With the current market environment continuing to evolve, the investment implications of economic growth, Fed policy, and interest rates are front and center of many investors’ minds. Please see below for an overview of our assessment and outlook.
Key Takeaways:
- Economic growth has been better than expected and current data indicates an increased likelihood of a soft landing.
- The Fed is likely to begin cutting rates this year but is likely to take a measured approach, contingent on inflation and growth data.
- We are positive about the outlook for stocks and expect long-term returns to align with historic averages. Any near-term volatility may offer enhanced rebalancing opportunities.
- Bond yields are more attractive today relative to recent history.
Economy Better Than Previously Anticipated
Economic growth continues to be robust and economic revisions continue to be revised higher. As of this update and per FactSet, the current expectation for 2024 real GDP growth is currently 1.7%. This percentage has consistently crept higher since the beginning of the year when expectations were 1.2% economic growth. Furthermore, just 12 months ago the market was concerned about the potential for an imminent recession.
Continued strength in the labor market has underpinned consumer spending, helping drive ongoing economic expansion. Economic data points have consistently come in better than expected so far this year, as measured by the Citigroup Economic Surprise Index (a measure above zero indicates positive economic surprises).
Soft Landing Probable
Recession probabilities have fallen on the back of improvements in economic data, though expectations are for an incremental slowdown in economic growth this year relative to 2023’s +2.5% real GDP growth rate. In other words, the market expects the economy to experience a soft landing: moderating, but still positive economic growth and no recession.
Risks to the economy appear to be somewhat balanced. On the one hand, a still resilient consumer and easing financial conditions may support GDP growth; while on the other hand labor market rebalancing, tight credit, and leading economic indicators point towards a potential slowdown in growth.
Resilient Consumer Spending
A commonly asked question is why the consumer has been so resilient in the face of the Fed raising interest rates. The composition of U.S. consumer debt may be a big reason why. 89% of U.S. consumer debt is fixed rate (including mortgages, student loans, and auto loans). As a result – and combined with the massive excess savings that were built up during COVID – the Fed’s interest rate policies have had a limited impact on slowing consumer spending.
Measured Rate Cuts Expected
What does a “soft landing” mean for Fed policy? Slower and potentially shallower rate cuts. The Fed is widely expected to begin cutting rates this year, but given the economic backdrop, expect rate cuts to be more measured than what the market had recently priced in. Fed Chair Powell reiterated this view in prepared remarks at the House Financial Services Committee.
Late last year and in anticipation of the Fed cutting rates, the market got ahead of itself, at one point pricing in six 0.25% federal funds rate cuts in 2024. That’s twice the amount of rate cuts the Fed has implied by way of its “dot plot” forecasts. Market expectations have since adjusted lower and are now in line with the Fed’s most recent forecasts from its December meeting.
Historic data supports a more measured approach to cutting interest rates. Per Goldman Sachs research and under prior “soft landing” economic scenarios, the median number of policy rate cuts for developed nation central banks in the first six months of a rate-cutting cycle was three. Assuming the Fed’s first rate cut occurs in June, that’s again in line with the Fed’s “dot plot” forecast.
Complicating the Fed’s job is inflation, which has recently been hotter than anticipated. While we do anticipate inflation to move lower over time, geopolitical issues – namely the recent Houthi attacks in the Red Sea – have increased shipping costs significantly, as ships avoid the Suez Canal. This may put renewed upward pressure on goods inflation. In turn, the Fed may be cautious to avoid overly aggressive interest rate cuts for fear it derails its goal of attaining 2% inflation.
Tighter Monetary Policy Environment
Unless we see a significant deterioration in economic fundamentals, we do not anticipate the Fed is likely to veer far from its current expected interest rate path. For per