New All-Time Highs at Last
- The S&P 500 Index set an all-time high for the first time in more than two years Friday.
- Setting all-time highs is generally supportive for markets, and they’re even better if it’s been a year or more since the last one.
- On the bond side, our base case is the Fed will cut rates 4-5 times this year with the first cut in May.
- As discussed in our 2024 Market Outlook, we believe the rate cuts would support a 4-6% total return for the Bloomberg U.S. Aggregate Index in 2024.
- For a broad view of our expectations for the economy, stocks, and bonds in 2024, download our 2024 Market Outlook.
It took more than two years, but the S&P 500 closed Friday at an all-time high. The previous record high was set on Jan. 3, 2022. Of course, that was followed by a vicious 25% drop and a bear market, sparked by the war in Ukraine, supply chain challenges, a generational spike in inflation, China on lockdown, and the most aggressive Fed in four decades. That bear eventually ended in October 2022, and since then stocks have defied many experts, who continually (and incorrectly) touted a weakening economy, tapped-out consumer, and many other reasons to doubt the new bull market. Fortunately, we’ve been on the other side of the strategist consensus, as we’ve firmly believed stocks would surprise higher and the economy would remain resilient.
The S&P 500 moved to 500 stocks in 1957 and, perhaps surprisingly to many investors, 7.1% of all trading days since have set new record highs. That is a new high nearly every 14 trading days! In other words, the S&P has set more than 1,000 new highs since 1957, so investors shouldn’t treat them as a reason to worry or panic. They are perfectly normal. While new highs were set before bear markets in 1987, 2000, 2007, and 2020 in recent memory, the market has also made spectacular gains following new highs. In general, these records have not been warning signs.
In particular, if it has been a while since a record high was set, such as there was before Friday, the outlook historically has been very good. The S&P 500 has gone at least one year without setting a new high 13 times. After the new high was set, returns were better than average and were higher 12 times one year later, up more than 11% on average with an even better 13% median return.
For the investors who withstood a bear market amid a barrage of continued negative headlines, congratulations on staying the course. The good news is we don’t think this bull market is over and 2024 may bring more gains.
Rate Cuts on the Horizon, But Timing is Uncertain
A key theme in 2024 is likely to be the Fed (again). In 2022, the big question was how high the Fed would raise interest rates (a lot), and in 2023, it was whether the Fed would cut rates (it didn’t).
Coming into 2024, it seems fairly certain the Fed will cut rates. As we wrote in our 2024 Market Outlook, rate cuts are now on the horizon thanks to inflation easing back to the Fed’s target. In fact, at their December meeting, Fed members projected three cuts (each worth 0.25%) in 2024. This was based on their projection of core inflation, as measured by the personal consumption expenditures index (PCE), easing to 2.4% by the end of 2024. Since then, December inflation data for the consumer price index and the producer price index have indicated that core PCE is likely to rise less than 0.2% month over month in December. That translates to an annualized rate of 1.9% over the last six months and 1.6% over the last three months.
In short, the inflation problem is over — at least for now. And therein lies two burning questions that investors are currently asking of the Fed:
- How soon will the Fed start cutting rates?
- How much will the Fed cut in 2024?
Fed members expect just 0.75% worth of cuts this year, based on a core PCE projection of 2.4%. But core PCE is clearly running well below that point. As a result, investors are a lot more optimistic about the prospect of rate cuts and are answering the above two questions as:
- Rate cuts will start as soon as March.
- The Fed will cut interest rates by about 1.6% in 2024.
But these are not certainties. At the end of 2023, the probability of a cut in March had risen as high as 90%, and it pulled back to 67% last week. So, the odds have gone from a near-sure thing to closer to a coin toss.
Fed Officials Are Not Quite There Yet
On Tuesday, Fed Governor Christopher Waller, who’s been ahead of the curve with respect to policy within the Fed, suggested in a speech that the first cut may not come as early as March. In fact, the title of his speech was “Almost as good as it gets … but will it last.” That should tell you where Fed officials are currently.
Waller acknowledged the remarkable progress in lowering inflation, even as the labor market stayed healthy and the unemployment rate sub-4%. But he wants to make sure that’s sustainable. As a result, Fed members don’t want to be rushed into cuts. Waller noted that in the past the Fed had lowered rates reactively, quickly, and by large amounts, but that was after shocks to the economy threatened recession (like in 2000-2001 and 2007-2008). However, this time he sees no reason to “move as quickly” or “cut as rapidly” as in the past.
The key is that Waller believes the other part of the Fed’s dual mandate, the labor market, is close to maximum employment and there’s no reason to think that’s deteriorating. Certain data have weakened recently, but Waller put that down to normalization more than a looming sign of collapse (we agree). That said, he noted that risks are balanced. There is a risk that the labor market could break, just as there is a risk that inflation could rise again. That focus is in contrast to the past 18 months when the Fed’s sole focus was on the risk of an inflation spiral.
Waller’s comments suggest Fed members are ready to cut to avoid keeping policy too tight and risking a break in the labor market. However, they don’t appear ready to move as early as March. We believe the first interest rate cut may come in May, unless inflation data over the next six weeks surprises to the downside or we get terrible payroll numbers.
As for how much the Fed will cut in 2024, the jury is still out. We expect to see rate cuts but perhaps no more than 1-1.25% (the equivalent of four to five 0.25% cuts), assuming the economy continues to avoid a recession and the labor market holds up.
In the meantime, don’t be surprised if markets swing back and forth wildly as investors hope for more rate cuts and wary Fed officials push back.
Bonds Are Back, But Stocks Look Better
We at Carson Investment Research just released our 2024 Market Outlook: “Seeing Eye to Eye.” While our view on the economy leads us to favor stocks over bonds in 2024, we believe bonds are poised to return to their traditional roles as portfolio stabilizers and sources of diversification. As they normally do, bonds are again acting as a strong source of income, even at shorter maturities.
