With the economy slowing, inflation moderating and unemployment claims rising, it is likely that the Federal Reserve has finished raising interest rates for this cycle. The cash built up from the Covid years in individual bank accounts has been exhausted, so the impact of higher interest rates may have a bigger economic bit. Bond market investors are factoring in interest rate cuts in 2024, although comments from Federal Reserve board members fail to collaborate the bond market action. Like the Federal Reserve’s slow response to raising interest rates, it is possible that rate cuts come after the economy “tanks” and multiple cuts are necessary in a panic fashion.
Now with a sharp drop in interest rates, (the 10-Year Treasury has fallen from 5.15% to 4.2% in 7 weeks), will the Federal Reserve suggest the decline of interest rates done by the bond market has done their work and thus do nothing? The implications for the financial markets could be higher bond yields and lower stock prices in the short term. Also, what happens with oil? Let’s think of OPEC cutting oil production by 30% to trigger higher prices (remember 1973-1975) to $100/barrel. Higher oil prices lead to inflation picking up, does the Federal Reserve raise, not lower interest rates? That would violate my education in monetary policy, responding to an inflating supply shock by choking demand with higher interest rates.
10 Year Treasury Bond Yield – Peaked At 5.15% And Dropping Like A Rock Since Then
Our best guess is the first interest rate cut will occur in July 2024. After August, the Federal Reserve will take no further action to avoid election interference. Total interest rate cuts may be 0.5%, less than expected.
Portfolio Strategy
The question most clients are wondering about is the potential returns on their portfolio for next year. For the typical client portfolio that includes an allocation of 60% in stocks, and 40% in fixed income, the expected return could be about 8%. Equities could return about 10% with dividends, in line with average returns during a presidential election year. Fixed income could deliver 5% returns for clients assuming longer-term interest rates don’t move materially over the year. Our goal is to outperform both markets by finding a few bargains and nimble trading. Most client portfolios are fully invested, and our investment strategy is to remain so for the short term. We are in the seasonally strong period for equities that usually lasts until May.
Looking into 2024, the setup is good, but not perfect for investors. Inflation is subsiding, the Federal Reserve is moving away from dominating the financial markets, and money market balances are high providing fuel for the next round of equity and bond purchases. The outlook for stocks and bond market strategies is detailed below. At present, we do not plan any major changes to the mix of equities and fixed income. We may shift the mix of holdings to more attractive sectors within the asset classes. However, circumstances may quickly change, which may warrant a reduction in equities and increase in fixed income as the year progresses.
Gross Domestic Product Consensus Estimates For 2024 Suggests Growth Of 1%. Pretty Sluggish, But Positive
While we have expectations for a generally positive 2024, there will be setbacks. The presidential election will be a challenge for the second half of the year, especially since the most popular candidate choice is “none of the above.” Other potential hiccups include higher oil prices or labor costs that spur inflation to reverse higher. Further, there are the usual known risks including geo-political issues of trade or actual wars including Taiwan and Russia progressing war beyond the Ukraine with China’s help. Natural disasters will be a factor, we just don’t know where. This issue may have greater consequences as the Federal government may not be able to cover the cost of rebuilding as it has done historically. This is an issue for municipal bonds. Just think if you owned Fort Myers sewer bonds in the wake of Hurricane Ian? In the financial markets, the domination of the SP500 to 7 mega cap companies presents a risk of one of them faltering. There are many other risks to consider, while the ones that most impact the markets are the issues that no one ever considers until they occur.
Fixed Income – Yields Still High, but off the Peak Levels.
Although interest rates have recently fallen, yields still offer attractive opportunities relative to the past decade. With our expected range on the Treasury 10-Year bond between 4% to 5% in 2024, the investment opportunities in high quality corporate bonds range in yields of 5% to 6% and tax-free municipal bonds yielding 4% to 5%.
High quality bonds make up the majority of our fixed income portfolios. Our strategy remains to match up annual maturities to a client’s projected portfolio withdrawals over the next five to seven years forming a bond ladder. Across all portfolios, the average Standard & Poor’s credit rating is AA- and the yield to maturity is 4.3%.
The largest fixed income holding is the Fidelity Conservative Bond Fund yielding 5.27%. As the Federal Reserve reduces interest rates, possibly 1% in 2024, the yield on this fund will drop by a similar amount. This fund has been a great strategy during rising interest rates thus it may be appropriate to shift some funds to individual bonds where the long-term yield to maturity may be better over the next few years. As we review each client portfolio, we will be considering this strategy.
Equity Strategy
Our expectation for the equity market performance is for average total returns of about 10% (with dividends) in 2024 with the bulk of gains coming in the first half of the year. Historically the presidential election year is the second-best year during the four-year cycle. Many models are pointing towards an economic slowdown that does not necessarily rule out corporate earnings gains. Corporate earnings could benefit from improved supply chains, less labor cost pressure, and lower energy costs. Moderating inflation will keep the Federal Reserve from further interest rate increases, thus removing a significant fear from investors.
SP500 Rallied 12% From The October Lows, But What’s Next?
At present, the equity holdings are concentrated in mega and large cap holdings. Some of the 2023 big gainers may consolidate the 2023 gains with 2024 but still have solid long-term holdings. Technology holdings in Microsoft, Nvdia, Apple and Adobe are trading at valuations well above the market, but their superior earnings growth and high return on capital justifies the premium. Nevertheless, the upward trend of many of these stocks may need a consolidation period before resuming a bull market.
One segment of the equity market that has been underperforming the SP500 for years is the small cap market. Small cap stocks have been hurt by higher interest rates and an economy that favors larger businesses that have more significant business leverage. Further, investors have pulled billions of capital from small cap funds to participate in the large cap growth rally. Lower interest rates could spark renewed small cap investment. Historically, when small cap stocks begin to outperform, the gains are very strong. We have begun to increase exposure to the small cap segment by investing in the Pacer U.S. Small Cap Cash Cows (CALF) that focuses on companies with strong cash flow. Also, we hold a position with PGT Innovations, a leading provider of windows and doors. We just started investing in Next Era Partners, a leading renewable energy provider that has gotten crushed by higher interest rates.