The Macro Outlook for 2024
#84: The outlook for stocks and bonds, and my 2024 macro portfolio.
This post is the first of a two-part preview of 2024. This week, we will cover the Macro outlook and the risk and reward in equity and fixed income markets. To translate words into practice, I include a sample portfolio of simple, low-cost and easily accessible ETFs that reflect these views.
Next week, we will focus on the Micro outlook - specific and more speculative trading ideas for those so inclined.
Of course, everything here is my opinion, not financial advice. Without further ado…
An Unusual Cycle
The old adage that history repeats is usually correct, but this cycle has been unusual.
In mid-2019, the global economy was slowing. Job gains (by private metrics) had stalled out, repo markets required intervention, and the Fed had already begun to cut rates. It was in this weak backdrop that a pandemic disrupted the entire world’s economy in 2020. Beyond disrupting specific sectors, the pandemic also ushered in the most aggressive monetary and fiscal stimulus of our lifetimes. By 2021, a rebounding real economy coalesced with pent-up stimulus and easy money, resulting in a fever pitch of excess in financial markets.
But 2022 brought the hangover, which continued into early 2023. While perhaps not qualifying as a “recession” in aggregate, we witnessed deep and painful headwinds in many parts of the economy.
We experienced a tech-cession. We witnessed the rinsing of early stage, unprofitable, and speculative IPOs and SPACs, along with a massive drop in market value for large-cap tech stocks. This period culminated in a meaningful wave of layoffs in the industry that hit in early 2023.
We experienced an infla-cession. The monetary expansion of the COVID-era first turbocharged demand until prices caught up. Inflation caused real incomes to shrink substantially through the first half of 2022, sapping consumer confidence.
We experienced a goods-cession. After an unprecedented shift towards goods-spending in the pandemic, a normalization of demand and overstocked inventories led to dramatic reversal in industries like manufacturing, trucking, and shipping after a period of extreme tightness during the pandemic. These signals led to many false-positive recession indicators that ignored the unusual decoupling of the goods and services sectors.
We experienced a rate-cession. Mortgage rates froze the housing and commercial real estate market1. Long-duration asset prices cratered, dragging down major U.S. banks, retirement accounts, and the classic 60/40 portfolio.
We experienced a deal-cession. New issuance in debt and equity markets came to crawl, M&A was put on hold.
Despite these micro-cessions, we held our breath for a macro-cession as we typically understand it — falling employment and outright decline in economic production. Of course, this hasn’t yet happened. And while history cautions against soft-landing optimism, high-level heuristics are insufficient when continuously contradicted by the data.
None of these headwinds were able to derail the overall growth in employment and production. More importantly, all of these factors are now improving.
The tech industry has trimmed its fat, has returned to growth and is embarking on a new wave of capital expenditures.
Inflation has receded, real purchasing power of income is improving, and families have already been largely weaned off pandemic-era stimulus. Consumer sentiment is low but improving.
Real goods demand appears to have normalized as prices have eased, logistics costs have cratered and real incomes have grown.
Interest rates have eased substantially in recent months, breathing new life into rate-sensitive sectors like real estate and banking, and nudging asset values to new highs.
Capital markets issuance is on the rise at the same time that banks are easing lending standards and loan growth is accelerating. These are important signals that the U.S. credit cycle has already turned the corner towards expansion.
Is it possible that the policy-induced recession that we have anxiously awaited has already passed us by?
As we move into 2024, it appears these positive trends will continue. The Federal Reserve has made clear its intentions to ease policy in the coming year, and the markets have already front-run this pivot. The easing of Fed policy and dollar weakness will allow monetary easing in other developed markets, where it is more urgent.
Meanwhile, after flashing warning signs of deterioration through much of 2023, employment data over the past several months have shown improvement. Initial claims have fallen, continuing claims have stabilized and both private and public payroll indicators show ongoing employment gains. Small business surveys show that employers are struggling to find employees, not thinking about layoffs. Today, the unemployment rate has barely budged over the past 2 years, even as labor force participation has rebounded to pre-pandemic levels.
The question of long-term structural inflation is, in my view, interesting but moot. The reality is that central banks globally are easing. One might have correctly predicted that the monetary easing of 2020 would lead to serious inflation, but fighting against policy is losing battle.
We are entering the new year with >5% nominal GDP growth, a resilient labor market, easing inflation and rising incomes, ongoing fiscal stimulus, and easing monetary policy. While risks remain (and will be discussed below), I don’t see these risks derailing economic growth in the near term.
Let’s consider the implications across equities and fixed income.
Given the macroeconomic backdrop, my view on U.S. equities is positive. Although I don’t expect to see a repeat of 2023 which was primarily a rebound from a historically poor year in 2022, I expect the market to rise over the coming year.
U.S. Large Caps (S&P 500)
After a year of falling earnings due to margin compression, corporate earnings in the S&P 500 found footing in 2023 and appear to be on the upswing on growing revenue and margin stabilization. Between moderate inflation (~2%), real growth (~2%), and stable or slightly expanding margins, it seems reasonable that earnings will grow by at least mid-single digits in 2024. (Consensus estimates suggest 13.5% earnings growth in 2024, though these estimates are often revised downwards throughout the year2).
As far as valuation multiples go, I’d consider today’s levels to be somewhat elevated, but maybe not extreme as you might think. Notably, stocks held these valuations in the 1990s when interest rates were far higher than today.
Assuming constant valuation multiples, ~5% earnings growth and a modest cash dividend (1.4% today), I’d expect a base case total return of 7% over the coming twelve months at the index level, which aligns with long-term historical averages.
Within the S&P 500, my preference would be to overweight the rate-sensitive sectors (Utilities, Real Estate, Financials) and 2023 laggards (Energy, Consumer Staples).
Big tech has been the long-time market leader and attracts the highest multiples. As such, the historically high concentration of the “Magnificent 7” is a risk. If this is a deep concern, one might consider an equal weighted index, or buying the underlying S&P 500 sectors in equal weight.
U.S. Mid and Small Caps (S&P 400, S&P 600, Russell 2000)
Over the past several years, smaller stocks have underperformed large caps, despite the fact that their earnings have grown much faster than large caps since 20193. As a result, the S&P 400 (mid-caps) and S&P 600 (small-caps) trade at attractive multiples relative to larger companies and their historical averages. If the current market rally continues to broaden, we could see small-caps outperform in a “catch up” to the larger names.
But keep in mind, small caps typically display more sensitivity to economic conditions, which is a double-edged sword. Further, a discount in trading multiple alone is not a catalyst. It’s possible that the mega-cap leaders continue to dominate and small caps lag.
Nevertheless, I think the small and mid cap stocks represent an attractive risk/reward opportunity over the coming year.
Outside of the U.S., I’m more hesitant of other developed markets that have weaker secular growth prospects, a poorer history of stock market returns, and yet have seen their markets rebound to new highs (Eurozone, United Kingdom, Japan)4.
But, the one international market that seems ripe for outperformance is China. The divergence between Chinese stocks and all other major economies has been extreme. While most stock indices around the world are at or near all time highs, Hong Kong’s Hang Seng index has now erased twenty six years of price gains, trading today at the same level as 1997 after falling 46% since early 2021.
The country faces a witch’s brew of property collapse, poor demographics, and tepid consumption, but these issues are now well known. Moving forward, I think that investors will shed some of their pessimism and begin to see value in the country. With a dividend yield of over 4.3% and significant room for capital appreciation, the Hang Seng is my candidate for the “obvious in hindsight” pick of 2024.