes.

The US economy and most other developed markets are late cycle. But everyone knows that. The consensus is focused on bonds and quality stocks. We generally agree, but with caveats. Those with high cash balances should consider moving into other asset classes, whether high-quality bonds or select riskier assets. For those who are still nervous, high-quality bonds make a good first stop. You’ll find some of the most attractive risk-adjusted returns on our radar there or in areas of private credit.

We almost always maintain a bias toward quality stocks but seeing them favored so widely in this environment makes us a tad cautious. Technology stocks in particular give us pause. Yet we still see value in several of the Magnificent 7. In addition, certain names in healthcare, consumer staples, energy, and banks could also prove attractive.

As always, we aim to be responsible stewards of capital in the long run. Even when we hold shorter-term, tactical views, we weigh them against our assessment of long-term risks and rewards. This approach has served us well in the past and we expect it will do so in 2024 and beyond.