In 2022, positive economic data typically led to a sell-off in the stock market, and weak data often led to a rally. This was due to the overriding worry that better data meant the Federal Reserve would hike rates and weak data meant it might cut. That wasn’t normal market behavior, and we are happy to report the market is reverting to more typical trends. Strong economic growth and better data should be viewed positively, as it shows the economy isn’t falling into a recession. And that is what is happening now.
- The bull market continued last week, setting new highs.
- Investors should rejoice, as we are finally entering a period where good news is good news.
- It took more than 15 months, but stocks at all-time highs suggests continued market strength.
- The economy ran above trend last year, despite high interest rates.
- Consumption is running hot, thanks to strong growth in inflation-adjusted incomes.
- Core inflation, excluding food and energy, is now running below the Fed’s target.
- We expect rate cuts in 2024, perhaps starting in May.
We will discuss the economic data in more detail below, but broadly, the data shows improvements in manufacturing, housing, services, and inflation as well as healthy employment and a strong consumer. Against this positive macro backdrop, stocks are setting all-time highs. Following the pandemic, the market took years to return to normal, and an environment in which good news is being treated as good news is part of the normalization process. This is a reason for investors to rejoice.
Another Reason to Rejoice
It took more than 15 months for the S&P 500 to rebound from the lows of the bear market in October 2022 to the new highs set two weeks ago. This was a long wait for investors. But data from the 10 bear markets that have taken place since 1950 show the market often took much longer to return to new highs. Of course, some of those bear markets were much worse than the 25% decline of 2022, so it makes relative sense.
Now that the market is back to all-time highs, what could happen next? The good news is waiting a long time to make new highs, then finally making them, could be one of the best reasons to expect continued strength.
One year after the previous 10 bear markets, stocks were higher nine times and up more than 10% on average. With many investors worried stocks have gone too high too fast, this shows those concerns may be overblown and this bull market should continue to move higher in 2024.
The U.S. Economy: This Time Was Different, and That’s a Big Deal
The U.S. received a rollicking GDP report on Thursday, showing the economy expanded at an annual pace of 3.3% after adjusting for inflation. That was well above forecasts of 1.8%. Yet again, the economy continues to be underestimated — a topic we’ve discussed on these pages several times. By now we were supposed to be in a recession, with unemployment rising, thanks to an aggressive Federal Reserve that took interest rates from near zero to above 5%. Prominent economists predicted inflation would not come down without the unemployment rate remaining above 5% for five years. Others raised the dreaded image of “stagflation” (high unemployment with high inflation) as occurred in the 1970s.
Instead, this is what happened:
- The economy accelerated in 2023, with GDP growth rising 3.1%, well above the 2010-2019 trend of 2.4% and 2017-2019 pace of 2.8%.
- Over the past six quarters, the period during which interest rates surged, real GDP grew at an annual rate of 2.9%.
- The unemployment rate fell to 3.7%, not far above 50+ year lows.
- Inflation dropped to 2.6% in 2023 and crashed further to 1.5% in the fourth quarter.
Here’s something incredible: The economy has grown faster than the Congressional Budget Office forecasted in January 2020, before the pandemic. In fact, inflation-adjusted growth has been almost 1% higher than what the office projected. That’s despite a worldwide pandemic that killed millions of people, an energy shock that sent inflation to the highest level in 40 years, and the most aggressive Fed tightening cycle since the early 1980s.
In nominal terms, the U.S. economy grew 5.8% in 2023, which is faster than China’s growth rate of around 5%, the first time that’s happened in several decades!
“This time is different” are the four most dangerous words in the investment business, but I think the current situation warrants it. We pointed out the high likelihood of this scenario playing out in our 2023 Outlook (released at the end of 2022). Understanding the underlying reasons this cycle has defied expectations also has implications for 2024, which we lay out in our recently released 2024 Outlook (download here).
The Economy Has Strong Momentum as 2024 Gets Going
Two volatile components of GDP tend to be inventories and exports, but stripping those out leaves the underlying signal, which is “final demand,” or how much households, businesses, and government are spending. Real final demand, after adjusting for inflation, averaged 3% in 2023. That’s well above the 2010-2019 average of 2.4% and indicates the economy has strong momentum.
Three reasons we’re optimistic the economic momentum can continue:
- Household incomes are strong, especially with inflation easing (a lot), and that’s driving consumption. We expect inflation to continue to ease, which means real incomes are likely to remain strong.
- Investment remains relatively solid, with a sharp pickup in investments related to technology, equipment, and structures. Residential investment is also likely to be a tailwind if mortgage rates ease once the Fed pivots to rate cuts.
- Defense spending has picked up over the last few quarters, and state and local government spending remains strong. States and local governments pulled back on spending and investment in 2020 and 2021 in an attempt to shore up budgets in the face of an anticipated recession. However, the recession didn’t arrive, and now they’re playing catch up with their excess money (including funds received from the federal government as part of COVID relief). This is likely to continue into 2024.
The Inflation Problem is Over, and the Fed Needs to Cut
A common question around investment circles is, “Why does the Fed have to cut interest rates if the economy is running strong?”
I think the simple answer is inflation has run below a pace of 2% over the last three- and six-month periods, at least as measured by the Fed’s preferred metric, the core personal consumption expenditures index (PCE ex food and energy). Even the year-over-year rate, which partly relies on year-old numbers that aren’t relevant anymore, came in at 2.9% in December. That’s down from 4.9% one year ago.
Normally, a strong economy raises concerns that inflation will remain high. But over the last 18 months, the economy has proved that model wrong, mostly because the spike in inflation was largely a supply problem due to COVID-19 and the Russia-Ukraine war. Once the supply issues were resolved, inflation fell. The inflation spike was not caused by consumers spending too much money. To the contrary, consumer spending has been running well above trend over the past year, but inflation has now fallen below 2%.
In short, the Fed does not have to worry about inflation resurging on the back of a strong economy.
In addition, productivity is likely to have grown 2-2.5% in the fourth quarter of 2023, which means productivity growth would have been close to 3% in 2023. That’s well above the 1.5% average between 2005 and 2019 and closer to the late 1990s. The beauty of productivity growth is that strong wage growth can be paired with low inflation, which we discuss in our 2024 Outlook.
Fed Chair Jerome Powell has noted that economic risks are now balanced: The risk of lowering rates and stoking inflation is similar to the risk of staying too tight for too long and breaking the labor market. He has also pointed out that inflation does not have to fall all the way back to 2% for Fed members to cut rates. They just need to know that it’s on a sustainable path to the 2% target. Well, it’s already there and is likely to fall further in 2024, barring any surprises. That means cuts are expected in the first half of 2024, perhaps not as early as March but likely in May and June. That’s going to be a relief for investors and provide a further tailwind for the economy.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
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