This is a brief overview of Cumberland Advisors’ thoughts on financial markets as we head into 2024. We are coming off an unusual 2023, which was helped by good bond and equity markets late in the year. One of our basic investment tenets is that markets revert to the mean over periods of time, and that is reflected in our outlook here as well.
CIO Thoughts – David Kotok, Co-Founder and Chief Investment Officer
In my opinion, the border and the US labor force are paramount political issues in 2024. The Biden administration has been viewed by many as weak and indecisive, and recurring border failures appear visually on the nightly news without respite. That is one side of the border issues divide.
On the other side we witness the Trump harangues against asylum seekers and immigrants with intensely negative rhetoric. Trump has invoked the historical “blood libel” images used in pre-WW2 rhetoric. It is fueled by Trump’s self-appointed acolyte, Stephen Miller, on the other side. This debate flows to the labor markets.
Economist Torsten Slok of Apollo has noted, “Foreign-born employment in the US is back at the pre-pandemic trend, and native-born employment is still 6mn jobs below the pre-pandemic trend… In other words, the post-covid normalization in the labor force participation rate has mainly been driven by immigration.” Torsten adds that “The same number of retired individuals has remained on trend,” and then he concludes that “The bottom line is that, even taking into account that about 1mn died from covid, there are still around 5mn native-born workers missing.” He concludes, “These 5 million missing workers are the reason why the labor market is tight and why wage inflation is likely to remain elevated.” We thank Torsten for permission to quote him.
We note that in a majority of the Senate and among many in the House of Representatives, there is a bipartisan middle that is trying to get to working solutions. These folks are trying to find a way to make the system work. Will a moderate or centrist compromise unfold? Can bipartisan solutions be reached in this heated election year where the two presidential front runners are an octogenarian and a soon-to-be octogenarian dueling with each other in a repeat of a national election when a very large portion of the voters are seeking other choices? Will the polarizing extremes, whether the alt-left “Squad” or the alt-right “Chaos Caucus,” end up setting the policy for the entire country? (The name Chaos Caucus was originated by Republican Karl Rove in a Wall St. Journal op-ed.)
I believe there are two huge issues that will dominate the election cycle as it unfolds. The first is national defense, about which I have written many times. The other issue is the border, immigration, and labor policies. Right now, the outlook on both fronts is problematic and unpredictable. Right now, financial markets seem to ignore outcomes because they are so unpredictable. One thing is clear to me. The outcome of this debate about defense and about the border will impact the United States for years to come. As the year progresses, we expect these issues to come to the fore and begin to impact financial market prices.
Economic Outlook – David Berson, Chief US Economist
Our view for 2024: choices (because nothing is ever certain in the economy).
With that as a precursor, what do we think will occur to the economy, inflation, and financial markets this year? Crystal balls are rarely clear, and all forecasts are conditional on certain assumptions. As a result, we will present the three most likely courses for 2024 rather than a single guess, accompanied by our subjective probabilities of occurrence.
Much of the difference in views for this year depends on whether you see the historical antecedents of recession as having broken down in this cycle. Or put another way, does the slowdown in the economy and lower inflation at end of 2023 portend a soft landing for 2024, or does the ongoing yield curve inversion suggest that it is an observation on the way from strong growth/high inflation to recession/low inflation?
Outlook #1: A modest 2024 recession (subjective probability 42 percent)
The current longevity and depth of the yield curve inversion is not atypical of the inversions that have preceded all recessions in the post-war period. While the average time from initial inversion to the start of the following recession has averaged about a year, there has been substantial variation in that timing. The current 14-month period since the inversion began is well within the historical spread. Moreover, many observers believe that monetary policy is not contractionary until the real federal funds rate turns positive. Monetary policy was so expansionary during and following the Covid downturn and inflation (from both supply and demand factors) so high that despite Fed tightening that began in March 2022, the inflation-adjusted fed funds rate didn’t turn positive until nearly a year later. In this view, Fed policy did not become actually tight until about 10 months ago. This is the recession-delayed view.
Even if the economy enters a downturn in 2024, the timing is still uncertain – but the second quarter may be the most likely for the start of a downturn. Should we anticipate another Great Financial Crisis (GFC) type of downturn? Or perhaps an average recession? Or maybe even something smaller than that? The good news is that, unlike in 2007, major sectors of the economy are not in severe disequilibrium. So, a deep recession appears unlikely for now (which is not to say that certain sectors of the economy – perhaps office buildings – won’t be hit hard).
Whether we end up with an average or a mild recession, we will almost certainly see the following: rising unemployment rates, lower interest rates (with the Fed easing significantly, although perhaps mostly when the recession is nearly or completely over), a drop in corporate profits, and for a time a decline in broad equity averages. Especially with a mild recession, the resulting drop in interest rates and equity markets should be at the mid to lower end of the scale. We would not expect anything close to the interest rate environment of 2009-10 or 2020-22 (with fed funds at zero and long-term rates at record lows).
