Following strong rallies in 2023, equity markets face several major issues in 2024.
Issue O1: Inflation Trajectory
Inflation has decelerated faster than expected over the last several months, leading to sharp declines in bond yields. Labor markets (especially in the US) have begun to loosen, although wage growth remains somewhat elevated. Core inflation measures are clearly showing signs of trending towards the Fed’s 2% target (and may be artificially high given the lag in elevated shelter inflation data). However, loosening financing conditions and robust consumer spending may restrain further progress on inflation reduction. If inflation continues to decline as, or faster than, expected, central banks are likely to cut rates more rapidly than they have signaled, which would be highly supportive for equity markets.
Issue O2: Economic Growth – soft landing, mild recession, or hard landing
The chances for a soft landing in the US have markedly improved as inflation has fallen quickly without a corresponding surge in unemployment. Consumer spending appears robust, and enterprise technology spending has increased following a lull in 2022.
However, manufacturing data remains weak, and cracks are emerging in the job market (a significant majority of job creation occurs only within government and healthcare services sectors). It is also unclear how much excess consumer savings remain.
The European economy likely entered a technical recession in H2 2023. While excess consumer savings remain higher than the US, Europe is more exposed to global macro conditions and could tip into a deeper recession should macro conditions deteriorate meaningfully in the US or Asia.
Issue O3: Corporate Earnings
Corporate earnings held up much better than expected in 2023. In fact, S&P 500 earnings grew YOY in Q3 and Q4 after declining YOY in H1. A combination of steady demand, cost reduction initiatives, and a catch-up price increases coupled with stabilizing or declining input costs led to margin stabilization or increases.
Analysts are forecasting 5% revenue growth and margin expansion driving 10% earnings growth for the S&P 500.
While we think 7%-8% EPS growth in more likely in 2024, several wildcards including stability of demand and effects of AI on productivity could affect this figure meaningfully.
Issue O4: AI Adoption
50%-200% appreciation across a select group of US technology / internet companies (the Magnificent Seven) helped fuel the S&P 500 25.7% 2023 return (significantly outperforming international markets yet again). Many of these stocks benefitted due to actual or perceived AI benefits.
Continued outperformance for these companies and for semiconductor stocks in general will depend on the level and breadth of AI adoption.
Similarly, it remains to be seen whether broader AI adoption (outside of technology companies) can drive the next leg of corporate productivity growth and margin expansion.
Issue O5: China Government Policy
China’s equity markets have declined 59% cumulatively (MSCI China Index) since their February 2021 peak versus a 13% cumulative increase in the MSCI ACWI Index over the same time frame. Significant changes in governmental regulation aimed at certain sectors, a large downturn in the property sector (accounts for 30% of China GDP), and a weaker-than-expected post COVID recovery all contributed to the decline.
China’s weak equity market performance has dragged down emerging market indexes (-9.3% annualized over the past three years versus +6.7% for developed markets).
It remains to be seen whether China undertakes aggressive fiscal and monetary stimulus (as they did post GFC and in 2016). Thus far, stimulus has been modest and equity markets continue to sell off.
Large scale stimulus would likely lead to rallies in Chinese equity markets and emerging markets more broadly. Additionally, European markets may also benefit under this scenario as Europe is a large exporter to China.
Issue O6: Geopolitical Conflicts
The Middle East seems delicately poised with chances increasing that conflict may widen beyond Israel and Hamas.
A widening conflict would negatively affect global equity market confidence and likely lead to surging oil prices which may reignite inflationary pressures.
The Russia / Ukraine war seems to be in a stalemate with outcomes uncertain.
Issue O7: US Presidential Election
US equity market have generally experienced higher than normal volatility during presidential election years. It remains to be seen whether there may be unexpected policy changes from either the Republican nominee (most likely Trump) or the incumbent (Biden).
As a mitigating factor, both candidates are well-known, and markets have already experienced their economic policies.
Policy proposals espousing a more widespread application of tariffs (favored by Trump) would negatively affect equity markets.
Shorter-term View: Scenarios
We see multiple potential paths for equity returns over the next 12 months (with reference to the S&P 500 which stands at 4,840 as of January 19, 2024).
Scenario A: Optimistic Case
Core inflation falls much faster than expected and the Fed pre-emptively cuts rates by 100bps or more. 2024 real GDP growth ranges between 1.5%-2.0%. Consumer spending remains healthy and steady AI implementation drives corporate profit margin improvement.
Under this scenario, S&P earnings could expand to $245-$250 in 2024 and $270-$275 for 2025 (versus $220 in 2023). Equity multiples may expand to 19.5x-21.0x forward earnings. The S&P 500 index could appreciate to 5,250 to 5,700 by YE 2024 (10%-19% total return).
Scenario B: Base Case
Fed holds rates steady through Q1 or even through H1 2024 and then cuts by 75bps. Economic growth slows but the US avoids a recession. Real GDP growth ranges between 1.0% and 1.5%. Unemployment modestly rises and consumer spending slows but does not decline meaningfully.
Under this soft-landing scenario, S&P 500 earnings could expand to $235-$240 in 2024 and $255-$265 in 2025. Equity multiples range between 18.0x-19.5x forward earnings with the S&P ending 2024 between 4,700 and 5,100 (total return of -1.5% to +7.0%).
Scenario C: Pessimistic Case
Consumers exhaust remaining excess savings and the economy slows faster than expected leading to intensified layoffs. European weakness may exacerbate the swiftness of a global recession. Another pessimistic outcome could be a reacceleration in inflation which leads to additional fed hikes which then leads to a hard landing in late 2024 or early 2025. This scenario leads to faster and deeper equity market declines followed by an eventual sharp rebound once Fed policy pivots.
Under this scenario, the resultant recession is likely to be deeper. S&P 500 earnings may decline 10% from 2023 levels with the S&P 500 declining by 15%-20% from current levels over the next 6-12 months as investors grapple with where corporate earnings will trough. However, such events also increase the chance for an ultimate swift Fed pivot with declining interest rates, which would ultimately lead to sharp equity rallies.
At this stage, outcomes remain highly uncertain and may be influenced by several external variables that are difficult to predict.
Given the significant increase in equity valuations over 2023 coupled with significant remaining macroeconomic risk factors, we would recommend that investors do not add substantially to equities at these levels.
7-year expected returns of 6%-7% are lower than historical averages.
