2024 outlook: Navigating the last mile of the cycle

The U.S. economy remained remarkably resilient for much of 2023, with GDP growth above 2% annualized for the first three quarters of the year. This was driven in large part by healthy consumption growth: Households continued to spend despite rapidly rising interest rates and tightening lending conditions.

We expect U.S. economic growth to soften in the first half of 2024, with growth rates likely falling to below 1.5% annualized. We believe somewhat weaker consumption, lower government spending and a cooling labor market will translate to slower growth.

The consumer faces some challenges heading into 2024, including declining excess savings, rising credit card debt and still-elevated interest rates. In addition, we believe some loosening in the labor market may put downward pressure on wage gains and consumer confidence overall.

While the economy may avoid a textbook recession, a rolling recession may emerge. Parts of the economy, such as manufacturing and perhaps housing, could bottom and then stabilize, while other parts, such as services and consumption, could peak and move lower.

After a year and a half of Fed tightening, we believe economic growth may finally feel the lag impacts in 2024. But on the positive side, a slowdown in growth would also potentially support lower inflation and less need for further Fed tightening.

As we look toward the back half of 2024, we would expect the economy to gradually accelerate once again. We believe ongoing inflation moderation, a Fed on the sidelines (and possibly signaling rate cuts), and better corporate margins and earnings growth will lead to improving economic growth later in 2024. And markets are forward-looking and can start to move higher even before economic growth stabilizes and improves.

In 2023, a strong labor market gave consumers the confidence to spend in the face of high inflation and rising borrowing costs. But the tight conditions also meant the Fed might need to keep policy restrictive to ensure higher labor costs don’t feed into higher inflation.

We anticipate some cooling in 2024 as business spending and hiring moderate in response to slower economic growth. This easing could drive wage growth and inflation lower, providing the Fed the opportunity to begin cutting interest rates.

As 2023 ends, unemployment has risen 0.5% from its 3.4% trough, mainly due to more workers reentering the labor force. Despite this, unemployment remains low, supporting income gains. However, the pace of job gains is likely to slow as companies reduce hiring to protect profitability.

The declines in job openings, the quits rate and temporary help payrolls are early signs of softening that will likely lead to better balance between labor supply and demand in 2024. While less of a tailwind, labor market conditions could remain supportive. The solid starting point of corporate finances indicates that any rise in unemployment might be moderate.

Significant progress has been made on the consumer price front, with core inflation (excluding food and energy) falling from a peak of 6.6% in 2022 to 4% recently. We think this downward momentum can continue through 2024, with inflation reaching 2.5%.

The silver lining of a deceleration in economic growth is that softer demand will exert further downward pressure on inflation. This, in turn, should enable the Fed to eventually cut interest rates to a more neutral level, acting as a sort of shock absorber that can help stave off a more severe recession.

What’s more, if labor supply continues to increase alongside rising labor productivity, this can foster an environment where economic growth holds up while wage pressures and inflation continue to fall.

Goods prices have been declining in late 2023, including needed evidence of moderation in car prices. The fly in the ointment has been stubbornly sticky shelter (rents, homes) prices. We think relief is on the way: Recent data signal to us that housing prices may allow overall inflation to fall faster in 2024.

Much has been made recently of the drop in the money supply (known as M2), comparing this to conditions during the Great Depression of the 1930s. We think this assumption ignores that some contraction is prudent, given the explosion of the money supply following the COVID-19 pandemic. Tight monetary policy and a moderation in M2 are also working to help rein in inflation.

At the core of our outlook for equity and bond markets is the trajectory of Fed policy, which is set to undergo a notable shift in 2024. We believe that, after the most aggressive tightening campaign in 40 years, the hiking cycle is now complete.

The Fed will likely err on the side of caution, signaling an extended pause and keeping the Fed funds rate at 5.25%–5.5% in the first half of the year. But easing inflation pressures, a cooling labor market and a slowdown in growth will likely pave the way for interest rate cuts in the back half of 2024.

Policymakers will likely push back against expectations for aggressive cuts to ensure inflation returns to the Fed’s 2% target. This push and pull between markets and the Fed could drive volatility. Yet, if price pressures continue to ease as we expect, the real policy rate (after adjusting for inflation) will become more restrictive.

The Fed will likely try to offset this by cutting rates potentially more than the two times projected at the September 2023 Federal Open Market Committee (FOMC) meeting. We expect a modest easing in policy, with the extent depending on core inflation approaching the Fed’s 2% target.

In 2023, an unexpectedly strong economy, the Fed’s higher-for-longer messaging on interest rates, and increased Treasury issuance for the expanding fiscal deficit pushed the 10-year Treasury yield to 5%, its highest point in 16 years. Subsequently, Fed-friendly data have supported a gradual bond recovery.

