Three Potential Economic Scenarios 2024
As is the case every year, there are a range of potential paths the US and global economy could traverse in 2024. Differing economic trajectories are anticipated to have varying impacts on consumer behavior, monetary policy, investor psychology, and asset market prices. In this piece, we will discuss the current consensus view for the economy in 2024 (per the December 2023 Bank of America Fund Manager Survey (BoAFMS)), unpack three possible economic outcomes for the US, and explore probable monetary policy and asset pricing implications under each scenario. Prior to diving in, it is important to note that although broad economic trends impact asset markets, there may be non-economic events that muddy the cause-effect relationship between the economy and asset values.
Scenario Analysis
Soft Landing: A gradual economic slowdown wherein gross domestic product (GDP) growth moderates but does not go negative. In this scenario inflation likely continues to abate as demand for goods and services is gradually lowered and brought in line with supply.
BoAFMS % of Respondents: 66%. Soft Landing is the consensus view for 2024, meaning that at this time asset market prices are likely to have at least partially incorporated this outlook.
Monetary Policy Implications: As can be derived from the December Summary of Economic Projections, the Federal Reserve is, at this time, forecasting a Soft Landing in 2024, wherein the rate of GDP growth will slow to 1.5% QoQ on a seasonally adjusted annualized (SAAR) basis while their preferred inflation measure (Core PCE) trends back toward 2.5% YoY. As such, the monetary policy setting body within the Fed (the FOMC) anticipates that they will enact roughly three one-quarter percent cuts to their benchmark Federal Funds Rate, in an effort to keep the real level of interest rates (real interest rate = nominal interest rate - inflation rate) at ~2%. It should be noted that the Federal Reserve has not heretofore demonstrated an ability to accurately model the rate of change or level of GDP growth or inflation on a forward basis.
Asset Market Implications: In an opinion that is shared with a majority of forecasters, the Soft Landing scenario has the highest probability of putting a tailwind behind stock and bond prices, in aggregate. Under this scenario, companies (and their share prices) may benefit from a continued decline in input costs, a rebalancing of labor market dynamics (reduced wage pressure), continued demand for the goods and services they provide, and a reduced cost of capital as the risk-free interest rate is lowered. Similarly, in the event of a Soft Landing, bond prices may rise as interest rates decline and as the likelihood of defaults (as measured by corporate credit spreads) is reduced.
Hard Landing: A pronounced economic downturn that may create recessionary conditions (consecutive quarters of negative GDP growth, a meaningful increase in the unemployment rate, a reduction in consumer spending, and an increase in credit spreads). Such a significant, albeit temporary, downtrend in household and business demand would likely serve to quickly reduce the rate of increase in consumer prices.
BoAFMS % of Respondents: 23%. Hard Landing is seen to be the second most likely outcome in 2024, meaning some asset classes may be incorporating this outcome into prices while others are not.
Monetary Policy Implications: Given the strong historical correlation between the rate of change of economic growth and that of inflation, and the Federal Reserve’s dual mandate of 1- price stability, and 2- full employment, we view it as probable that the FOMC would reduce the Federal Funds Rates by more than the three 25bps cuts that are currently being forecasted. In line with this view, futures markets predict that the Fed will reduce interest rates in 25bps increments 5-6 times in 2024.
Asset Market Implications: Should recessionary conditions materialize, we would expect a drawdown in major stock market indexes (like the S&P 500, for instance). Historically, stock index prices have bottomed near the middle of most past recessionary periods and have commonly rebounded significantly by the time the economy officially pivots from recession to expansion. At the outset of an economic downturn, less volatile sectors of the economy may outperform, while cyclical components have a track record of producing alpha (excess risk-adjust returns) once there are signs that the economy is regaining its footing. Importantly, a sharp reduction in inflationary pressures (as is our base case expectation in an environment where economic growth is weak/negative) may help to restore the inverse correlation between stock and bond prices and dampen overall volatility in multi-asset class portfolios. Said differently, low/negative growth -> rapidly declining inflation -> a reduction of the Federal Funds Rate to support the economy now that CPI is no longer running well above target -> an increase in the price of high quality bonds which serves to offset stock market declines.
No Landing: The economy continues to expand at or above its trend growth level, keeping the unemployment rate low (3.7% as of December 2023), consumer spending robust, and potentially providing a tailwind for the Consumer Price Index (CPI).
BoAFMS % of Respondents: 6%. No Landing is thought to be a low probability event, meaning, at present, asset market prices are unlikely to be reflective of this scenario.
Monetary Policy Implications: All else equal, an economy that continues to expand at an above trend rate is likely to put upward pressure on the aggregate price level of goods and services. This may be especially true when economic growth is being driven to a large degree by debt-based consumption and large fiscal deficits. As such, the No Landing scenario presents the clearest upside risk to interest rates, both absolutely, and relative to the expectations set by the Federal Reserve and futures markets. Should inflation remain sticky throughout 2024, the FOMC may continue to prioritize its price stability mandate by keeping the Federal Funds rate unchanged or by enacting further interest rate increases.
Asset Market Implications: Since beginning to climb in mid-2021, the rate of change and level of the CPI index has been a primary determinant of stock and bond prices. As consumer price growth accelerated and remained high throughout 2022, stocks and bonds were, by and large, adversely affected. As CPI reverted toward 2% YoY throughout 2023, both asset classes rallied as other themes were allowed to come to the fore. Somewhat paradoxically, we view the No Landing scenario (the only scenario where the US economy continues to expand at an above average pace) to present meaningful and possibly underappreciated risks, particularly to fixed income assets, with potential cross-asset class implications. These risks are partially resulting from the fact that current market prices are not factoring in a high probability of such an outcome, and therefore may need to adjust meaningfully. Should rising consumer prices, spurred by strong consumer and business demand, necessitate a continuation of the current interest rate regime, bond prices could reverse much of their recent bullish behavior as yields rise in response to incrementally hawkish data. Considering that a portion of the rise in global stock prices over the past year has been attributable to the market’s expectation for lower interest rates (thereby reducing debt service costs for households and businesses, improving credit availability, and possibly incentivizing spending over saving), it is reasonable to question the direction of travel for stocks in an environment where inflation ceases to trend downward and yields normalize at a higher level. Alternatively, an upside surprise in corporate earnings growth, resulting from government, household, and business spending, could offset the impact of increasing yields.
We believe shifting economic sands necessitate a thoughtful and reasonably adaptive investment approach. While we monitor the unfolding economic machinations, we will continue to promote a diversified, risk-aware, long-term investment strategy that is complemented by timely and well-sized tactical tilts. Regardless of the economic scenario that unfolds, our commitment to your financial well-being remains unwavering.
Aaron
