Forecasting the 2024 Markets Outlook: Bonds Triumph Amid Recession Risks and Equity Market Uncertainties

Forecasting the 2024 Markets Outlook: Bonds Triumph Amid Recession Risks and Equity Market Uncertainties cover

Making definitive predictions about the financial future can often feel like a losing game. Yet, years of historical data and the analysis of pertinent indicators can provide us with a dependable foundation on which to base our decisions.

Gazing into the economic crystal ball for 2024, I see yet another tough year ahead for the 60/40 portfolio, with bonds likely to outshine stocks in the year to come. But why? Let's scrutinize the available facts that have shaped my bearish perspective.

Inferring from History: Series of Federal Reserve Hikes

For followers of financial history, the signs may already seem clear. The US economy has just endured the most aggressive Federal Reserve rate tightening cycle in over four decades. Since World War II, there have been 14 Federal Reserve rate hiking cycles; strikingly, 11 of these cycles precipitated a recession. When these hiking cycles didn't trigger an economic downturn, inflation had not strayed too far from the Fed’s comfort zone. However, unlike those three exceptions, this current cycle saw inflation that significantly exceeded the Fed's target.

chsart showing fed interest rate cycles and recessions
Arrows highlight peaks in the Fed Funds Rate onset of recession (Source: St Louis FRED)

Fall of the Confidence Gauge

The Conference Board Leading Economic Index, a reliable barometer of economic prospects, has been trending lower for 18 consecutive months. Historically, this kind of trend is a strong sign that we’re heading for a recession.

chart of the conference board leading economic index
Conference Board Leading Economic Indicator – shaded areas indicate recession (Source: Rosenberg Research)

Coupled with this, the ISM new orders index—a key indicator of future demand—has contracted relentlessly for 14 months straight. A year is a long time in the world of finance, and this declining metric throws up more red flags for the future of the economy.

Ailing Manufacturing Sector

The faltering rhythm of the manufacturing sector is another sign of looming economic turbulence. The ISM manufacturing data shows that this critical engine of the economy has been mired in contraction for 12 straight months. In reviewing past cycles, we can see the Federal Reserve typically cutting rates when the ISM manufacturing index displays such a shrinkage in activity.

chart showing manufacturing activity in decline
The red arrows show the direction of the Fed Funds Rate when manufacturing activity is in decline. Normally the Fed would be cutting rates here (Source: TradingView)

Unsettling Fall in CPI Inflation

Inflation – typically blamed as an obstacle to economic stability – has ironically fallen with alarming speed. In just over one year, CPI inflation has plummeted from a high of 9.1% to a mild 3.7%. To give you some historical context – such a precipitous fall in CPI inflation's trajectory has only occurred five times in the past seven decades. In each of those prior instances, a recession followed. Could this instance be an anomaly? Or is it a reliable warning of another economic downturn?

chart showing an unsettling fall in CPI inflation
CPI annual change in year-over-year percent change – shaded areas indicate recession (Source: Rosenberg Research)

Tightening Credit Conditions

Leading indicators of bank credit suggest a sharp slowdown in the growth of bank lending over the next year. The Fed’s Senior Loan Officer Outlook Survey (SLOOS) suggests that the proportion of banks tightening rather than loosening standards for commercial loans has now hit almost 50%. This has only been exceeded during the worst moments of the pandemic, and the global financial crisis.

a chart showing tighter credit conditions
SLOOS shows severe tightening in credit standards (Source: Bloomberg)

And it’s not just commercial borrowers feeling the pinch. The decline in willingness to make consumer loans has also reached levels consistent with recession.

a chart showing tighter credit conditions
Reduced credit availability to consumers has reached recessionary levels (Source: Bespoke Invest)

Declining credit issuance and availability across commercial and industrial, and consumer sectors will be detrimental to the growth prospects of a credit-driven economy like the US.

Beneath the Surface: Labour Market Weakness

While the headline unemployment figures present a reasonably upbeat image, a peek beneath the veneer exposes problems. Last Friday (November 3rd), nonfarm payrolls came in lighter than expected at 150k. What was more telling, however, was revisions to the prior two months came in at -101k. Negative revisions like this are an important leading indicator.

Nonfarm payrolls, a principal labour market barometer, have seen downward revisions in eight of the past nine months. This reveals an evolving weakness, a vibe of vulnerability building beneath the labour market's façade. Furthermore, in addition to rising tech-sector job cuts, the US economy has seen job losses in the most cyclical sectors of the economy throughout 2023, namely transportation and warehousing, manufacturing and construction.

Equity Risk Premium Warnings

Warning bells are also resonating in the realm of the equity market. The equity risk premium (ERP) —a measure of the compensation stock investors receive for braving the waters of risk over secure bonds—is now negative. This means equity investors are paying for the additional risk in equities rather than being rewarded for it.

chart showing equirt risk premium ERP is negative
The ERP is negative, meaning equity investors are paying for the additional risk in equities rather than being rewarded for it (Source: Apollo Global Management)

At a stock market bottom, the ERP averages 4.25%. A return to a comfortable risk premium will necessitate some combination of a stock market tumble and/or a bond rally. If bond yields were to retract back to 3.0%, the S&P 500 index would still need to fall back to the low 3000s range. Therefore, as the shadows of a 2024 recession lengthen, bond investors could gain respectable returns while equities face a likely downfall from current rich valuations.

The Looming Threat of Recession

Since the 1950s, all recessions have followed a familiar pattern. Leading indicators start to contract (e.g. manufacturing PMI, Conference Board Leading Economic Indicator), then credit issuance contracts (Senior Loan Officer Outlook Survey). This, in turn, leads to a contraction in new orders (ISM new orders) and job losses in the more cyclical sectors of the economy. This is exactly where the US economy is right now.

I expect the Fed will be forced to cut rates in 2024 as the US economy decelerates, contrary to their widely publicised mantra of "higher for longer". Fiscal policy will have limited firepower. The $5.2 TRILLION spent on fiscal stimulus since 2020 has left the US with a budget deficit of 6.3% of GDP. This is the highest-ever budget deficit outside of a recession and coincides with a decline in federal tax receipts that is approaching recessionary levels. Even if the recession is not severe, it will likely be protracted and could last for several quarters.

delcine in tax receipts looks recessionary
The fall in tax receipts this year also looks recessionary (Source: St Louis FRED)

Over $2 trillion dollars of the fiscal stimulus went straight into the hands of consumers. The resilient consumer – thanks to pandemic-related government spending – is a key reason why the US economy has remained so resilient throughout 2023. However, according to research by the San Francisco Fed, consumers are just about to run out of stimulus money.

As bearish as all of this sounds, none of this means stocks have to fall immediately. The stock market does not equate directly to the economy, and the stock market is able to ignore bad news until facing the bad news becomes unavoidable. However, investors should be prepared for a more bearish trend in the stock market in 2024, a year where I expect bonds will shine in comparison to stocks.

If you would like to learn more about the outlook for markets in 2024, I invite you to join an upcoming live online workshop where I will provide in-depth information on how I intend to navigate the markets next year. To learn more and save your spot, click here: