Welcome to the second post in our 3-part series on the State of the Markets. In this series, we're focusing on three key areas: how stocks performed in 2023 and what drove performance, where we are now, and what financial experts forecast for 2024. We’ve looked at some factors affecting market performance in 2023. Next, let’s look at where we are now and examine the headwinds and tailwinds that could affect the direction of economic growth and financial markets in 2024.
Where are we now?
To create some context around where the economy stands now, let’s examine where we stood in November 2020. We picked this as a reference point since it represents a moment in which the nation was finally emerging from the pandemic, though not completely out of it, and Americans went to the polls to vote in national elections.
As the indicators suggest, the outlook for the next 3-6 months was mixed. The Federal Reserve’s monetary policy was still accommodative, and interest rates sat at historical lows. Nevertheless, the economy appeared weak, hurt by consumer sentiment and the labor market. We want to draw your attention to inflation in the bottom left-hand corner. It still looked unthreatening at that time.
Now, let’s look at the end of 2022 when many economists and market watchers predicted a recession in 2023. As the indicators suggest, there were good reasons to worry about a recession. As we can see, no economic or financial indicator suggested a strong economy or stock market.
Important measures, like consumer spending, corporate profits, and inflation, were neutral, while monetary policy, housing, interest rates, and leading economic indexes were all in flashing red.
Fortunately, the economy and the stock market were a bit more resilient than many imagined. Despite the gloom entering 2023, the economy and stock market would defy expectations–a reminder that investors should pause before adjusting their long-term investment plans.
Now, let’s take a look at January 2024. As the indicators suggest, “caution” may be a good word to describe the economy as we enter the new year. Consumer spending, corporate profits, inflation, monetary policy, housing/mortgages, interest rates, and the leading economic indicators are all neutral. Additionally, the geopolitical risk and international economic categories are red. It seems that despite the stock market’s end-of-the-year rally, nearly all financial indicators remain neutral as we enter a presidential election year.
Leading Economic Index
Let’s examine one of those speedometers more closely: the Leading Economic Index (LEI). This index includes ten components, ranging from stock prices to manufacturing orders. This data may give a clearer view of where we are when examined together.
As this chart shows, the outlook trended lower throughout 2022 and 2023, though it appears to have bottomed out at the close of 2023. The LEI has been accurate in anticipating the three recessions since the year 2000. However, it appeared to signal a recession for 2023 incorrectly. In fact, GDP growth rose even as the LEI was painting a weaker economic picture.
So, while no economic indicator is ever 100% perfect in predicting the economic future, the LEI remains an important input into developing our views about the economy in the coming months.
Remembering that past performance may not lead to future direction is important. But, as we review charts like these, history can help suggest where we are in the economic cycle. It’s also important to remember that forecasts are based on assumptions and subject to revisions over time. Financial, economic, political, and regulatory issues may cause the actual results to differ from the expectations as you see them expressed here.
From the leading economic indicators and the economic speedometers we just reviewed, it’s clear that “uncertainty” is the watchword for the economy in 2024 economy. The outcomes range is quite wide, as economic performance may turn on a few key variables.
The first potential headwind facing the markets is inflation. While inflation has come down from its post-pandemic highs, it has remained persistently above the Fed’s 2% inflation target. It may handcuff the Fed a bit if inflation remains stuck in the 3-4 percent range. However, at its final meeting in 2023, the Fed said it anticipates three rate cuts in 2024.
That leads to our next potential market headwind – recession. The much-feared recession did not materialize in 2023, but recessions are a natural and inevitable part of the economic cycle. While a case may be made for avoiding a recession this year, there are plenty of reasons that a recession may emerge. Among them are resilience of consumer spending, continued global economic weakness, especially in China, and the surfacing of the delayed impact of the steep rise in interest rates over the last two years.
Corporate earnings may be a headwind. If stock prices are to move higher, they need to improve from recent levels. We earlier showed how third-quarter earnings have hinted at this recovery; the market’s current valuation level may have already priced in this recovery, and should the expected growth in earnings fail to materialize, it will be difficult for stocks to rise from these levels.
Geopolitical tensions are always a wild card for the markets. First, it was the unanticipated invasion of Ukraine in 2022, and then it was the conflict with Israel in 2023. Looking ahead, we see a stalemate in Ukraine, ebbing Western support, and uncertainty as to what follows in the Gaza Strip, and, of course, China’s muscle flexing in the Pacific region remains worrying.
Finally, the stock market now has competition for investor dollars. With bond yields at levels not seen in decades, many investors may find that they can obtain reasonable returns at less risk, leading to fewer dollars to support higher stock prices.
While the headwinds facing stocks are uncertain, they are not to be underestimated. There are several potential tailwinds that may support the financial markets in 2024.
One reason for the rally in the fourth quarter of 2023 was continued deceleration in inflation. If inflation maintains its downward trend, it will be positive for stocks since it may help increase corporate profits and allow the Fed to move ahead with rates cuts in 2024. The caveat here is that the Fed has said it will need to stay committed to the inflation fight.
Another potential tailwind is the prospect of China returning to strong economic growth, which can have broad benefits for the global economy. China’s economy has been struggling under the weight of a late lifting of COVID-related restrictions, among other factors. Nevertheless, they remain a dynamic economy that may only be a government intervention away from a recovery.
Finally, there is the start of a new economic revolution, akin to electricity and computers. Of course, we're referring to artificial intelligence, or AI. The emergence of AI was a big story in 2023 and a major catalyst for the market. Much of the excitement was based on the future potential. This year we may begin seeing the initial real-world impact to businesses as AI potentially turns into a new and substantial revenue stream for the AI ecosystem of providers, from chip makers and software companies to cloud providers through which these AI models operate. Perhaps more importantly, we may also see non-technology companies begin wider implementation of AI in marketing, sales, operations, and administrative functions to drive growth, productivity, and higher profits.
Before discussing the 2024 forecasts, let's examine this chart to see where stock prices trend against historical averages. The most common way to do this is to look at the P/E, or price-to-earnings ratio, which measures investors' willingness to pay for a company's earnings.
Looking at the dotted line in the middle, you can see that the P/E for the last 25 years is, on average, 16.76.
You can also see that the P/E moves quite a bit, with a peak near 1999 and a trough in 2008.
The chart shows that the P/E was 17.83 on September 30, 2023. Does that mean stock prices will head lower or climb in the months ahead? That's difficult to answer. But it's fair to say that past performance does not guarantee future results. And the return and principal value of stock prices will fluctuate as market conditions change.
These were a few of the headwinds and tailwinds that could affect the direction of economic growth and financial markets in 2024. In our next State of the Markets post, we'll talk about what financial professionals have to say about where they think the market is headed in the context of a more detailed discussion of some of the possible headwinds and tailwinds we just finished reviewing. If you have any questions about the market, please contact one of our financial advisors today.
Conference-board.org, November 20, 2023. Chart through October 2023 https://www.conference-board.org/topics/us-leading-indicators
JPMorgan.com, November 30, 2023 https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/?gclid=Cj0KCQiA4uCcBhDdARIsAH5jyUlcc-W0VFSX9QQgC4YoNnyIzgriupxHdS9VoLRqDJEAzva1AU8iBqIaAl0eEALw_wcB&gclsrc=aw.ds