We think conditions are in place for the Fed to stop hiking rates, removing a major headwind to bond performance. We’ve seen seven major Fed tightening cycles over the past 40 years. In each, short- and long-term yields were lower six month after the last hike, declining about 1% on average.

While it’s hard to pinpoint, we anticipate a similar trend this time, suggesting that last year’s surge in interest rates might have marked the peak for this cycle. The Fed’s policy-sensitive 2-year Treasury yield could fall more sharply, reflecting expectations for rate cuts, while the growth-sensitive 10-year yield could decline more modestly if a recession is averted.

The yield curve represents the difference between short- and long-term yields. We see the 10-year yield falling slightly below 4%, accompanied by a steepening yield curve. After being inverted for the longest stretch since the early 1980s, the yield curve could turn positive, in our opinion.

After declining nearly 20% in 2022, the S&P 500 experienced a solid double-digit rebound in 2023, albeit driven by a narrow set of sectors and large-cap tech stocks. We believe the stock market has room to continue to build on 2023’s gains and move higher.

These gains may come from corporate earnings growth, which we believe will accelerate to 5%–10% next year, and some valuation expansion, especially as interest rates continue to moderate. Keep in mind that the large-cap technology space, especially among the Magnificent 7 stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla), likely has less scope for substantially higher valuations. The remaining stocks of the S&P 500, however, may offer better prospects for valuation expansion.

We would expect stock markets to end higher in 2024, but likely not without their fair share of volatility. Markets may not be able to ignore a potential economic slowdown, which we expect will emerge in the first half of the year. Absent a deep downturn, we believe markets can look past a slowdown to a period of growth ahead.

2024 is a presidential election year, which also can spark some headline volatility and near-term uncertainty. But historically, election years have been positive for the markets. Once the election is over, an overhang is lifted as well.

With Congress still divided, we would expect gridlock to remain in place in 2024, regardless of the election outcome. This typically means no new legislation or regulations are likely to get passed, which markets tend to favor as it makes the operating environment more favorable for companies. 

Overall, we see a trifecta of fundamental factors that may favor market performance in 2024:

• Ongoing moderation in inflation
• The potential for Fed interest rate cuts
• A growth re-acceleration in the back half of the year

In our view, investors could use potential market volatility in 2024 to rebalance, diversify or add quality investments in the growth and value sectors, as we believe positive returns are likely in the year ahead.

If a key theme in the stock market for 2023 was narrow leadership — with the Magnificent 7 driving many of the gains — then perhaps we would view 2024 as the year when some laggards play catch-up.

We see this playing out in two phases of the economic cycle. Early in 2024, we would expect the economy to remain in the “late cycle and economic slowdown” phase. During this time, we would expect investors to gravitate toward parts of the market that have been working already, such as large-cap technology, and perhaps tilt a bit more defensively in sectors such as health care and staples.

Once the late cycle or downturn is confirmed, markets may look quickly toward an early cycle economic recovery. This phase of economic growth is when we see the typical recovery playbook emerge: Leadership tends to be in areas such as small-cap stocks and cyclical parts of the market that are leveraged to economic growth, including industrials and consumer discretionary. International and emerging-market stocks may also lead, especially if global growth is rebounding.

We recommend complementing growth investments with some of these lagging assets, including cyclical sectors and small- and mid-cap stocks, which could play some catch-up this year. With generative AI (artificial intelligence) in the early innings of multiyear growth, we still view the large-cap technology space favorably. But we see diversification beyond technology more critical to portfolio returns in 2024.

The Magnificent 7 have enjoyed full valuations, perhaps somewhat justified given their consistent earnings growth overall. However, stocks outside large-cap technology may have a better chance for valuation expansion in the year ahead. As the economic cycle turns in 2024, so could stock market leadership.

In 2023, cash outperformed investment-grade bonds for the third consecutive year, something that hasn’t happened since the early 1980s. Despite the attractive yields in certificates of deposit (CDs) and short-term bonds, which carry little or no price risk, we see compelling opportunities in intermediate-term bonds, which have higher sensitivity to interest rate changes.

The end of Fed tightening has historically meant above-average bonds returns. An upcoming inflection point in the interest rate cycle, combined with historically attractive valuations, could mean cash will give up its lead in 2024. If the Fed pivots to lower rates later in 2024, we see an opportunity for investors to slightly extend the duration of their bonds.

If CDs represent an oversized part of a fixed-income portfolio, we recommend reducing the cash allocation or reinvesting the maturing principal into longer-maturity bonds. These bonds can help investors lock in the historically high yields for a longer period. They also may appreciate as the Fed makes further progress toward its 2% inflation target.

On the credit side, we believe a resilient economy could provide a stable backdrop for corporate credit conditions, potentially allowing credit spreads to remain range bound. We recommend a neutral allocation to credit risk.

