Economic Outlook

• 216,000 jobs added in October
• Unemployment at 3.7%

Payrolls rose 216,000 in December, and unemployment held steady at 3.7%, about where it has been since March of last year. Job openings continue to trend down, as do hires and “separations.” There is a softening in the labor market, but it has not impacted the unemployment rate yet. Low unemployment, ongoing growth, and declining inflation together form the strongest arguments for the “soft landing” scenario.

• Inflation ticked up in December
• Core CPI at 3.9% and still trending down
• Road down to 2% may be rocky

The monthly “all items” inflation index ticked up to 0.3% in December after registering a subdued 0.1% in November. Many media observers suggested that this result may represent a concerning change for the worse in the battle to control inflation and might even justify further tightening by the Federal Reserve. Economic data never moves in a straight line, particularly in its monthly intervals. The road to lower inflation was eventually going to hit a bump. Today, as we look at the larger picture of improving inflation, we do not view the December result as a change in direction. However, we have said for some time that the last few percentage points down to the Fed’s target of 2% may be harder to achieve than the early gains that were so clearly supported by repairs to global supply chains and declines in energy pricing. It is probably also true that once the current decline in inflation has run its course, inflation in the future may very well be more volatile than it was for the two decades prior to COVID. That is because one of the primary forces that constrained inflation during that period, globalization, seems to have exhausted some of its anti-inflationary power, and is now being disrupted by renewed geo-political strife. Our relations with China are not as constructive as they once were when our collaboration helped make that country one of the most effective low-cost producers in the world. It is especially difficult now to fully realize the benefits of a global supply network when piracy is disrupting one of the world’s critical sea lanes.

We believe that inflation will continue to abate in 2024, although at a slower downward rate and with the possibility of a few monthly reversals along the way. The easy work is behind us. Nevertheless, the longer-term measures of inflation continue on a downward trend. Year-over-year CPI for “all items” was 3.4%, and the core measure for “all items less food and energy” was 3.9%, a new low for this cycle.   Inflation is currently running hotter for services over goods. The improvement in supply chains over the past 18 months has primarily benefited pricing for goods, but services comprise the greater part of the US economy.

• Fed rate increases are over
• Debate over timing and extent of future cuts
• Fed still shrinking its balance sheet

The Fed Open Market Committee met on December 12 and 13, and they will meet again on January 30 and 31. At their last meeting for 2023, they once again held steady on their target for overnight interest rates. They have now been on hold since September of last year. Taking into account their own actions and remarks, it is only reasonable to assume that this period of rising rates and monetary tightening is over. The upper bound of the overnight target remains at 5.50%, up from virtually zero post-pandemic, and the highest it has been for most of this century.  

The Fed continues to reduce its bond holdings, which has the effect of reducing liquidity in the economy at a rate of $95 billion per month. This process is referred to as “quantitative tightening.” However, it is now anticipated that this additional tool for monetary constraint may start to wind down over the first half of 2024.

The 10-year Treasury note currently yields 4.15%, after dipping below 4% earlier this year. The yield curve continues to be inverted, and rates have proven to be quite volatile this year as markets attempt to anticipate when the Fed may begin to cut interest rates and by how much. Markets appear to be anticipating an initial rate cut in March and a total reduction of 1.25% for the year. Those assumptions look aggressive to us, but we certainly believe that the Fed’s next move will be to cut interest rates and that those cuts will begin in the first half of 2024. We anticipate that there will be meaningful reductions in short-term rates this year and next. We believe that short-term rates may settle in the 3.0% range by the time the Fed completes this next phase and that the yield curve will return to a positive slope during that process.

• S&P 500 sets new high
• Bond market anticipating lower rates

The S&P 500 reached a new high on January 26 and is up over 2% so far in 2024. That index was up over 20% over the past year. The index remains richly priced with a price/earnings multiple above 26. That being said, there does appear to be some momentum in the market’s recent moves, and some recent sessions have displayed signs of a market attempting to “spread out” its gains. So much of last year’s gains were concentrated in a short list of technology mega-cap stocks, and a significant part of current gains are being concentrated in the stocks of companies positioned to benefit from the development of Artificial Intelligence (AI). Some parts of the market not associated with technology are more attractively priced, so skillful stock pickers may find opportunities in sectors that were neglected in 2023. These include energy, healthcare, and consumer staples. However, it should also be pointed out that valuation alone is not a very good indicator for timing. To the extent that fundamentals still matter to stock values, the market would benefit greatly from an improvement in corporate earnings. A strong US economy would support such an improvement. Analysts project earnings growth for the S&P 500 at 12.2% for 2024. That projection includes a low of -1.7% for the energy sector and a high of 18.2% for healthcare. It should be noted that analysts’ projections are often optimistic at the beginning of the year.

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