2024 is set to be an interesting year as central banks shift gear and move into the next stage of the rate cycle. While interest rate cuts will undoubtedly play a leading role in the direction of global equity markets, countries making up nearly 70% of global GDP will face general elections in 2024, which also has the potential to sway markets.
After rates peaked in 2023, 2024 should deliver the first rate cuts and kick off the next chapter. While the Fed and the market differ on the quantity of rate cuts expected in 2024, there is no doubt that rate cuts will be positive for equity markets.
As we look at what to expect in 2024, we see a soft landing becoming more of a reality, with continuing disinflation supporting real yields, allowing the Fed more room to cut rates. With this backdrop, equity markets are set up for another year of good returns, supported by historical precedent, valuations, earnings, and bulging money market accounts which will be searching for better returns. 2024 is set to be another year for active managers, with the potential to deliver returns of between 10-15%.
Rate Cuts Coming
We have just come through an 18-month period where U.S. interest rates were raised 525bps; one of the steepest hiking cycles in history. Rates peaked in July last year as the Fed’s policy measures successfully turned around inflation and put it on course to return to its 2% target rate. The Fed’s job is to succeed in maintaining inflation’s glide path without causing any significant damage to the economy. This sets up 2024 for the first cuts of this cycle. As of the Fed’s December meeting, Fed governors are forecasting three 25bps cuts in 2024, while the market is currently forecasting up to six 25bps cuts.
Clearly the talking heads are all focused on whether there will be 3 or 6 cuts, and who will be forced to concede. This will be a second half of the year problem, the focus in the first half of the year will be on when the first cut occurs. Equity markets will no doubt react positively as and when the first cut is delivered.
History suggests that equity markets perform strongly after the Fed are done hiking and we enter the cutting cycle. Historically, the S&P 500 has rallied between 20-30% and 40% over the subsequent 12 and 24 months after the last interest rate hike, respectively. Currently the S&P 500 is up only 5% since the Fed’s last hike in July. If history is any guide, we still have plenty of upside!
Applying some science to calculate the magnitude of interest cuts we can expect, we look at real interest rates (U.S. 10-year yield less CPI). The Fed has stated that the real interest rate level that is neither stimulatory nor contractionary is around 1%. Real rates are currently 0.62% (black line in the chart below); assuming the Fed would like to keep real rates in this area, the Fed currently has room to make cuts without impacting real rates [Capacity to cut = Fed Rate – 2yr Government yield (blue bars)]. CPI is currently sitting around 3.2%, so as CPI falls toward the Fed’s target of 2%, the more room the Fed has to cut rates to prevent real rates rising into contractionary territory. If inflation falls to 2.5%, that gives the Fed room for a further 75bps of cuts.
The graph above is a slightly complicated way of demonstrating that the market’s current expectation for 6 cuts is not without merit.
Valuation Can Be Misleading
Market commentators like to focus on the Price-to-Earnings multiple as a reference point to whether the market is attractive or not. Currently the S&P 500 is trading at 19.5x forward 12-month earnings, which is slightly higher than the 5-year average of 19x. This higher-than-average multiple is a stick used by the bears to suggest any further upside in stocks is limited.
This time is different… the market has developed multiple personalities since the pandemic. One needs to look deeper to make a more comprehensive valuation call on the market. In 2023, the Magnificent 7 (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla) significantly outperformed the other 493 S&P 500 stocks. Given their inherent higher multiples and increased weighting in the index, this resulted in the Magnificent 7 singularly pushing the S&P 500’s PE multiple higher than average. Digging below the surface and excluding these 7 stocks reduces the S&P 493 PE multiple to 16.5x; 1.5 multiple points below the 10-year average and sending quite a different message on upside potential.
Earnings Growth Returns
The second major contributor to market performance, alongside valuation expansion, is earnings growth. Over the last 2 years, the S&P 500 has showed relatively negligible earnings growth, delivering only 5% in 2022 and slightly negative growth last year. In 2024 we are set to see the return of double-digit earnings growth, with analysts currently forecasting 11.5% Y/Y earnings growth. The resumption of double-digit earnings growth supports share price appreciation.
15% Potential Upside
The pantomime of any outlook piece is trying to put a number on what return one can expect over the next 12 months. While a fool’s errand, we try put some maths into our call. We view the S&P 500 as 2 separate markets: Big Tech and the Rest. Rate cuts and a return to earnings growth will drive the Rest, while accelerating growth potential driven by AI and Big Data will continue to support Big Tech. To put this into numbers, assuming FY25 S&P 500 earnings growth of 10% ($267) and a market multiple that remains in the 19.5-20x range, comes to an index level of 5300-5400; representing 12-15% return.