Outlook #2: A soft landing (subjective probability 38 percent)
The economic unicorn of a soft landing (when the economy slows to around trend growth, unemployment is mostly stable, and inflation is low and stable) is rarely achieved – at least for long. We did, of course, see long periods of relatively stable growth and inflation between the recessions of 1990-91, 2001, and 2007-09. But they were not soft-landing periods because monetary policy did not tighten significantly (i.e., cause a yield curve inversion) until late in those expansion periods, with recessions following shortly thereafter. They were not periods in which the Fed eased off of its tightening, as we anticipate for 2024. Still, the economy today appears to be in pretty good shape; inflation is falling close to the Fed’s goal; and the Fed itself anticipates easing policy this year.
What would a soft landing look like in 2024? Probably, stable unemployment (perhaps edging up a tad, depending upon how much the economy cools), inflation falling to around the Fed’s 2.0 percent goal by the end of the year (or by early 2025), lower interest rates (mostly on the short end of the yield curve, as long rates have already fallen substantially in anticipation of Fed easing), and probably another good year for broad equity averages (despite valuations being high historically, continued positive earnings and lower interest rates are a good environment for equities).
Outlook #3: Sticky inflation (subjective probability 12 percent
Covid caused both supply-side and demand-side inflation. Supply-chain and production problems appear to be mostly in the rear-view mirror, however, with goods prices from the PCE price index little changed from a year ago in December. But excess demand on the services side continues to run hot, even if somewhat cooler, with services prices up by 3.9 percent from a year earlier in December. While excess savings from Covid relief have diminished over the past year or so, some still remain – keeping consumer spending stronger than it would otherwise be, even with above-trend job growth and low unemployment. Moreover, housing costs are an important element in inflation measures (in CPI more than PCE), and we have been waiting for these components to show more disinflation stemming from market-based measures of rents. Is the lag between the situation on the ground and market-based measures just longer than usual, or is there something more fundamental occurring?
If the economy continues to grow and the job market remains tight, wage gains may also move higher (or at least maintain their current pace), making it additionally difficult for services inflation to fall significantly. And if this large component of overall inflation remains elevated, it will be difficult for overall inflation to dip back to the Fed’s 2.0 percent goal.
In this scenario, sticky inflation – keeping the overall measures higher than expected – would weigh on the Fed’s decision to ease monetary policy. While we view this as a much-lower-probability event than a recession or a soft landing, the odds are not de minimis. Not only would the Fed ease by less than expected, it might not ease at all (and could even engage in some additional tightening). With long-term rates having fallen sharply in recent months with market expectations of significant Fed easing, this could cause a meaningful backup in rates. The outlook for equities is more difficult, as higher prices and continued economic growth would be positive for earnings. Offsetting this would be a higher interest-rate environment than the market expects.
Outlook #4: Everything else (subjective probability 8 percent)
A bonus outlook! Since the subjective probabilities of the three most likely scenarios don’t add up to 100 percent, this is a catch-all category that would include, for example, a more severe recession, a growth recession (slightly positive growth, but so slight it feels like a downturn, with unemployment rising), and boosts to either the supply or demand sides of the economy (the former positive for inflation, the latter negative) that would allow the economy to reaccelerate rather than slow (or go negative). Plus, anything else that would have a low probability of occurrence.
The Fed – Bob Eisenbeis, Vice Chairman & Chief Monetary Economist
The FOMC December meeting minutes were released on January 3, 2023, and were greeted by a slight market turndown. After the meeting, markets quickly priced in the three rate cuts included in the December SEPs (Summary of Economic Projections) for 2024. However, review of the minutes subsequently failed to reveal that there were significant discussions of rate cuts included in the SEPs. Indeed, the minutes themselves suggested that while baseline projections implied that a lower target range might be appropriate by the end of 2024, that outlook was highly uncertain; and it was even possible that, depending on incoming data, the policy course for 2024 might include either further tightening or keeping the current target range in place for a longer period of time than was currently anticipated.
The 5.2% increase in the second release of the estimate for GDP for Q3 2023 was a bit of a surprise, but this was tempered by the downward revision to 4.9% in the final release. Release of the first estimate of Q4 GDP came in higher than expected at 3.3% and for the year was up 2.5% as compared with 1.9% for 2022. At the same time labor markets continue to be tight and appear to be coming into better balance with unemployment, at 3.7%. While inflation had clearly declined over 2023, it was still above the Committee’s 2% target range. PCE inflation, the FOMC’s target index, declined to 2.6% in November, while core PCE was down to 3.2%. For the quarter, the PCE index was up 3.1% while core PCE was up 4.1% To be sure, inflation has been uneven across key components. Energy, core goods, and housing services seem likely to continue to decline; but core services have been increasing. Release of the CPI inflation index for the month of December actually rose to 3.4%, while core PCE declined 0.1 percentage point. While markets backed up a bit on the CPI news, the views moderated upon release of the Producers Price Index, which showed that the prices of inputs clearly moderated in December. The index increased 0.4 percentage points.
