Courtesy NBT Bank
By Kenneth J. Entenmann, CFA
Happy New Year! And that means it is prognostication time. Economists, Chief Investment Officers, your plumber and neighbor announce their bold predictions for the economy and the financial markets for the coming year. Beware! These predictions will likely be wrong, regardless of the level of the forecaster’s sophistication. And yes, that includes your humble blogger!
Look back at 2023. The overwhelming consensus called for a recession. It never happened. More importantly, the gloom associated with a recession also didn’t materialize. The labor market did not falter, ending the year with an unemployment rate of 3.7%. The Fed did not increase interest rates to “infinity and beyond!” as they hit the pause button in September and have been there ever since. The equity markets didn’t collapse, with the S&P 500 ending the year at 4765, up 25.83 percent for 2023. That is a far cry from the doom forecast of an S&P 500 price level of 3000. If you followed the pessimistic forecasts for 2023, it was a very expensive mistake!
The forecasts for 2024 are quite optimistic. As discussed in the last blog, the ferocious year-end rally in both stocks and bonds has priced in a perfection. In general, the consensus for 2024 is:
• The economy avoids recession and maintains growth around the trend of 2 percent.
• Inflation continues to trend toward the Fed’s 2 percent target.
• The labor market remains stout, with unemployment ticking marginally higher but remaining below 4 percent.
• Corporate earnings will accelerate, with the consensus growth of 12 percent.
• The Fed begins to cut interest rates in March and rates will be 160 basis points lower by year-end.
Each of these consensus forecasts seem to be reasonable in isolation. However, it is hard to reconcile all of them occurring at the same time. Perfection rarely occurs.
Let’s assume the forecasts are correct. The economy does sustain positive growth around 2 percent. Unemployment remains below 4 percent and wages continue to grow at 4 percent. A December employment read showed the unemployment rate at 3.7 percent and wage growth of 4 percent. The labor market shows no sign of imminent collapse. This would bode well for consumer spending and strong earnings growth would likely come to fruition. Great! But, given this rosy outlook, is it reasonable to expect the Fed to cut interest rates by 160 basis points?
What if the optimistic forecasts are wrong and the economy does enter recession? Economic growth, by definition, is negative. Unemployment is likely to increase meaningfully. This would stretch the consumer and spending would come down. Corporate earnings would contract. In this case, the Fed would certainly be forced to cut rates, but for the wrong reason!
Fed interest rate policy creates the greatest uncertainty for the first half of 2024. The market is calling for 160 basis points of rate cuts in 2024, with over a 50 percent probability of the first cut occurring in March. Yes, the core inflation data continues to trend lower, but remains well above the Fed’s 2 percent target. In addition, the Fed has repeatedly stated it wanted to see the labor market cool. As a recent employment report demonstrates, it has not happened. Therefore, I think interest rate expectations are overly optimistic, and it would take a much weaker economy to justify the current expectations.
It has been a long, arduous road back to interest rate policy “normalization.” After all, 0 percent interest rates are not “normal.” The last 12 years of interest rate policy compelled by the Great Financial Crisis and COVID pandemic were abnormal. What does “normal” look like. One measure is the yield spread between the inflation rate and the yield of the 10-year Treasury note. Historically, the yield of the 10-year note is roughly 200-250 basis points above the inflation rate. Let’s give the optimistic inflation forecasts the benefit of the doubt and assume inflation will soon be 2 percent. That would put the 10-year yield at 4 percent. Where is the 10-year note today? 4.04 percent. Not much room for improvement there. In just a few months, the market’s interest rate forecast has gone from “higher for longer” to “remaining high for longer” to rate cuts in March. That is a fast change in sentiment!
The Ghost of Arthur Burns haunts the Fed. He was the Fed Chair in the 1970s when the Fed fought inflation, and then cut rates too soon. Inflation returned with a vengeance and the Fed had to reverse course. This Fed cannot and will not let that happen again. It will be cautious. As such, and the current economic performance will have to be perfect for the Fed to cut rates as aggressively as the market suggests.
Financial market forecasts suffer from the same hubris as economic forecasts. Recall that the S&P 500 lost nearly 20 percent in 2022. For 2023, market prognosticators were generally bearish. They extolled the virtue of cash with a 5 percent+ yield. You would be paid to wait. Stocks would continue to suffer due to the imminent recession. Bonds would plunge in an inflation fueled, rising rate environment. Boy, was that wrong! Yes, cash paid 5 percent. But the S&P 500 was up 25.83 percent and the aggregate bond index was up 5.5 percent. Both asset classes outperformed cash. A simple, dull and boring 60 percent Equity/40 percent fixed income “balanced” portfolio, left for dead after 2022, posted a remarkable 18 percent return. Once again, the market proved the folly of market timing.
As we begin 2024, beware the prognosticators. There is no doubt that some will nail their forecast and be hailed as heroes, at least for a fleeting moment. But consistently forecasting the economy and markets is incredibly hard, and the data clearly demonstrates that. Therefore, it is more important that investors properly access their long-term risk profile and set their investment allocations accordingly. Investing is a long-term game, and it requires patience. In the long run, market prognostication (yes, including mine) are for entertainment purposes only!