The probability of a soft landing has increased
Review the latest Weekly Headings by CIO Larry Adam.
Key Takeaways
- The probability of a soft landing has increased
- The trend in bond yields remains lower
- Mild recession will keep earnings growth subdued
Happy National Ugly Christmas Sweater Day! This hilarious tradition is one of my favorites of the holiday season. It’s always fun to see what festive sweaters your neighbors, family and friends wear to holiday parties. Whether it’s a classic style with snowflakes, Santa Claus or reindeer or a more modern version, which ups the ante on the classic type, there are plenty of styles to choose from if you want to be the talk of the town. And speaking about talk of the town, with investor attention focused on the Federal Open Market Committee (FOMC) and Chair Powell this week, the Federal Reserve’s (Fed) final policy meeting of the year sure was a head turner. The updated dot plot confirmed that the Fed’s tightening cycle is over, and policymakers are now openly discussing the path to lower rates in 2024. What implications does the Fed pivot have on our economic and financial market views?
Over the last few months, we have highlighted that the Fed should be done with its tightening cycle based on real-time, high frequency data that suggested that economic growth and inflation were cooling. And on cue, the Fed this week reinforced our views and signaled that rate cuts are on the horizon. How did it do that? First, within the Fed’s economic forecasts, inflation forecasts were downgraded for 2023-2025 with Chair Powell noting in his press conference that inflation remains on a downward path. While inflation has not yet reached the Fed’s 2% target, it is worth noting that Fed cutting cycles have begun before inflation hits 2% in nine of the last ten easing cycles. Second, the Fed downgraded its 2024 GDP forecast and Chair Powell highlighted that economic data has shown signs of slowing and that there are risks if the Fed were to keep interest rates too high for too long. Third, the Fed lowered its 2024 dot plot to reflect the median participant expects 75 bps worth of cuts in 2024 (up from 50 bps) and Chair Powell acknowledged for the first time that the Committee openly discussed the timing of the first Fed cut at this meeting. It appears the Fed is satisfied that Fed hikes have contained inflation and now it will turn its attention to the economy. As a result, we expect the Fed to cut interest rates 3-4 times in 2024, beginning in July. Below is what this means for the economy and various asset classes.
- ‘Slowcession’ or soft landing | On the back of a slowdown in consumer spending, our base case remains that the U.S. economy will experience a mild recession (albeit the mildest in history) beginning in the second quarter of 2024. However, the potential for more proactive easing from the Fed increases the probability of a soft landing in a few different ways. First, with the trajectory of inflation moving downward, the Fed will have the ability to cut more aggressively if there are any signs of slowing activity. Second, as bond yields have already fallen in anticipation of Fed cuts, some of the harder hit interest rate sensitive areas such as housing and autos could see a boost over the coming months. Third, as loan rates decrease (particularly consumer, auto and mortgage rates), this may well improve consumer sentiment and spur additional consumer spending. Lastly, signs that the Fed is easing should lift business sentiment which could boost the labor market and capex spending. So, while we continue to expect the mildest recession in history or ‘slowcession’ to evolve in 2Q, the probability of a soft landing is incrementally increasing.
- Fixed income | The Fed’s pivot is good news for the bond market as the market has grappled with whether the Fed’s tightening cycle is done for the last few months. The news sparked a strong rally across the curve, with the 10-year Treasury yield now comfortably below 4.0% – a decline of ~100 bps over the last two months. The more dovish stance by the Fed provides fixed income investors with comfort that yields have peaked in this cycle. The only question being the pace and magnitude of the Fed’s expected rate cuts. With the market now pricing in six 25 basis point rate cuts in 2024, nearly double the Fed’s dot plot (and our) projections, the market could be vulnerable to a mild reversal if the economic data continues to shows resilience. But if our view of a mild recession holds and the Fed begins cutting rates by midyear, the path for yields moving forward is lower. Our 2024 year-end 10-year Treasury yield forecast remains at 3.5%.
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- Equity market | While the Fed pivot occurred earlier than we expected, it does not alter our year-end 2024 S&P 500 forecast of 4,850 unless as discussed above, the economy averts a mild recession which would place upward risk to that target. With the P/E multiple nearing our target of 21.5x (currently at 21x), much of the good news (e.g., easing inflation, falling interest rates, Fed expected to cut rates) has already been priced into the multiple which leaves minimal room for further expansion. As a result, earnings will need to drive the market higher over the next 12 months. And given our expectation of a mild recession, we are forecasting only mild EPS growth of ~2% to $225. However, with the consensus pricing in 14% EPS growth ($245/share) in 2024, markets are likely too optimistic, and those estimates will in all probability have to be revised lower. While earnings are typically revised ~4% lower in a given calendar year, our estimate reflects ~10% downside from current estimates. This likely sets the market up for disappointments and bouts of volatility in 2024, and only modest upside from current levels.
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