The Covid-19 pandemic that began in early 2020 marked a crucial inflection point for the global economy and was arguably one of the most significant economic shocks of the past 100 years. Perhaps the most significant repercussion of the pandemic is an enlarged presence and role of the federal government. Exceptionally large budget deficits are likely to persist in future years, with broad economic, financial, and investment implications.
Compared with an average annual rate of 2% since 2000, consumer inflation is likely to average close to 3.3% over the next five years. Investors should expect the Federal Reserve to embrace a more restrictive monetary policy when compared to recent decades, implying a flatter yield curve.
Two thousand twenty four should be a year of sustained economic growth, albeit at a more moderate pace than in 2023, accompanied by solid gains in both employment and company earnings. The downtrend in inflation will persist during the first half of the year but will reverse course later in the year. The FOMC tightening cycle has ended and rate cuts are likely during 2024, but to a much more modest degree than discounted in the futures market. Private sector borrowing costs will rise during the year and credit losses will remain on an upward trajectory. Recession has been postponed but not canceled, and economic risks will increase as the year unfolds, consistent with the current mature phase of the expansion cycle.
Market yields on the benchmark ten-year US Treasury bond have surged from a low of 3.25% earlier this year to 4.6%, down from a peak of 5%. The current 4.6% market yield is comprised of a real yield of 2.2% and an inflation premium of 2.4%. Nearly 90% of the increase in yields can be attributed to the spike in real yields. Assuming a normal real yield of 2% and an inflation premium of 3%, fair value for ten-year US Treasury bond yields would be 5%.
From a short-term cyclical perspective, bond yields are likely to remain in an interim consolidation phase uptrend, followed by further increases in 2024. Rates will not peak until there is concrete evidence that aggregate spending is peaking. For borrowers, the key takeaway is that market interest rates will remain higher for longer.
An analysis of fundamental trends suggests that the next five years will be very different from that of the previous five, characterized by higher inflation and interest rates. My forecast assumes that the inflation rate will average 3.5% over the five years ending in 2028, with an average yield of 5% on benchmark ten-year US Treasury bonds. Global equities should outperform global bonds, with leadership likely to be found in international markets. Small-capitalization stocks and value stock managers should also outperform the S&P 500, which is intrinsically a large-cap growth index. Following a period of cumulative losses since 2018, a diversified portfolio of investment-grade bonds should generate positive total returns, although only slightly above the 3.5% inflation rate.
As widely anticipated, the Federal Reserve held policy rates steady at its FOMC meeting yesterday, with the federal funds target remaining in a range of 5.25% to 5.5%. At the same time, the Fed delivered a hawkish message with respect to economic growth and the future path of policy rate.
There are no changes to the broad contour of my economic forecast. Real GDP should expand at a 2% annual rate over the next four quarters, accompanied by a 5-8% increase in company earnings through the middle of 2024. Currently at 4.5%, core consumer inflation will continue to decline but will encounter resistance early next year around 3.5%. Credit quality has deteriorated — consistent with business cycle theory — but not yet at an alarming pace. Federal Reserve policy is on hold for the foreseeable future, but policy rates are likely to remain higher for longer than currently discounted in the bond market.
The trend in core inflation will continue on a downward path over the next six months, but at a slower pace than generally expected. A further meaningful decline in inflation from current levels will be difficult to achieve over the next year in an environment of solid economic growth, business pricing power, and the tightest labor market in 50 years. The Fed will be compelled to maintain policy rates at current levels, thereby disappointing bond bulls. The path of least resistance for Treasury bond yields is upward.
Underlying economic and policy conditions remain supportive of sustained growth in spending and output at least through the middle of next year. The inflation rate could drift higher in 2024 in an environment of continued strong economic momentum and the tightest labor market in 50 years. The fixed-income market is vulnerable in an environment of strong economic growth, sticky service sector inflation, full employment, and continued monetary restraint. Bond valuations are also an obstacle to rising bond prices. Underlying fundamentals strongly suggest that equity investors should exercise caution.
Solid growth in consumer spending has been the cornerstone of the US economic expansion over the past three years. The likelihood of recession is extremely low in an environment of robust spending growth. Continued solid economic momentum will exert upward pressure on both inflation and long-term interest rates and prevent the Federal Reserve from lowering policy rates as currently discounted in the bond market. Equity valuations are stretched, as measured by P/E ratios and by the equity risk premium (ERP).
The vast majority of economists have been mistakenly predicting a recession over the past 18 months. The obvious explanation is that traditional indicators of the business cycle have been of little value in tracking this unprecedented expansion cycle. The basic conclusion of this report is that the exceptional strength of private sector balance sheets has more than offset headwinds associated with the severe tightening in monetary conditions. The three critical implications of sustained economic growth are stubbornly high inflation, better-than-expected corporate profitability, and a prolonged period of elevated policy rates.
The US manufacturing sector is on the cusp of a major transformation that could unfold over many years, a culmination of powerful structural forces unfolding within both the public and private sectors. A manufacturing boom will augment GDP growth, enhance productivity, and exert upward pressure on inflation and interest rates. Equity market leadership would shift from the consumer and technology sectors to the industrials and capital goods sectors.
