Juncture Wealth Strategies - 2024 Year Ahead Market Commentary

JWS 2023 Prediction

Result

Equities

Leadership transition from US large cap value stocks to global small/mid cap growth stocks.

US large cap growth (Magnificent 8) led most of the year. However, since 10/19, US small cap stocks have taken the lead. We didn’t consider that investors would see the Mag 8 tech stocks as risk-free.

Fixed Income

High credit, long duration, fixed rate outperform.

High yield, senior loans, and long duration outperformed during a year beset by yield volatility.

Real Assets

Energy/Metals outperform.

Metals led 2023 while energy lagged. Since 10/19, US REITs have outperformed.

GDP

Growth

Slows with possible recession

US economy was resilient as fiscal policy helped support growth while Europe struggled with a recession. China’s growth slowed as it dealt with a real estate bust.

Disinflation

Inflation continues to slow.

CPI slowed from 6.5% to 3.1% while PCE declined from 4.9% to 3.2%.

Interest Rates

Fed pauses rate hikes; continues shrinking balance sheet.

Since July, the Fed paused raising interest rates while it continued to shrink its balance sheet by $1.14 trillion annually.

Geopolitics

Russia/Ukraine war stabilizes; Iran & China heats up.

Russia-Ukraine war stabilized with Ukraine making gains while Iran’s proxy wars with Israel escalated. China continued its aggressive actions towards Taiwan and the Philippines.

Economy: Consumer Confidence is shaky

Finally, consumers may feel poorly about the economy because price inflation in our frequent purchases often skew our perception of overall inflation. Take gasoline. The media has covered high gasoline prices over the past few years even though gasoline comprises a small portion of the average US consumer’s budget. The chart to the right is produced by the Bureau of Labor Statistics, the agency responsible for the CPI Index. The colored circles represent different spending categories for the average urban consumer. The size of the circle indicates how much the average consumer spends on that category. The purple circle shows the significant amount of money spent on Services. In comparison, Energy Commodities (orange circle), which represents gasoline, is much smaller.

While smaller, that gasoline expense is experienced by consumers more often as they fill up their vehicles. The more often a consumer sees inflation via a transaction, the more likely the consumer’s perception may be reinforced that inflation is still too high. This may cause consumers to feel as if inflation is higher than it is. And, if the consumer’s wages don’t keep pace, then inflation becomes an issue.

Economy: Consumer Debt Service

Consumer debt service is one way to ascertain if the consumer has capacity to spend more. Since consumer spending is approximately 2/3 of US economic growth, it is critical for the economy that the consumer continues to spend. To the chart on the right, looking at the ratio of consumer debt service to disposable income provides a good way to determine if debt service payments are becoming onerous relative to history. The ratio of 5.78% is close to its long-term averages. The ratio hit its cyclical low in the first quarter of 2021 at 4.84%. Investors need to monitor this ratio to see if the consumer begins to lag on paying these debt service costs which would negatively impact future consumer spending.

Economy: US Gross Domestic Product (GDP)

The Conference Board’s 2024 US Economic Outlook suggests that the US GDP growth will become negative for the first two quarters but will strengthen to an annualized growth of 2.2% by the fourth quarter. This will impact consumers by restricting growth in real disposable income (i.e. the income consumers can spend on discretionary items). Our resilient economy in 2023 was bolstered by fiscal spending of approximately 6% of GDP. This fiscal stimulus helped blunt the impact of tighter monetary policy. It also may have been a reason the job market has remained strong.

In conclusion, the economy will slow in the first part of the year and strengthen in the last half of 2024. The risk may be to an upside surprise if the consumer and productivity remains strong.

Inflation:  Expected Inflation

Based on the contracting money supply and stable supply chain, it is unsurprising to see expected inflation decline to within the Federal Reserve’s target range in early 2024. As shown in the chart, the most recent expectation of inflation (orange line) drops into the 2% range in 1 month and continues in that range for the foreseeable future. This should allow the Federal Open Market Committee (FOMC) to reassess how high interest rates need to be. If the economy slows more quickly or aggressively than anticipated, the FOMC will feel more comfortable lowering short- term rates.

In conclusion, we expect that inflation will most likely be within the Fed range by year end. One risk to this prediction is the labor market. If the labor market continues to be strong, it could cause inflation to reaccelerate which may delay our prediction into 2025.

Bond Markets

Bond yields were the most important factor in 2023. Yields have been extremely volatile as investors reevaluate the Fed’s intentions with interest rates. For example, the 10-year US Treasury yield hit its 2023 low in April at 3.3% and hit its high in late October at 5.0%. Since late October, the yield has dropped to 4.0% as the Fed has been perceived as dovish on rates. For the bond market, these are very large movements!

On the chart to the right, you can see the inconsistency of bond yields over the last three months depending on the time selected.

Currently, there is no clear short-term trend. Over the course of 2024, the US Treasury yield curve may begin to “disinvert” meaning that long-term yields may begin offer higher yields than short term. As investors begin to price in lower rates, we may see the yield curve resume a “normal” shape of upward sloping. A key risk is that the bond market’s predictions of lower rates in the first half of the year may be too optimistic.

