Published December 15, 2023
Below we continue our offering of 2024 financial outlooks. This one comes to us from JP Morgan. It’s a broad look at the economy and markets now that interest rates have returned to historic norms.
It’s a New Interest Rate World
“Three years ago, nearly 30% of all global government debt traded with a negative yield. It seemed the era of super-low interest rates might never end. But it did. Today, negative yielding debt has all but disappeared. Over half of the developed world’s sovereign debt trades with a yield higher than 4%, and U.S. Treasury yields across the curve, from 3-month bills to 30-year bonds, range from ~4.5% to 5.5%. The rise in global bond yields is not just historic—it marks the most important development in markets since the world emerged from the COVID-19 pandemic. It has also reconfigured the investing landscape. Rates near 5% give investors more choices in crafting their goal-aligned wealth plans than at any time since the global financial crisis (GFC).
The reason for the abrupt shift in rates was a rise in inflation as a myriad of Covid-related and post-Covid factors converged to push prices higher. While inflation has come down markedly, investors are starting to believe inflation will be higher than it was in the late 2010s. Higher policy rates will be needed to help keep it in check.
Stocks should do well in this environment
We believe large public companies will be able to continue to maintain both pricing power and their margins. This is not just a U.S. phenomenon. Look no further than the European luxury goods sector, which commands pricing power while delivering robust growth. In fact, if inflation ranges between 2% and 3%, as we think it will, it should be good for stocks. The average S&P 500 year-over-year return is nearly 14% when inflation runs in that range.
We think that real assets may also be a good choice. In the last cycle, investors used bonds to insulate portfolios from slower growth. In the cycle now emerging, we think investors can use real assets to insulate their portfolios from higher inflation.
Stocks should keep rising
In 2024, equities offer the potential for meaningful gains. Even as economic growth slows amid higher rates, we think large-cap equity earnings growth should accelerate, and that could propel stock markets higher over the next year. Why do we anticipate improving corporate earnings? It’s partly because we believe the U.S. large-cap corporate sector has gone through an earnings recession already (nine of the 11 major sectors in the S&P 500 reported negative earnings growth for three consecutive quarters in 2022– 2023). They have emerged with leaner cost structures, which should help them face a still resilient (if slowing) demand environment in 2024. Indeed, since 1950, earnings per share has been accelerating about 25% of the time when GDP growth has been decelerating.
Higher rates may also make you skeptical of valuations. But we think they appear reasonable in the United States and inexpensive elsewhere. The S&P 500 trades at above-average valuations on a price-to-earnings basis, while U.S. mid-cap and small-cap stocks (and European, emerging market and Chinese stocks) all trade at a substantial discount. Indian stocks, meanwhile, trade with fair valuations, but we are optimistic about their low leverage and high growth rates.
Some investors argue that U.S. stock valuations need to correct further to account for higher interest rates. But today’s 18x–20x forward P/E multiples appear reasonable to us, given that the index currently has wider margins (free cash flow margins are 30% higher than they were 10 years ago) and healthy interest coverage (11x EBITDA to interest expense). We also see prospects for better corporate revenue growth over the medium term, given the tailwinds from fiscal spending and productivity gains from artificial intelligence.
The risks to the economy and markets
An inescapable fact of the business cycle is that higher interest rates make credit harder to come by. Of course, companies and households can still borrow money when credit is tight, but not as easily, and not in the ways they are used to. Not surprisingly, we expect the coming year to see more stress in certain sectors of the credit complex. Vulnerable sectors include: commercial real estate loans, leveraged loans, and some areas of consumer credit (e.g., autos and credit card) and high yield corporate credit. Small-cap equities may be similarly affected by higher rates, given the levels of debt on their balance sheets.
But we think these stresses of higher rates will be manageable—and more importantly—not enough to cause a recession in 2024. Indeed, some sectors of the economy have fared better than some might have expected in the face of rising rates. For example, U.S. residential home values have accommodated the recent and substantial jump in mortgage rates. Even though financing activity has collapsed (J.P. Morgan Private Bank and Wealth Management is on pace to underwrite just one-third of the mortgages that we did in 2021), home prices have been supported by the lowest supply on record.
Corporate credit has also held up well across a number of global markets, as U.S. and European corporates took advantage of the low interest rates of prior years to extend the maturities of their debts. It is also notable that to take advantage of higher rates in their own fixed income portfolios, companies increased their holdings of shorter-duration cash equivalents, which are now yielding higher coupon payments. All of this means that non-financial corporate interest payments as a share of after-tax profits are at their lowest levels since 1980.
All-in-all, we find that equity markets have reasonable valuations, bond yields will remain elevated and attractive, and company balance sheets are strong. We believe the economy will likely avoid a recession while corporate profits grow in 2024, supporting a good year for markets.
Market Update
Another week focused on inflation and the possibility of coming Fed rate cuts. Stocks have rallied strongly since November on the notion that 2024 will bring a series of interest rate cuts as inflation has come down and the economy might be slackening. Monday brought a +0.4% gain while money came out of the Magnificent Seven stocks that have driven much of this year’s equity market gains. A benign inflation report Tuesday (prices +3.1% as expected) sent stocks further upward. The S&P 500 registered a +0.5% gain on the fresh data. Fed Chair Powell’s accomodative words gave investors what they hoped for Wednesday. Stocks ripped higher as the Fed signaled no new rate hikes and the possibility of up to three rate cuts next year. Stocks vaulted +1.4% while small and midcap stocks, laggards in this rally, popped over +3% on the day. The party continued Thursday as yields on the 10-year Treasury note fell back under 4%. The +0.4% move was enough to push the Dow Industrials to a new record close. Stocks paused Friday as investors digested the heady moves this week. Stocks closed little changed.
The seventh week of this rally saw the hoped-for expansion as several lagging areas joined the move higher. The S&P 500 (SPY) added +2.36% to eke out a new high. Nasdaq 100 (QQQ) stocks posted a +4.17% lift. Smallcap stocks (IWM) surged +9.73% as the expectations for the end of Fed rate hikes appeared to be confirmed.
Warm wishes and until next week.