We believe European and Canadian economic growth could stall in 2024, with the potential for a brief, mild recession. In Europe, higher interest rates have weighed on economic activity across the region, particularly within the manufacturing sector. Despite the impact of central bank rate hikes and slowing growth, inflation remains above central bank targets.

In the United Kingdom, CPI inflation excluding food and energy rose by over 6% year over year in October 2023. Additionally, measures of U.K. wage growth have been slow to moderate, rising more than 7% year over year in late 2023. If this situation remains, it could lead to stubbornly high inflation and force central banks to keep rates higher for longer.

In Canada, household debt levels have risen to over 100% of GDP. Additionally, more variable and short-term mortgages make households susceptible to higher interest rates. As Canadians spend a greater portion of their household income on debt payments, we believe consumer spending and loan growth in Canada could slow in 2024, weighing on economic growth.

Economic growth in China and Japan could fare better. In China, deflationary and property sector concerns have led policymakers to enact stimulus measures to help bolster economic and financial market activity. While risks remain, we believe the enacted stimulus could offer support to the Chinese economy in 2024.

In Japan, inflation is higher by historical standards but has been contained, with headline CPI peaking at 4.4% in January 2023. Some inflation is likely welcome for Japan after it struggled to fight off deflationary pressures for much of the past three decades. While higher inflation could weigh on consumer confidence and spending, still-accommodative policy, steady wage growth and a tight labor market could help offset these headwinds in 2024.

In a diverging world, one common thread might be a gradually softening U.S. dollar. The Fed hiked interest rates further and more aggressively than other central banks. This tilted interest rate differentials between the U.S. and other countries in favor of the dollar.

As the Fed pivots to rate cuts in late 2024 and with more room to ease, the case for a stronger dollar weakens. A softer dollar — together with discounted valuations and higher dividend yields — supports the case to maintain an appropriate allocation in international equities.

A view that gained popularity amid 2023’s banking turmoil was that a coming crash in commercial real estate would trigger a larger financial and market crisis. We don’t subscribe to this view, but we do think a slowdown in economic activity will bring some credit stress, with commercial real estate becoming more of a sore spot in the credit cycle. We expect overall loan delinquencies and losses to rise in 2024, with the shifting post-pandemic real estate landscape possibly exerting the most pressure on commercial property prices and loan performance.

All that said, we don’t think this will spill over into a larger credit crunch that inflicts wider economic damage. Commercial real estate investment and prices haven’t experienced the same mania as residential housing did in the late 2000s. Instead, we think some evidence of deteriorating credit conditions could resurface worries about loan losses for the banking sector and resulting capital constraints. This could spark an episode of volatility in the broader markets, although we doubt it will be a repeat of the bank failure turmoil experienced in March 2023. We believe any such episode would be short-lived and likely centered more on small and regional banks, which account for nearly three-quarters of commercial real estate lending.

2024 is an election year, of course, but history shows that the partisan outcomes of U.S. presidential elections don’t play a material or lasting role in dictating market performance. This won’t, however, prevent stocks from going through a spate of indigestion leading up to the 2024 election.

This is not to downplay the importance of our democratic process or the office. Instead, it recognizes the lesson we believe history teaches every four years: Markets will be guided by the path of the broader economy, earnings and interest rates, rather than the outcome on election day.

That said, we doubt the election will clear the gridlock in Washington, which offers a potential silver lining for markets by reducing the likelihood of new, sweeping regulation. At the same time, the longer-term geopolitical backdrop still hangs in the balance, as the president will likely further shape the tone with China and global alliances. Given the ongoing wars occurring overseas, we believe geopolitical tensions will be the source of temporary but noticeable weakness in 2024.

Equity markets are likely to react to political headlines, but any election-driven weakness will, in our view, prove fleeting. To us, this would present a compelling buying opportunity ahead of markets reconnecting to what we expect will be a time at which the economy and corporate earnings cycles are looking up.

Although we anticipate inflation to slow in 2024, prices are higher than they were a year ago. Consequently, your expenses may have increased, and you may have had to dip into your emergency cash or taken on debt to cover them.

• Review your budget. Make sure you’re still living within your means. Look for opportunities to adjust your spending if needed.
• Replenish your retirement spending account. We recommend retirees maintain 12 months’ worth of withdrawals from their investment portfolio in cash and an additional three to five years’ worth of withdrawals in CDs and short-term fixed income. Ensure you’ve set enough aside to meet your upcoming spending needs.
• Replenish your emergency cash. If you spent from your emergency cash fund or simply want to build it up, we recommend having three to six months’ worth of living total expenses in cash or cash equivalents for emergency needs.

Interest rates have risen over the past year, which could present some challenges.