Many investors’ fixed-income holdings still heavily favor short or ultra-short maturity bonds or cash-like vehicles. According to quarterly Federal Reserve data, money market assets were more than $6 trillion at the end of the third quarter of 2023, roughly double what they averaged from 2011 to 2017. We believe 2024 may see substantial demand for bonds as market participants anticipate the Fed beginning to lower short-term rates, which may help anchor yields despite some likely continued volatility.
Our outlook for the total return of the Bloomberg U.S. Aggregate Bond Index (Agg) in 2024 is 4-6%. That is based on a yield of 4.65% as of Jan. 16 and a stable yield outlook overall given our expected path for inflation, the Fed, and the economy. It is possible that some bond gains were pulled forward when yields plunged in the fourth quarter of 2023, but we still maintain a favorable outlook.
While our outlook is for a favorable economic backdrop for credit-sensitive bonds, we’ve grown somewhat more cautious because credit spreads are already tight and we see more upside for equities, including some pockets of attractive valuations. We recently raised the credit quality of our bond allocation while still maintaining some overweight exposure to credit-sensitive bonds.
Longer-Term Yields May Not Follow Short-Term Yields Lower
There will be two competing forces on yields in the coming year: the typical pattern of falling short-term yields from prospective Fed rate cuts pulling longer-term yields with them. That force is opposed by some likely normalization of a still heavily inverted yield curve, which would make long-term yields less responsive, or even unresponsive, to short-term yield changes, especially in the absence of a recession.
Since 1963, the three-month Treasury yield and the 10-year have moved in the same direction, using annual data, 74% of the time. And when they have moved in opposite directions, the changes have typically been small. The change also scales well in general — larger changes in one means larger changes in the other. On average, the 10-year yield moves 0.5-0.6% for a 1% move in the three-month yield. From that alone, you would expect four Federal Reserve rate cuts by the end of the year (our current base case as discussed above) to lead to about a 0.50% decline in the 10-year yield.
On the other side, the yield curve is still very inverted (long-term yields lower than short-term yields), which is not the normal relationship. Currently, the 10-year yield is about 1.38% below the three-month yield. Historically, on average, it’s 1.32% above it. That would mean the three-month Treasury yield, which runs at about the level of the federal funds rate, would need to fall 1.70%, or the equivalent of almost seven cuts, without the 10-year Treasury moving at all to get back to an “average” level of steepness.
Because of that, our base case is a relatively stable 10-year yield over the course of the year with a slight downside bias supported by demand, depending on the path of rate cuts. Even if yields end near where they began, the path may be somewhat bumpy as above-average inflation increases rate volatility. Nevertheless, we don’t think the path will be nearly as volatile as 2023 when the 10-year yield finished about where it started but with giant swings in between.
The Risk of Short-Term Bonds
Probably the most common bond question we’ve received over the last year is whether it’s safe to lengthen the maturity profile of bond holdings and hold a more traditional core bond portfolio again. That question is just as relevant for 2024, and we believe the answer is yes.
The main risks with short-maturity bonds are not losses (although they can experience some short-term losses) but that investors may have to settle for a lower rate if yields drop (reinvestment risk) and lose the added portfolio ballast if equity markets become volatile and bonds return to their role as a diversifier.
At the same time, some bond features make core bonds less likely to experience the types of losses they have experienced over the last several years. First, higher yields mean higher coupon payments to offset potential price losses from raising rates, making fixed income more resilient. Over the long run, coupon payments are overwhelmingly the main driver of bond returns, not price changes, since every bond’s eventual price at maturity is fixed at the par value of the bond. That’s why bonds are considered a safer investment. It doesn’t matter what the price is now — investors know exactly what the price will be at maturity (outside of default risk). In early 2020, the Aggregate Bond Index (Agg)’s yield would have had to climb just 0.2% over a year to generate a flat return. Anything more than that would have resulted in a loss. Now it would require a move four to five times as large. (Some of that resilience can also come from the natural price movement toward par over time.)
These features of bonds also make the Agg’s yield a strong predictor of returns over the long run. Of course, climbing yields are why bonds have seen losses the last several years, but those bond losses do point to stronger return prospects in the future. As noted above, the yield to maturity for the Agg on Jan. 16 was 4.65%. The average yield from 2010-2021 was just 2.34%.
As shown in the chart below, annualized returns for the Agg over the next eight years track the yield at the beginning of the period fairly closely, coming within +/- one percentage point annually 74% of the time. By contrast, current short-term bond yields are a weak predictor of future long-term returns because the yield is only good for a short time before the bond needs to be rolled over. And it’s hard to forecast where short-term bonds yield will be in the future, especially as you move further out.
Another way of saying it: Short-term bonds have low short-term return uncertainty but high long-term return uncertainty. Long-term bonds have relatively high short-term return uncertainty but relatively low long-term return uncertainty.
Our recommended maturity profile for bond holdings was quite short at the beginning of 2023. We slowly faded rising rates over the course of the year and moved just short of the Agg toward year-end. This final move was based on the historical pattern that intermediate-maturity bonds start to outperform ultra-short maturity bonds in the six months before the first rate cut after a hiking cycle. This isn’t surprising, as markets are forward looking. We believe the effect in 2024 may be consistent with the past but somewhat weaker, since many initial cuts historically are in response to an economy entering a recession following Fed overtightening, which is not what we expect to see next year.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ 100 Index is a stock index of the 100 largest companies by market capitalization traded on NASDAQ Stock Market. The NASDAQ 100 Index includes publicly-traded companies from most sectors in the global economy, the major exception being financial services.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
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