An answer year: A soft landing, U.S. elections, more geopolitical rift or repair?

2024 should provide answers to many key investor debates; whether a soft or hard landing follows the U.S. Federal Reserve’s (Fed) many hikes to fight inflation, determining a short or longer lasting expansion post COVID. This will shape monetary policy and normal interest rates. Yet, fiscal policy remains on an unsustainable path. U.S. elections can set new paths, influenced by the candidates and conditions. Beyond elections during a pivotal cyclical year, peace is still not yet found and U.S. and China tensions remain high as each tightens its circle of friends. If two cliques form, we’ll judge the situation by the friends each keeps and the new friends each attracts. Beyond the macro, we watch powerful micro and thematic forces such as Artificial Intelligence (AI), which stole the show in 2023 and might again for the decade, but probably not in 2024.

Investment themes and views for 2024:

1. Small U.S. recession first half (1H24), sub 1% 2024 gross domestic product (GDP) in U.S. & Europe, but corporate profits climb: We expect a small recession in 1H24 led by continued weakness in durable goods demand and manufacturing, slow service consumption as jobs growth stalls along with a brief dip in investment spending as companies look to protect margins by curbing hiring, inventories and capital expenditure (capex) until more macro and cost of capital clarity emerges later in 2024. Despite brief GDP contraction, we expect very limited jobs losses owing to resilience in service consumption and tightness in labor supply from demographics. We expect disinflation, not deflation, benign credit costs and higher profits.
2. 2024E S&P earnings per share (EPS) $242 up 8.5%: S&P EPS outlook assumes $80/barrel avg. oil, stable dollar, benign credit costs at banks with a Fed Funds rate cut in June and at 4.5-4.75% at 2024 end. Our profit outlook differs greatly by sector, we expect flat Financial, Energy and Auto profits, but up about 20% at mega-cap Tech firms, such as the Great Eight, with healthy 7-8% EPS growth elsewhere.
3. 4700 S&P 500 target for 2024 end with a sustained near 20 trailing price-to-earnings (P/E) ratio: Our S&P target is 19.5x our 2024E EPS, supported by Treasury yields still below average since 1960, the S&P being more growth and Tech stock tilted and lower investment fees than history. Our real cost of equity (CoE) estimate is 5.75% = 1.75% 10yr Treasury Inflation-Protected Securities (TIPS) yield + 4% Equity Risk Premium (ERP). This supports a fair steady-state PE of 1/5.75% = 17.5. We then add a 10% premium for economic profit growth potential.
4. When will the Fed cut? Unless the recession is sooner/deeper than we expect, we think rate cuts are unlikely until June 2024 to help smother the risk of inflation reaccelerating. While we think the Fed would like to validate a soft landing with a few cuts in 2024 (like 1995), opening the door to victory over inflation cuts before the November election likely requires unemployment over 4%, a few months of sub 100K new jobs and a stock market not near all time highs. Rate cuts continuing every other meeting in 2025, as we forecast, likely requires some fiscal tightening in our view.
5. Long-term interest rates rise to pre financial crisis range. What’s the norm for the 2020s?: We expect 10yr Treasury yields of 4.2% at the end of 2024 with long-term inflation expectations and breakevens at about 2.5%. We estimate 10yr TIPS yields of about 1.75% at 2024 yearend, down from about 2% today; a bit higher than our 1.5% 10yr TIPS yield estimate going into 2023. 10yr yields overshot our expectation to touch 5% in October 2023, but since retreated to 4.2%. The bond market expects a weak 2024 economy and further disinflation. But the basics of reasonable long-term inflation assumptions and inflation/duration risk premiums remain unsure. Moreover, the deficit remains high and we believe the Fed will likely sell over $1 trillion of Treasuries and mortgage-backed securities (MBS) next year.

6. How to tame inflation in 2020s? Fiscal discipline and more productivity are key: Keeping inflation tame will be challenged by conflicts, reshoring, demographics, environmental and other regulations, also the stable but slower inertia of mature service oriented economies. This should affect real growth more than inflation if there is monetary and fiscal policy discipline; but discipline can be tough politically, so it’s important to guard against inflation risks. Productivity is key to good growth and alleviating difficult policy choices. Artificial intelligence (AI) is exciting, but meaningfully boosting productivity and growth takes time. Healthcare is the biggest and fastest growing part of the U.S. economy, consumption and jobs; innovation here is crucial for productivity and growth.

7. S&P sector strategy: With disinflation and a weak macro backdrop seen ahead, we embrace less cyclical and intermediate duration assets, including investment grade credit. In equities, we seek bond substitutes (Utilities, Infrastructure) and secular trends resistant to cyclical disruptions, such as Healthcare in an aging world, productivity enhancers in a tight labor market (Tech Services, Capital Goods). We’re cautious on Consumer Goods and now also many Services, but we see further rebound for advertising and airlines. We cut Financials to neutral, with a smaller overweight on big Banks and Insurance and now a small overweight on Energy. We remain overweight Health Care, Communications, Industrials and most underweight Tech and Consumer Discretionary, particularly Semiconductors and Auto. Beyond cyclical risks, car wars will continue and chip wars are likely next. We expect companies and governments to compete aggressively to ensure a place in electric vehicle and chip making and don’t expect shareholder returns to be prioritized.
8. A better relative decade likely for small vs. large caps: We believe competitive U.S. corporate tax rates, strong/stable dollar, normal interest rates and reshoring suggests better small vs. large cap performance.
9. Keep foreign equities in the portfolio, search for value and lower correlations: The 5 largest companies are 25% of the S&P 500, thus we value diversification. Europe and Japan are value tilted with less Tech. We keep modest exposure to China’s Tech firms which we think are heavily discounted for government risk.
10. 2024 chutes & ladders: Negatives: Recession or <5% S&P EPS growth, destabilizing U.S. election results. Positives: S&P EPS growth >10%, 10yr Treasury yield <4% and no recession.