• Review your debt. Higher interest rates mean a higher cost of borrowing for those with new loans or variable interest rates (as with most credit cards). Make sure you’re building minimum payments for your debt into your budget. Where possible, consider making extra payments to pay down high-interest debt.
• Review your student loans. Those with federal student loans saw payments resume in late 2023. Visit studentaid.gov/loan-simulator if you’re having trouble with your student loan payment.

Higher interest rates may have affected your debt, but they also bring investment opportunities to consider.

• Review your cash and cash equivalents. The increased interest rates on savings accounts, CDs and annuities could provide near-term opportunities. That said, while rates may look attractive today, we recommend ensuring you have the appropriate amount in cash relative to your emergency savings and spending needs. 
  
  Aside from emergency savings and retirement spending, we don’t recommend holding more than 5% in cash for longer-term goals such retirement. You may be looking only for the highest yield. But remember to review an instrument’s liquidity and duration to avoid a potential cash crunch should you need to access your funds early.
   
• Don’t forget about annuities. Payout rates for annuities have increased. This could be an attractive solution if you’re looking for a consistent lifetime income stream to help cover your necessary expenses. When evaluating an annuity, it’s important to consider how inflation may impact your fixed payments over the long term.
   
• Take advantage of higher retirement contribution limits. As you review your financial situation and potential investment and saving opportunities, check your budget to determine if you can take advantage of these increased limits.

* Participants of eligible SIMPLE plans can contribute 110% of normal contribution limits, including catch-up contributions.

• 401(k) access for part-time employees — Beginning in 2024, employees who are at least 21 years old and have at least 500 hours of service for three consecutive years must be eligible to contribute to a 401(k) if one is offered by their employer. Review your situation to see if this could provide you or a family member with an opportunity to participate in a 401(k).
• Employer matching contributions on qualified student loan payments — Beginning in 2024, employers are allowed to make matching employer plan contributions for qualified student loan payments. Availability depends on the terms of your company plan. Check with your plan administrator regarding eligibility.
• RMDs eliminated for Roth employer plans — Beginning in 2024, required minimum distributions (RMDs) are no longer required from Roth employer plan accounts for the original account owner. Individuals who turned 73 in 2023 and waited until April 1, 2024, to take their 2023 RMD must still take the 2023 amount by April 1.

While the current individual income tax environment is historically low, talk with your tax advisor and financial advisor if any of the following apply.

• Increase in taxable income — Due to the strong economy, some may have benefited from an increase in income. If you had a meaningful increase to your income, review your situation to plan for any potential federal or state income tax liability.
• Large income event — If you plan to sell a business, exercise stock options or potentially gain excess income at retirement, review the timing of the transaction given that the current rates resulting from the Tax Cuts and Jobs Act of 2017 (TCJA) are set to sunset at the end of 2025, barring additional legislation.
• Monitor RMDs for inherited IRAs subject to 10-year rule — In 2023, the IRS proposed regulations that would require RMDs to be taken during the 10-year period when the original account owner passed away after their RMD beginning date. If final regulations are issued in 2024, impacted inherited IRAs may need to begin RMDs this year.

• Annual gifts — The annual gift exclusion increased to $18,000. This could provide additional opportunities for lifetime gifts.
• Qualified charitable deduction (QCD) — As a result of SECURE 2.0, individuals 70½ or older can exclude up to $105,000 of QCDs from taxable income in 2024.
• Estate plan — Review your estate plan to ensure it aligns with your wishes and that beneficiary designations are up to date. Also, ensure it is drafted with flexibility to take advantage of the current estate tax environment.
• Use of gift and estate lifetime exemption — If you plan to make a large lifetime gift, speak with your tax and legal advisors to determine if you should use a portion of your lifetime exemption. The 2024 exemption of $13.61 million per individual is scheduled to be reduced roughly in half at the end of 2025.
• State estate taxes — Although the federal estate and gift tax exemption is large, many states have put transfer taxes in place. Ensure your estate plan accounts for state tax obligations.

The above tables compare 2023 YTD performance in varying asset classes and stock market sectors with three-year and five-year returns. Among asset classes, cash rose 4.8% YTD, U.S. investment-grade bonds rose 2.7%, U.S. high-yield bonds rose 10.1%, international bonds rose 6.2%, emerging-market debt rose 5.8%, U.S. large-cap stocks rose 22.3%, international large-cap stocks rose 13%, U.S. mid-cap stocks rose 11.8%, U.S. small-cap stocks rose 8.5%, international small- and mid-cap stocks rose 8.7%, and emerging-market equity rose 4.2%. In stock market sectors, communication services rose 48.8% YTD, consumer discretionary rose 37.7%, consumer staples fell 2%, energy fell 3.9%, financials rose 7.8%, health care fell 0.9%, industrials rose 13.4%, materials rose 7.8%, real estate rose 5.5%, technology rose 54%, and utilities fell 7.3%.The S&P 500 rose 22.3% YTD.