Trees in clouds

In brief

  • Our base case view continues to see the U.S. economy rebalancing this year without a recession. In short, we expect a soft landing.
  • U.S. economic growth has proven to be resilient and disinflation is not linear.
  • Easier monetary policy is coming but the magnitude and timing are in question.
  • As rate volatility remains elevated, we recognize the two-sided risk to duration.
  • U.S. equities have had a solid run; we maintain our preference for large caps over small caps. 

U.S. economic growth has been stronger than expected in recent months, with the back half of 2023 consistently above trend and 1Q24 tracking close to 3%, according to the Federal Reserve Bank of Atlanta’s GDPnow model. While this robust growth backdrop in 2023 was coupled with relatively steady disinflation, the dynamic may be challenged going forward.

Improvements on the supply-side of the economy, among other factors, allowed this unusual combination of above-trend economic growth and falling inflation to take hold. The economy’s supply side troubles began during the pandemic, when supply chains collapsed and labor force growth came under pressure. Gradually those issues receded. Last year supply chains continued to heal– as evidenced by goods price disinflation – and labor force participation and immigration moved higher. These developments, along with a dovish pivot by the Federal Reserve in December, sparked a powerful fourth quarter rally, with yields falling and equities running higher.

 A rebalancing (soft landing) remains our base case scenario for this year. The recent market rally made a good deal of sense when it looked increasingly like a “goldilocks” environment of above-trend growth and normalizing inflation might emerge. But then came the hotter-than- expected January employment and inflation reports, calling the goldilocks scenario into question and reminding us that financial and economic variables rarely move in a straight line.

Do we really need to worry about sticky inflation? While this outcome is possible, we do not believe it is probable. The bigger issue seems to be that low levels of labor market slack could lead inflation to stabilize above target. Markets had clearly been underpricing this risk, as evidenced by the past week’s move higher in rates and lower in equities. As such, we are watching for further improvement on the supply side – namely an increase in labor supply or productivity – or alternatively, a cooling in the pace of growth and the labor market. Either could provide more clarity on the U.S. economy’s broader direction of travel this year.

The who and when of rate cuts

While market participants have reconsidered the likely magnitude of any monetary policy easing, we continue to expect a fairly synchronized global easing cycle even if the path of inflation data proves bumpy. Importantly, a downtrend in inflation implies that real policy rates will rise if nominal rates remain unchanged. With the real fed funds rate now at its highest level since 2006, and the Federal Open Market Committee’s (FOMC’s) Summary of Economic Projections signaling that the real target rate is approximately 2%–2.5%, it still seems reasonable to expect some modest easing from the Federal Reserve this year.

Outside of the U.S., we see signs that the European Central Bank (ECB) is approaching an easing cycle as growth cools and inflation moderates. That said, the state of growth and inflation in the U.K. suggests that the Bank of England may be a bit of a laggard. In Japan, recent GDP data have challenged the Bank of Japan’s (BoJ’s) view that domestic demand had been strong through year-end 2023. But the implications for the path of policy normalization seem limited, and we continue to expect the BoJ to exit its negative interest rate policy and remove yield curve control at its April meeting.

Central banks will be cutting rates, but perhaps not as soon as expected. Thus, we maintain a positive view on duration as the easing cycle approaches. Importantly, European bonds look increasingly attractive due to better valuations, and will be more so if the timing of ECB easing aligns roughly with the Fed.

Turning to currencies, the U.S. dollar seems caught in a tug-of-war, with U.S. exceptionalism supporting the USD as rate differentials begin to push the other way. While we continue to believe that the dollar is overvalued and needs to decline in the long run, a material downtrend would require growth to take a more convincing upturn in China and Europe.

Tactical approaches amid a running of the bulls

As the balance of risks surrounding growth and inflation has shifted, equity markets have pulled back from the all-time highs reached earlier this year. We continue to look for the S&P 500 to trade around 5100 at year-end, although we recognize that if a goldilocks scenario seems to be taking hold, it would present potential additional upside to equity prices.

However, in the absence of a shift in the underlying fundamentals, near-term upside will likely be more technically driven. Consider valuations: The S&P 500 equal-weighted forward P/E ratio is nearly back to its pre-COVID level and about 8% below prior peaks. Further, the forward P/E ratio of the Magnificent 7 looks reasonable relative to these companies’ underlying fundamentals. As such, an acceleration in AI adoption or an investor embrace of the goldilocks scenario would present the greatest upside risk to our valuation view.

The other upside risk to equity prices stems from earnings, and more specifically profit margins. The 4Q23 earnings season reaffirmed our constructive outlook on corporate profits this year. We note, however, that our estimate remains below consensus.

We expect that consensus estimates will drift lower this year, in line with the historical record. The extent to which they decline, however, will be a function of what happens to profit margins. Consensus estimates project nearly 50 basis points of margin expansion this year, which would boost earnings pershare growth by 5%. On the other hand, we anticipate no meaningful margin expansion this year (Exhibit 1). But if it becomes increasingly apparent that companies can not only defend but expand their margins, we would upgrade both our earnings estimate and price target for 2024.

However, absent any fundamental improvement, this is likely becoming a market to trade. Technical indicators appear mixed, but they should be viewed against a broadly favorable near-term fundamental backdrop. Thus, we remain positive on U.S. large caps due to their higher quality and, in some cases, superior cash flow generation.

Asset class implications

Our base case continues to anticipate a soft landing, where economic growth gradually decelerates toward its long-term trend and inflation moderates to levels more consistent with the Fed’s mandate. In such an environment, we would expect that the FOMC will be able to cut interest rates this year, although the magnitude of cuts remains subject to debate.

The combination of slower growth, cooler inflation and lower rates continues to support our preference for large cap U.S. equities and shorter-duration, higher quality credit. Japanese equities also look attractive given the prospects for reflation and corporate governance reform. At current levels, we express our duration views as a mix of European and U.S. government bonds. With rate volatility still elevated, we recognize the two-sided risk to duration positions. Over the near term, though, we see duration as part of a financial conditions trade in which the positive stock-bond correlation persists, rather than as a hedge against a sharp downturn in growth.