The central theme in the investment outlook resolves around the traditional business cycle, which is currently in the final phase of expansion that began in mid-2020. Economic and financial conditions will deteriorate as the expansion cycle draws to a close, thereby sowing the seeds for a recession later next year. The outlook for world financial markets will be determined primarily by monetary policy and the future path of inflation. Further meaningful gains in stock prices seem implausible in the face of tightening financial conditions. A combination of elevated inflation and continued monetary tightening will trigger a breakout in yields later this year, accompanied by a contraction in equity valuations.
There are no changes in the broad parameters of my forecast: Continued economic growth for the remainder of this year with only modest progress against inflation, excluding energy prices. The current expansion cycle has entered its final phase, which means that investors should expect a progressive increase in classic cyclical pressures over the next six to nine months. The odds of recession will increase during 2024. History shows that long-term financial assets perform poorly in the final stage of an economic expansion cycle.
The current economic cycle that began in mid-2020 is the most unconventional of the 12 previous cycles since 1950. The pandemic created unprecedented distortions to the traditional flow of spending and output, resulting in widespread confusion and profound challenges for investors. The central theme in the economic outlook is that there exists an underlying imbalance between aggregate supply and demand. As a result, the Federal Reserve is faced with a daunting challenge to successfully reduce the core consumer inflation rate from its current level of 5.5% to its long-term target of 2%. Economic growth will gradually slow as financial conditions tighten, ultimately culminating in a recession, most likely in 2024.
On the basis of both economic theory and historical analysis, sustained periods of high inflation are detrimental to the health and performance of the real economy. Nonetheless, the impact of inflation on company profitability is not monolithic: Companies in various sectors have operating characteristics that result in resilient profitability and cash flow growth even during periods of high inflation.
The current economic expansion that officially began in the third quarter of 2020 is extremely unique. The peculiar nature of the current economic cycle can be attributed to several exogenous shocks, the most significant of which was the pandemic. In combination, these shocks disrupted the natural tendencies within the global economy, thereby greatly increasing the challenges faced by economists and policymakers. The most important implications pertain to inflation. The US economy is faced with an imbalance between aggregate supply and demand, which will result in a much higher rate of inflation compared with the previous 25 years.
The US economy continues to expand at a moderate rate, led by service sector spending, while inflation continues to decline, but at a painfully slow pace. Financial conditions have tightened in the aftermath of the banking crisis but are currently far from restrictive. Corporate earnings are drifting lower but continue to outperform pessimistic Wall Street estimates. The Federal Reserve will soon vote to pause its tightening cycle in order to assess the economic impact of monetary policy. The equity market is likely to outperform a significantly overvalued bond market through yearend.
The long-term outlook for inflation will be more problematic than previously assumed. A sustained trend of elevated inflation is a result of a structural imbalance between aggregate supply and demand. A sustained excess of demand versus supply is the result of several powerful structural forces, including unprecedented government stimulus in response to the pandemic; a chronic shortage of workers relative to the demand for labor; and a long-term trend of increasing industry concentration that enhances business pricing power.
The government released important quarterly data last week regarding first quarter GDP along with data pertaining to wage and price inflation. Last week was also the biggest week for first quarter earnings reports, with more than 50% of companies in the S&P 500 reporting Q1 results through last Friday. Collectively, the data reflect an economy that is expanding at a moderate but sustained pace along with a corporate sector that has been able to maintain high levels of profitability, despite massive headwinds. In the negative column, last week’s government reports on consumer prices and wages show that although inflation has peaked and is in a downtrend, the pace of the decline is disappointingly slow.
The US labor market is approaching a major inflection point, with the unprecedented boom in payroll growth finally nearing an end. Net new job creation will soon transition to a sustained slowdown phase. The crucial questions for equity and fixed-income investors are the actual pace of the slowdown in hiring; the impact of the slowdown on wages; and the policy response of the Federal Reserve’s to the slowdown. The labor market will steadily weaken over the next six months but a major contraction is unlikely.
The US investment cycle has reached a mature phase but an end-of-cycle recession is not imminent. Continued moderate economic growth over the next year accompanied by falling inflation and a less hawkish monetary policy should be mildly positive for the equity and bond markets in the months ahead.
The banking crisis is a mild positive for the stock and bond markets over a time horizon of three to six months. In the absence of a recession, a temporary period of slower economic growth will relieve financial pressures, as inflation moderates and as the Federal Reserve tightening cycle is put on hold, all of which should result in falling long-term interest rates and rising bond prices. Stock prices should drift modestly higher as investors begin to discount improved earnings in the second half of this year and in early 2024.
Investor concerns over the banking crisis and credit conditions in general are exaggerated. The banking sector is in excellent health and the potential for credit problems within the household and business sectors are minimal, with the exception of the commercial office sector. A temporary pause in the Fed rate-tightening cycle will likely defer the inevitable late-cycle increase in credit problems until later next year.
The banking crisis will result in a mild tightening in financial conditions in the short term as small and mid-sized banks de-risk and curtail lending. The odds of a financial crisis and recession within the next year are low but will increase in 2024 along with a resumption of the Federal Reserve’s rate-tightening cycle. Sustained growth in services will support GDP growth, while corporate earnings will decline modestly in Q1 and Q2 but stage a recovery later this year and in early 2024.