Markets are starting 2024 on a solid foundation: The U.S. economy is expanding and the Federal Reserve has said it’s likely done hiking rates and might even cut rates this year.
But that relatively positive economic outlook is not necessarily the best for investors. “A lot of good news is already priced into the markets, which implies asset valuations may make it more difficult for returns to surprise on the upside in 2024,” consultants to pension funds, endowments and others wrote in a new Fidelity Investments report. With asset prices always sensitive to surprises, Fidelity cautioned institutional clients about some potential stunners to watch out for this year.
“The U.S. may be headed for its longest late cycle expansion on record, overcoming a treacherous global backdrop that includes a lethargic Chinese economy — the world’s second-largest — and wars in both Ukraine and the Gaza Strip,” the report says. “Nevertheless, a powerful year-end rally in 2023 solidified that a lot of good news now is priced into asset markets. This implies asset prices may be vulnerable to either a persistence of inflation or negative economic news as 2024 progresses. Or maybe there are other less visible positive surprises lurking in the year ahead.”
In 2022, the Fed began aggressively hiking its benchmark interest rate to tamp down inflation. It worked and consumer price inflation slowed in 2023 to between 3 percent and 4 percent, depending on the measure, without wrecking the U.S. economy (although a recession is still possible). Markets last year reacted to the fall in inflation as if victory was achieved, but Fidelity thinks that might have been premature.
The breadth of inflation has expanded, meaning where inflation is relatively prominent has changed. Goods inflation has all but disappeared but housing and services ex-housing have remained elevated and steady — resulting in the median and the trimmed mean of the CPI Median drifting higher late in 2023, the Fidelity report points out. And inflation — which is still above the target rate — could end up being stubbornly persistent in 2024. Fidelity also noted that while the overall unemployment rate has ticked slightly higher, it remains near an all-time low and demographic trends continue to point toward an aging U.S. workforce and a declining number of working-age adults.
Additionally, the fall in inflation may hit a limit as globalization continues to be pressured and as new geopolitical risks disrupt supply and demand for natural resources. Fiscal and monetary policy tend to remain accommodative alongside record-high levels of debt — something else inflationary. “The financial markets may be overly sanguine about how easy it may be to achieve the ‘last mile’ of disinflation,” according to Fidelity’s report.
Fidelity also thinks the economic future is more opaque than markets led on at the end of last year, which could put the Fed, and ultimately institutional investors, in a tough spot.
“At the end of 2023, financial markets priced in expectations for about 150 basis points of rate cuts during 2024. If this happens because disinflation continues while the economy hums along, it should continue to be a constructive backdrop for asset prices. Given our inflation outlook, we’re concerned that if this much monetary easing occurs, it’s because recession risks have increased,” Fidelity says.
But what if the opposite happens? That wouldn’t be reassuring to Fidelity: “Conversely, if the economy and inflation remain solid and the Fed doesn’t cut rates aggressively, bond yields might rise again on the disappointment. After all, markets prematurely priced in Fed easing several times during 2023.”
While many celebrate what seems to be the soft-landing achievement, Fidelity’s report also alerts investors that a soft landing comes with its own baggage. The late-cycle expansion could face greater risks in 2024 than what is being appreciated. For example, special situations firms are drawing attention to the difference between the current health of publicly traded companies compared to smaller private ones, some which are in dire straits.
“Earnings expectations may be too high. Analyst estimates imply a profit rebound of about 11 percent in 2024, on the heels of a slight contraction in 2023. If businesses have less pricing power and slower top-line sales than when inflation was running hotter, they’ll probably need to increase profit margins to meet the market’s growth expectations. If those margins deteriorate, we’d be more concerned about demand for workers and knock-on effects to consumer spending, as well as rising recessionary risks,” Fidelity says.
Considering the late-cycle environment, Fidelity says investors should keep their portfolios flexible as they navigate the many crosscurrents.
“Beyond a focus on diversification, the current environment will continue to warrant smaller portfolio tilts relative to benchmarks, which could allow for some dry powder to take advantage of improved valuations going forward. Fixed income continues to be relatively attractive,” Christian Pariseault, head of Institutional Portfolio Management at Fidelity Investments, told Institutional Investor.
