PID 3651


Market Commentary: January 2024 – Changing Drivers

Changing Drivers
January 2024

By Jonathan McAdams, CFA


I have twin 15-year-olds who just passed their driving test and will soon be launched out onto the roads unsupervised – wear those seatbelts everyone! As nerve-racking as the prospect is, it is a welcome respite from having to drive them all over the map to get to their various destinations and activities. It is time to change drivers.

Likewise, for the past few years, the Federal Reserve has been in the driver’s seat of the stock market as it responded to COVID stimulus and its inflationary effects. To say it has been a bumpy ride would be an understatement. The Fed has oscillated from overly dovish in 2021 as it was skeptical of burgeoning inflation, to historically hawkish as it tried to put out the inflation fire with higher rates, now settling back to a mildly dovish stance as inflation has subsided. The market, in concert, has taken a wild ride along with it – up 29% in 2021, down 18% in 2022, and up 26% as 2023 ended. As shown in Exhibit 1, almost every dip and rally in 2023 was driven by interest rates except for the mid-year move sparked by excitement around Artificial Intelligence.

By its own admission, the Fed now views its inflation fight as largely accomplished and signaled at their December meeting that rates were at, or near, their peak for this cycle. As shown in Exhibit 2, the Fed has finally relented and is now baking several 2024 rate cuts into its projections. The green line shows that the market expects the Fed to be even more aggressive with cuts than what they are publicly stating.

Regardless of who is right, the Fed is now trying to find an equilibrium interest rate that balances inflation and economic risks on either side – but this is more fine-tuning than massive reactionary moves.

Moving to the market foreground this coming year will be the economy and the prospects for a potential recession – the same recession that investors have been prematurely predicting for the past few years now. 2023 proved elusive on that front due to the continued resiliency of US consumer spending, strong corporate balance sheets, and real interest rates that were not historically punitive. Of the three, the key this coming year will be the consumer and their willingness to continue to spend. The good news is that employment data continues to be strong, and people will spend when they have jobs. In addition, consumer balance sheets are starting from a relatively solid position. As seen in Exhibit 3, consumer debt service payments relative to disposable income are at historically low levels thanks in large part to borrowers locking in low rates on mortgages over the past several years. And while credit card debt has been on the rise and recently crossed a record $1 trillion, when scaled against disposable income the numbers are much less frightening.

However, there are warning signs of a weakening consumer that will need to be monitored going forward. Delinquencies on consumer debt are starting to tick higher, particularly for the low-end consumer in areas like subprime autos and credit cards as this cohort is hardest hit from the bite of inflation and the depletion of COVID stimulus money. Between the combination of higher interest rates and inflation pressures, consumers are not as willing to buy big ticket items like appliances, autos, and homes (Exhibit 4).

But if the consumer can hold the line this year, that will give corporate earnings room to expand – which will help underpin the market. In fact, corporate earnings are returning to year over year growth for the first time in several quarters as cooling inflationary pressures have allowed margins to re-expand. In addition, corporate balance sheets are in a strong position and banking crisis fears have so far relented. The employment picture is still strong with unemployment and initial jobless claims at healthy levels, and the housing market continues to show resilience. In short, there are many reasons to be optimistic.

In our last communication we outlined multiple paths the market could take this year depending on the path of real interest rates. While interest rates and Fed policy are always a vital component of any market outlook, these factors may finally be moving to the passenger seat after many years of driving the market. We are handing the market keys over to good old-fashioned fundamentals like consumer spending and earnings as the economic landscape returns to a more normalized environment after almost four years of COVID induced effects. And, just like my sons, we are hoping for a clean driving record this year.

Shannon Dermody

Shannon DermodyTEST

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