As interest rates increased during the year and money market funds became more attractive, this sucked funds out of equity and bond markets into money market funds. U.S. money market funds increased from $4.5trln to almost $6trln, as interest rates increased from 2% in June 2022 to 5.5% currently. As we begin to see rate cuts around mid-year, we would expect some of these flows to reverse as investors sell out of money market accounts in search of more attractive returns.
Alongside record money market fund levels, Global Fund managers continue to be generally underweight equities. Although, we are recently seeing the first signs of this sentiment changing. Not only are market fundamentals attractive heading into the rate cutting cycle, but there is also a significant quantity of cash that can flow into equity markets as sentiment changes and drives price levels higher.
Soft Landing Becoming a Reality
There remains some skepticism that the Fed can pull off an elusive “Soft Landing” – the ability to reduce inflation without driving the economy into contraction. Commentators are divided, on the one side if the market is correct and we get 6 cuts this year, that reflects a scenario where the U.S. economy is heading into recession forcing the Fed to cut aggressively. Alternatively, the U.S. economy remains as resilient as it was in 2023, resulting in above target sticky inflation that will reduce the Fed’s appetite to cut rates. The possibility of 6 rates cuts and economic resilience, is mostly viewed as being mutually exclusive.
We are less concerned about the exact quantity of interest rate cuts and more focused on the directional change. As discussed earlier, we do think that the Fed will have room to cut between 3-6 times without inflation having to drop all the way to 2%. Additionally, we are also comfortable that the U.S. economy will avoid a damaging recession.
Globally, central banks have done an admirable job successfully bringing inflation down from its highs in 2022. While most measures of inflation remain above the banks’ target, they are moving in the right direction with all major developed markets seeing inflation in the 2-3% range in 2024.
GDP Growth Slowing
One of the big surprises in 2023 was the resiliency of developed market economies in the face of record interest rate hikes and inflation. Forecasts for all major economies to experience some form of economic contraction in 2023, never materialized. In fact, we actually saw U.S. GDP growth gain momentum throughout the year.
Looking ahead, we expect U.S. GDP growth to be slower than 2023, but remain positive and slowly accelerate towards the backend of the year as the impact from interest cuts begin to materialize.
Confident Economy Remains Resilient
Economic growth is an aggregate of many moving parts. However, there are a few major components that allow us to note the state of the economy in general – Consumer and Corporate health, the housing market, and the state of companies’ inventories.
Consumer spending makes up more than two-thirds of GDP, thus the health of the consumer is a key determinant to the direction of economic growth. The U.S. consumer remains very well placed. Spending in 2023 benefited from more than $2trln of excess savings built up during the pandemic. While exact numbers vary, the U.S. Consumer still has anywhere from $300mln to $1.2bln in excess savings available to support spending going forward (equivalent to more than 12 months of personal expenditure). Consumer balance sheets remain stable, debt service costs are at historically low levels, and the majority of homeowners have locked in mortgage rates at levels around 3.74%. Consequently, we don’t see a significant threat of default.
Higher inflation diminished purchasing power in 2022 and 2023, forcing the U.S. consumer to tap into savings in order to sustain their standard of living. However, as inflation falls and wage increases remain strong, consumers once again are earning positive real earnings and suggests spending will be supported going forward.
In the same vein, U.S. corporates continue to be in good shape. Most took the opportunity to refinance debt when rates were much lower. Interest coverage ratios remain at the lowest levels in 40 years alongside healthy cash levels. Corroborating this, interest spreads on corporate and high yield bonds reflect levels that suggest bond markets are very confident that U.S. corporates are unlikely to default on loans and meet debt payments.
These metrics point to U.S. consumers and corporates who generally remain in good health, showing little signs of any major stress.
Imbalances in the housing market and companies inventory levels can also be precursors for recessions. Housing fundamentals are showing little signs of strain with households in significant positive equity positions, with manageable debt service levels.
Inventory levels remain at reasonable-to-low levels, suggesting minimal risk of a massive inventory correction weighing on the economy.
The current backdrop does not throw up any red flags.
We expect 2024 to be another good year for Global Equities. Rate cuts are typically positive for stock markets, together with reasonable valuations and the return of double-digit earnings growth we have the ingredients for solid returns in 2024. There remains a significant level of cash sitting on the sideline that can be put to work as rate cuts commence; providing fuel to drive equity markets higher.
Both the U.S. consumer and corporates are well placed with strong balance sheets and debt service costs at low levels. Coupled with low inventory levels and a massive positive equity buffer in the housing market, encourages us that the Fed can indeed pull off a soft landing.
Aside from rate cuts, general elections as well as geopolitics will also be front and center this year.
Taking this all into consideration, we forecast that investors can earn close to 15% return in 2024.