 Bonds:  Inverted Yield Curve

Inverted yield curves have generally indicated a coming recession, but they have not indicated the timing of the recession. Historically, it takes 12-24 months for the economy to slow enough to be pushed into a recession. In July 2022, the yield curve inverted as measured by the difference between the 10-year US Treasury yield and the 2-year US Treasury yield. It has been inverted for approximately 18 months. It’s a bit too soon for us to conclude that the US won’t experience a recession even though the inversion between the has lessened from -1.61% three months ago to -0.36%. The chart illustrates the yield differences since 1980 and includes recessions (gray bars).

Financial commentators have long discussed that prior to recessions the US Treasury yield curve will invert. It is interesting to note that the yield curve transitions to a normal shape just prior to recessions. We expect the yield curve to continue to progress towards a normal, upward sloping, positive yield curve.

Bonds:  Future Interest Rates

Bond traders have begun to price in lower interest rates in response to weaker economic data and lower inflation. This chart shows that futures markets are currently projecting 1.25% to 1.50% interest rate decreases in 2024. This is a volatile measure and will change as more economic data is reported. We expect the Federal Reserve hold interest rates steady for the until inflation is nearly within the target range of 2%. Expected interest rate decreases have already incented investors to begin investing in the neglected Small Caps, Financials and Real Estate.

We expect the Federal Reserve to begin lowering interest rates this year by mid year.

Bonds:  Corporate Yields

A slowing economy may mean that the Fed can begin to lower interest rates, particularly if the US slips into negative growth rates. As shown, Moody’s offers a forecast for the average corporate bond yields for companies with Baa and Aaa ratings. Here, they forecast stable to lower corporate yields over the course of the 2024. This may help all assets which are interest rate sensitive like real estate, banks, and small caps.

In conclusion, the yield curve will most likely return to a “normal” yield curve shape this year as the Fed lowers short-term rates and long-term yields continue to be stable. If the economy is weaker than expected, we could see much lower long-term yields. We would advise income-oriented investors to lock in higher yields/coupons in long term, high credit quality fixed income.

Equities:  Stock Valuations

Stock valuation is a tricky art. It is not a timing tool as valuations can stay cheap for long periods of time. However, valuation provides important context to the equity markets. The Equity Risk Premium (ERP) is the Earnings/Price, or the earnings yield, minus the 10-year US Treasury Yield. It provides an indication of how much an investor may be paid for owning equities relative to a Treasury bond. The highest ERP is generally considered to have the least expensive valuation relative to its earnings. It also may be interpreted as that area having the best probability of outperformance.

As shown to the right, the highest ERPs are the stocks that have underperformed the most relative to their fundamentals (see Energy, Mining, Emerging Markets, International and Small Cap). Again, we don’t know when they will begin to outperform. Please notice that the areas with the lowest ERPs are the ones most affected by the eight mega cap stocks which have driven the headline indices (see S&P 100, S&P 500, Russell 1000 Growth, Nasdaq 100, and Technology sector) over the past year. Real Estate also has a negative ERP due to the uncertainty surrounding future demand, loan covenants, and interest rates. While the timing is unknown, the probability is the stocks with high ERPs (in green) will outperform over the next cycle.

Equities:  Small Cap Underperformance

Small cap stock are generally considered to have more risk inherent in their businesses. They also tend to have more bank debt which makes them susceptible to changes in interest rates. These are some of the reasons that small caps have underperformed over the past few years. However, if the Fed has finished raising rates, then small caps may be poised to increase their earnings faster than large caps.

Higher earnings growth may translate into better stock returns. One overlooked aspect of small caps is that they have been one of the most innovative parts of the market. Some of the biggest innovations and technological revolutions have originated from small cap companies. Our analysis suggest we may see a change in stock leadership in 2024. As shown in the chart, this stock leadership change may be seen in the returns from Oct 19 through year end.

A key reason for the potential outperformance is lower interest rates. Small caps are generally reliant on floating rate loans to fund their businesses. As rates decline, small caps may see a significant increase in earnings. However, if rates remain at high levels, small caps may delay the transition in leadership.

Equities: Election Year Returns

Another major event next year is the Presidential elections occurring in November. Just by their nature, elections create uncertainty. Generally, campaign efforts can impact stock market returns depending on how investors react to the candidates’ stated policies. This illustration provides historical perspective on returns for the year of and year after elections. As shown, incumbency victories lead to better equity returns in both periods. Mostly likely, the better returns may be attributed to policy consistency which mitigates uncertainty for investors.

Equities:  Election Year Returns

In the current divisive political environment, each political party may frame the opponent’s victory as disaster for the economy and stock market. It is important to put these comments in perspective. Historically, the stock market’s best returns were seen when a Democratic President was combined with a Republican Congress. The worst returns were seen in years when a Republican President was combined with a Democratic Congress. None of the compositions were a disaster for the US economy nor the US equity market. Elections can cause fear among voters which may cause them to change their investment allocations. This volatility should be short-term in nature.

In conclusion, we expect equities, overall, to have a good year as more stocks begin to participate. At the same time, we expect the Mag 8 (& cap weighted indices) to lag this rally while we experience a transition from large cap to small/mid cap stocks.