Three Key Thoughts:

1.       Inflation Down, Stocks and Bonds Up
2.       Labor Market Slowing Gradually
3.       A Tricky 2024 for the Fed

Inflation Down, Stocks and Bonds Up
Lower inflation, solid labor market, a growing economy, lower interest rates: this “Goldilocks” scenario came together in the fourth quarter. Starting with the reports for October, inflation began to slow sharply. Stocks took off in November on the expectation that the Federal Reserve was finally done raising interest rates. Bond prices rallied strongly too as investors reversed their “higher for longer” thinking. And the Fed joined the party, confirming at their early December meeting that rate cuts are likely in store for 2024.

The rally in financial assets continued right up to year end, with the US stock market finishing close to, but not quite reaching, a new all-time high. Bond prices more than reversed the decline we saw in the third quarter, with the yield on the ten-year Treasury bond falling from its peak of 5% to less than 4% at year end. So far in 2024, a bit of the unbridled optimism has been tempered but the big picture remains very positive.

The drop off in inflation was broad-based but falling energy costs were the biggest contributor to the decline. Looking at the geopolitical situation today, you would think that oil prices should be higher – Russia engaged in war with Ukraine and the Middle East in turmoil. However, US oil production is at an all-time high, even as global demand is barely above pre-pandemic levels. As the world makes (slow and steady) progress on reducing reliance on fossil fuels, demand growth probably stays in check, keeping prices reasonable. That could change quickly if geopolitical conflicts accelerate. For now, though, energy is a stabilizing force on inflation.

Housing continues to exert upward pressure on reported inflation, even though anecdotally it seems that rents and housing prices have stalled. While it would seem logical for this component of inflation to fall from here, we need to keep in mind that we are very undersupplied on housing, relative to the demographic demand. For now, higher mortgage rates have slowed buyer demand, but this could change quickly if interest rates continue to fall.

Labor Market Slowing Gradually
Through December, the labor market remained reasonably positive, with jobs being added across many sectors of the economy. Two data points are of note, however. First, the biggest increase in jobs in 2023 came from governments, which added an average of 56k jobs per month in 2023, more than double 2022’s additions. Second, wage growth continues at a rate slightly above inflation, which might be expected to continue as compensation tries to catch up with past inflation.

Looking at the jobs creation picture over the last three years, however, indicates a very clear slowing. To some extent, slowing was to be expected from the torrid pace of 2021, when we were emerging from the pandemic. So to cut the three month average job gains in half from the end of 2021 to end of 2022 wasn’t surprising. But it was nearly cut in half again from the end of 2022 to end of 2023. Surely, these numbers fit with a slowing economy and, combined with the decline in the rate of inflation, argue strongly that the Federal Reserve will be cutting rates in 2024.

A Tricky 2024 for the Fed
With short term rates currently set at 5.5%, inflation now running at 3-3.5% and declining, and the labor market slowing, it’s a slam dunk that the Fed will be cutting rates significantly in 2024, isn’t it? Well, not so fast. After having been embarrassed by their incorrect “transitory” inflation call in 2021, the Fed wants to make sure that inflation is down to stay. They don’t want to have to reverse course abruptly as they did in 2022.

The Fed also seems wedded to the short-term data on inflation, the economy and the labor market. These monthly or quarterly numbers can be volatile and subject to big revisions. Ideally, the Fed would like to take its time to see real trends develop. But time in 2024 may be in short supply, which brings us to our final factor: the election.

Usually, the Fed likes to make sure it stays out of the way in presidential election years. This is likely to be true again this year as keeping the economy healthy is a huge priority for the incumbent. If the Fed keeps rates too high, the economy could well slow down too much. And, on the flip side, if they cut rates sharply, they could be seen as trying to help the economy in advance of the election. Bottom line, the Fed faces a tricky year of policy choices.

We expect the Fed will try to get some modest interest rates cuts out of the way in the first half of the year and hope that they can stay out of the way in the second half.

Investment Implications
We get a bit uncomfortable when the consensus becomes an “all clear.” That said, we think there are still opportunities to earn excellent “real” returns on bonds. After a very strong year for US technology stocks, market leadership may shift, making stock selection even more important than usual. We are positive about the prospects for several international markets, except China, as we believe supply chain diversification and a weaker dollar will be tailwinds.