2024 Outlook: Less rocky, more boring

The hope that springs eternal within the breast of every investor is for a slow, steady rise in the market to ever higher levels, as positive fundamentals gradually work out in the form of solid earnings growth and steady valuations. Unfortunately, in today’s world of 24-hour news cycles, geopolitics, asynchronous micro and macroeconomic cycles, global trade wars and heavy involvement in the private economy by monetary, regulatory and fiscal authorities, markets have a way of zigzagging up and down in ways that sometimes obscure the underlying trend. And while 2024 is sure to have plenty of noise for the market to chew on daily, by this time next year at least, it may prove to be the most “normal” year for equities since the pre-Covid era. Our outlook, though among the high Wall Street forecasts Street at 5,000 on the S&P 500, is only 9% above present levels, and if achieved, would be a rarity. Over the last 20 years, a single-digit positive return has only been recorded four times. 

And after the wild ride of the last four years, 9% would be welcome in our books. More importantly for stock pickers such as our gang at Federated Hermes, the real action in the market is likely to happen beneath the surface, driven by smaller and mid-sized stocks that really haven’t participated until recently in the big rally this year. This theme of a market that is more of a grind than a hockey stick led by these unappreciated stocks, and not the “Magnificent Seven,” is one we’ve been talking about on these pages since the summer. So, let’s review some of the key elements of our Boring Outlook: 

