“Resilient” was a good descriptor for the U.S. economy in 2023, but for 2024 that’s likely to change to “inevitable”. Leading economic indicators have been flashing recession warnings for some time, so 2024 might be the year when these readings are inevitably proven correct. Restrictive monetary policy from the Fed is likely to lead to enough spending reductions by consumers and businesses to drive a recession in 2024, likely by mid-year. But the projected recession should be relatively short and mild, with the economy bouncing back later in the year and above-trend growth projected for early 2025.
Employment is expected slow sharply in the coming months as businesses look to cut expenses with profit margins squeezed by high interest rates and waning price increases. We may even see modest job losses by the midpoint of 2024. Correspondingly, consumer spending should struggle in 2024 as lower incomes and job concerns weigh on activity. In addition, elevated inflation concerns are likely to linger into 2024 as rising costs for services and housing maintain an above-trend pace of price growth. Headline inflation readings should continue to slowly fade throughout next year, with year-on-year readings for the Consumer Price Index (CPI) dipping below 3.0% by the end of 2024. Aided by recessionary reductions in demand for goods and services, CPI inflation is expected to return to trend of around 2.0-2.5% in 2025.
The Fed shifts to rate cuts
While it looks like the Fed is done with rate increases for this cycle, we expect an extended period of restrictive monetary policy with inflationary pressures extending into 2024. Any rate cuts by the Fed are likely to be more cautious than usual and may not happen for some time; as of this writing, the first rate cut is not expected until the Fed meetings in May or June. Rate decreases throughout 2024 should be more modest with the Fed funds target rate dropping to the 4.00-4.25% range by year-end. This cautious approach to rate easing could extend into 2025 and beyond, especially if a potential recession is as mild as expected.
This higher-for-longer path from the Fed is expected to keep Treasury rates elevated over 2024 as well. The 10-year Treasury note yield should fade later in 2024 as the Fed starts to ease, suggesting that the yield curve (e.g., the spread between short- and long-term rates) could remain inverted into 2025. As a result, consumer and business loan rates are likely remain elevated in 2024, limiting the initial recovery from an expected recession and maintaining tighter financial conditions for some time.
A focus on quality for stock
With slower economic growth, narrowing profit margins, weakness in the jobs market and consumer spending ahead, the “soft landing” debate is likely to persist in early 2024. In this case, portfolio strategies that emphasize quality will likely offer a key differentiator for returns, such as factor-based investing focusing on positive earnings growth, strong free cash flow yield, positive return on equity and lower debt-to-equity ratios. For example, during prior recessions, the relative performance of the S&P 500® Quality Index outperformed the broad-based index, which suggests a quality-focused approach can help investors during more difficult economic conditions.
As the potential for market volatility remains high, investors should view any selloff event as an opportunity to build an equity portfolio for the next bull market, such as a core equity allocation in the centerpiece of a multi-asset portfolio. In addition, small-cap stocks present an attractive opportunity because of their historically cheap valuation relative to large-cap stocks. As of this writing, the 12-month forward price-to-earnings (P/E) ratio of the S&P SmallCap 600® Index trades at about 12-times future earnings. At that level, small caps are approximately 35% cheaper than their large-cap counterparts, as represented by the 18.2 forward P/E ratio for the S&P 500® Index.
Given the macroeconomic backdrop, a focus on small-cap factor performance—considering factors such as interest coverage, return on equity, return on invested capital and debt coverage—may help insulate investor portfolios from the rising cost of capital. In the event that the U.S. economy avoids recession in 2024, perhaps because of disinflation, small caps could lead the next bull run for investors.