Making definitive predictions about the financial future can often feel like a losing game. Yet, years of historical data and the analysis of pertinent indicators can provide us with a dependable foundation on which to base our decisions.
Gazing into the economic crystal ball for 2024, I see yet another tough year ahead for the 60/40 portfolio, with bonds likely to outshine stocks in the year to come. But why? Let's scrutinize the available facts that have shaped my bearish perspective.
For followers of financial history, the signs may already seem clear. The US economy has just endured the most aggressive Federal Reserve rate tightening cycle in over four decades. Since World War II, there have been 14 Federal Reserve rate hiking cycles; strikingly, 11 of these cycles precipitated a recession. When these hiking cycles didn't trigger an economic downturn, inflation had not strayed far from the Fed’s target.
However, unlike those three exceptions, this current cycle saw inflation that clearly exceeded the Fed's comfort zone.
The Conference Board Leading Economic Index, a reliable barometer of economic prospects, has been trending lower for 18 consecutive months. Historically, this kind of trend is a strong sign that we’re heading for a recession. Coupled with this, the ISM new orders index—a key indicator of future demand—has contracted relentlessly for 14 months straight. A year is a long time in the world of finance, and this declining metric throws up more red flags for the future of the economy.
The faltering rhythm of the manufacturing sector is another sign of looming economic turbulence. The ISM manufacturing data shows that this critical engine of the economy has been mired in contraction for 12 straight months. In reviewing past cycles, we can see the Federal Reserve typically cutting rates when the ISM manufacturing index displays such a shrinkage in activity.
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Inflation - typically blamed as an obstacle to economic stability - has ironically fallen with alarming speed. In just over one year, CPI inflation has plummeted from a high of 9.1% to a mild 3.7%. To give you some historical context - such a precipitous fall in CPI inflation's trajectory has only occurred five times in the past seven decades. In each of those prior instances, a recession followed. Could this instance be an anomaly?
Or is it a reliable warning of another economic downturn?
Leading indicators of bank credit suggest a sharp slowdown in the growth of bank lending over the next year. The Fed’s Senior Loan Officer Outlook Survey (SLOOS) suggests that the proportion of banks tightening rather than loosening standards for commercial loans has now hit almost 50%. This has only been exceeded during the worst moments of the pandemic, and the global financial crisis. Declining credit issuance and availability will be detrimental to the growth prospects of a credit-driven economy like the US.
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While the headline unemployment figures are presenting a reasonably upbeat image, a peek beneath the veneer exposes problems. Nonfarm payrolls, a principal labour market barometer, have seen downward revisions in eight of the past nine months. This reveals an evolving weakness, a vibe of vulnerability building beneath the labour market's façade. Furthermore, in addition to rising tech-sector job cuts, the US economy has seen job losses in the most cyclical sectors of the economy in 2023, namely transportation and warehousing, manufacturing and construction.
Since the 1950s, all recessions have followed a familiar pattern. Leading indicators start to contract, then credit issuance contracts. This, in turn, leads to a contraction in new orders and job losses in the more cyclical sectors of the economy. This is exactly where the US economy is right now.
The warning bells are also resonating in the realm of the equity market. The equity risk premium—a measure of the compensation stock investors receive for braving the waters of risk over secure bonds—is teetering at a wafer-thin 0.80%. At market bottoms, this indicator averages 4.25%. A return to a comfortable risk premium will necessitate some combination of a stock market tumble and/or a bond rally. If bond yields were to retract back to 3.0%, the S&P 500 index would still need to fall back to the low 3000s range. Therefore, as the shadows of a 2024 recession lengthen, bond investors could gain respectable returns while equities face a likely downfall from current astronomical valuations.
I expect the Fed will be forced to cut rates in 2024 as the US economy decelerates, contrary to their widely publicised mantra of "higher for longer". Fiscal policy will have limited firepower. The fiscal stimulus since 2020 has left the US with a budget deficit of 6.3% of GDP. This is the highest ever outside of a recession and coincides with a decline in federal tax receipts that is approaching recessionary levels. Even if the recession is not severe, it is likely to be protracted and could last for several quarters.
As bearish as all of this sounds, none of this means stocks have to fall immediately. The stock market does not equate directly to the economy, and the stock market is able to ignore bad news until facing the bad news becomes unavoidable. However, investors should be prepared for a more bearish trend in the stock market in 2024, a year where I expect bonds will shine in comparison to stocks.
Simon Ree is the founder of Tao of Trading