1. GDP growth should slow but not retract. This week’s second pass at an estimate for Q3 GDP of 5.2% notwithstanding, most incoming data of late point to slower economic growth ahead, starting now. Job markets appear to be softening, ISM indexes and leading economic indicators have been soft for some time, the Atlanta Fed’s real-time GDP measure is around 2% for Q4, and retail sales suggest the low-end consumer, at least, is running out of gas (almost literally). On the other hand, the often predicted but forever postponed recession seems less and less likely. Indeed, most normal forces which can spark an economy-wide recession seem more behind than in front of us. Inventory levels across the economy have normalized, so a big cutback is unlikely. Housing starts are at a multi-year low and inventories tight, so again a big cutback in construction doesn’t seem in the cards. With mortgage rates starting to moderate, existing homeowners who’ve been holding on to their low-rate mortgages could begin to loosen up. The chip sector’s first-half downturn has now corrected and things there are looking up, driven partly by the AI boom. Ever since the spring, the banking system has been quietly and steadily reserving against potentially problem commercial real estate loans, so a sudden crisis there seems unlikely. For sure, plenty of statistical models based on past history are still forecasting a recession, but those models assume the post-Covid economy is similar to past history; this alone probably explains why they’ve been so wrong-footed all year long. Bottom line, while our own 2024 GDP forecast is not great (1.5% to 2%), it’s also not terrible for stocks, especially since nominal growth, which includes inflation, likely will run close to 5%. Call it boring.
2. Inflation seems likely to settle around 3%, the Fed’s “informal” target. With growth slowing in the broader economy, inflation would be expected to slow with it, and that seems to be exactly what’s happening. Whatever your favorite inflation indicator is, from this week’s core PCE to average wage gains to PPI to CPI, all are trending down and suggestive of an inflation run rate somewhere between 3-to-4% annualized. Our guess is this trend continues, and the Fed is acting as if, as one Fed watcher recently commented to me, “3% doesn’t light their hair on fire.” Next year’s softer GDP backdrop could well see continued improvement in the inflation rate, and at Federated Hermes we’re forecasting a gradual downward trend all year to a 2.5% pace by the time we get to Q4 of 2024. Inflation progress could even be stronger, though certainly the continued tight labor market implies that would be less likely. Kind of boring, but good enough.
3. The Fed is likely to remain in pause mode, not in hike or cut mode. Here’s the other possible sleeper for next year—what if the Fed does nothing, at least till after the November election? The logic of this seems pretty clear to us, given its framework—the 1970s’ inflation fight, which was highlighted in the Fed’s post-mortem of the period as one in which a supply-constrained economy (sound familiar?) produced a runaway inflation environment with a negative feedback loop between consumer prices, wage demands, then higher prices, then more wage demands.  This negative loop was never fully addressed by the Fed’s series of sharp hikes, then premature cuts, leading to more hikes. So, this time around, the Fed is determined to NOT cut prematurely in the face of supply-side constraints on the economy, particularly in the face of record low unemployment. Markets are hoping for some early cuts by the Fed, either because inflation drops to its 2% target very soon and/or a sharper economic pullback begins at the currently rescheduled time and hour (I believe the doom-and-gloom folks have moved this now to Feb. 2 at 10:30 a.m. based on their models). We don’t see it. The 70s’ mistakes that still haunt mean the Fed is not going to blink in this environment until it sees a more prolonged set of target inflation readings, which seem extremely unlikely given the current labor market or a very sharp economic contraction, which we see as highly unlikely. So, pause mode until further notice. Boring but OK.
4. Earnings are likely to grind higher. This year’s rally off of last year’s bear-market lows has famously been fueled not by earnings rising, but simply by earnings not falling further. Indeed, although the first half of this year saw continued earnings declines, the third quarter saw a modest inflection upward, as we’d expected. And the fourth quarter is likely to follow this trend, bringing full-year 2023 earnings for the indexes close to flat on a year-over-year basis. But with inflation stabilizing and all the post-Covid imbalances now worked out, we expect corporate America, in general, to get back to the business of growing earnings. Importantly, corporations will be doing so against a backdrop of higher nominal GDP, which we are forecasting to be about 15% higher than it was in 2022, when S&P earnings were $223. In this light, our Street high $250 earnings forecast for next year, which would be only 12% ahead of 2022’s earnings, seems quite reasonable. And our $275 forecast for 2025, which by this time next year the market will be looking forward to, also seems pretty conservative, just 10% higher even as the economy likely reaccelerates. At a bottom-up level, many of the companies our analysts at Federated Hermes are speaking with are corroborating our idea. They have plenty of levers to pull to get there, including healthy nominal GDP and revenue gains, efficiency improvements to offset wage pressures, and reduced share counts through share buybacks. So, while the bears see earnings next year as contracting or barely up, we’d say they are forecasting what just happened, not what’s ahead. What’s ahead is, well, boring. But good enough.
5. The election might prove to be more boring than usual. A well-known Street analyst was in our offices recently giving us the rundown on what happens “statistically” in an election year when the incumbent wins (“market up”) and when the incumbent loses (“market down”). He was on a roll until I asked him, “What happens when an incumbent is running against another incumbent?” The point is that this year might be unlike all others. As much as we’ve been programmed to thinking election years mean volatility, this time around the policy uncertainty of a newcomer president taking over won’t be hanging over us—either candidate seems likely to be a pretty “known” quantity, at least given the current state of the primary races. And interestingly, both of the current front-runners offer some policies the market likes, and others the market doesn’t. For example, President Biden is probably viewed as a more status quo force on trade policy, while President Trump more likely to reignite a market unfriendly trade war. On the other hand, President Trump would clearly back a more supply-side economic program than President Biden’s somewhat tired demand stimulus ideas. Given the supply-constrained issues driving the inflation problem, the market would see that as a positive. Bottom line, while both sides will make the case for why their policies are best for the long-term health and security of the country, the market might see the near-term implications more ambiguously, or even more neutrally. Boring perhaps, at least at the level of the averages. (But maybe more interesting for picking stocks, a theme we discussed in “Separating the wheat from the chaff,’’ i.e., enter the stock picker.)

If we’re right about the overall “boring” outlook for next year, how will we get there? In our view, that path might also be a lot more boring than this year’s ride of the Magnificent Seven. While we understand that it’s hard to bet against these names, given their very positive fundamentals, we think an awful lot of their forward fundamentals have been discounted in their collective 80% rise from their January lows. Rather, when the recession that’s “coming” doesn’t pull into the station on time and in fact doesn’t come, we expect the market to finally broaden out to the very stocks being held back this year by those recession fears: financials, small caps, emerging markets. So, as we exit 2023, our PRISM^® committee is recommending overweights in all those areas, most recently adding another point to small cap value stocks, where a lot of the most cyclical stocks, along with a healthy dose of regional banks, reside. Stocks in these indexes have some of the best earnings growth/rebound prospects in the markets, and ironically at the same time, the cheapest valuations. In all, equities represent 65% of our moderate allocation portfolios, half our maximum potential overweight and the highest equity weighting we’ve recommended in nearly two years. We don’t think next year is going to be a barn burner, for sure. But 9% for the averages, with some active management alpha on top, will be just fine. Maybe even a little boring.