After release of the FOMC minutes, we got new data from the Institute for Supply Management showing that its Purchasing Managers Index increased to 47.40, up from 46.70 for October and November. That piece of information was sufficient for the Atlanta Fed to increase its GDPNow forecast for Q4 GDP from 2% to 2.2% and then up to 2.4% upon release of strong consumer spending data in December. On Friday, January 5, we got the jobs report for December. The economy created 216,000 new jobs, exceeding the 170,000 that had been expected.
GDP is above potential for Q4 2023, and this should further dampen expectations that a recession is on the horizon. That strength also implies that the FOMC could be comfortable holding rates steady, notwithstanding the recent increase in the CPI, further dampening the market’s expectation of rate cuts being on the near-term horizon. FOMC Vice Chairman John Williams stated on December 15, after the Fed’s December FOMC meeting, that he felt it premature to be even thinking about rate cuts at this point. Similarly, FRB Cleveland President Loretta Mester, who will be a voting member in 2024, noted on December 18 that she felt that markets had gotten “a little bit ahead” of the FOMC and that the next phase for policy was to focus on how long rates had to remain restrictive to bring inflation down, before being concerned about cutting rates. Just a day later, FRB Atlanta President Raphael Bostic, who will also vote next year, noted that he felt there was no urgency to cut rates, in part because he believed that inflation would come down slowly over the year. That same day, FRB Richmond President Barkin, a 2024 voting member, essentially echoed President Bostic when he said while the FOMC had made good progress in bringing rates down but that he needed to see more evidence of consistency in the data on inflation before rate cuts could begin. The only voting Fed president who viewed rate cuts as likely to be needed in 2024 was FRB San Francisco President Mary Daly. She stated on December 18 that she felt three rate cuts would be appropriate next year.
With four of the five voting Federal Reserve bank presidents already expressing some skepticism about cutting rates in the near term, when might we reasonably think that a rate cut would be likely? First, there will not be a new set of SEPs until March 19–20. This timing means we will likely get no clue as to how views may or may not have changed at the FOMC’s first meeting on January 30–31, unless we hear differently from FOMC members going forward. The Committee will have received the first estimate of Q4 2023 GDP right before its upcoming January meeting, but preliminary estimates are that it will be reasonably firm. In January, the FOMC will only have data on inflation for December, but by its March meeting it will also have more data on inflation, with data on PCE for November, December and January. November’s PCE showed the first decline since 2020 even as employment grew 173,000, revised down from the initial estimate of 199,000 that month. That number was followed with December’s 216,000 jobs. Barring some shocking development, it would likely take large adverse movements in other data, such as a sharp increase in the unemployment rate, for the Committee to conclude that rate cuts were needed.
Looking even farther into the future, since the next SEPs will not occur until March 2024, it isn’t likely that rate cuts would begin before that meeting. For rate cuts to be justified, there would need to be new evidence of a sharp decline in GDP in Q1 of 2024 or forecasts of a significant decline in employment and substantial further progress on the inflation front.
Equity Markets – Matt McAleer, President & Director of Private Wealth
After a strong conclusion to 2023, it is reasonable for both domestic and international equity markets to back and fill for a period. Moderating interest rates along with solid growth projections should lend a bid to pullbacks in indices and sector exposure. As always, we can expect doses of extreme volatility that create opportunity if we are positioned correctly. From a domestic perspective, we are currently using a barbell approach between growth and value in the broad indices. After a difficult 2023, it was encouraging to see value start to perform well in Q4. Any further strength would be indicative of a healthy, broadening market. While we have exposure to large-cap growth, we tend to manage in a more diversified approach to equity allocation and would welcome continued participation from the small- and mid-cap equity sleeve. Q1 2024 will be a very telling period for equities, as growth and tech positions continue to trade well but are trading at levels that do not leave much room for disappointment.
Internationally, we are tilted towards the developed regions and countries vs. emerging markets. Europe and Japan finished 2023 in strong fashion and offer reasonable valuations along with solid dividends. Both areas can be added to on weakness, as we currently have a small cash allocation. From an emerging-markets view, we continue to focus on India and Latin America as those positions have traded in strong fashion recently. While volatile, both areas have benefited from investment capital being reallocated away from China. There will be a time when China is investable, but we have currently stepped aside from direct exposure. Flexibility and approaching markets with an open mind will continue to be key in identifying interesting opportunities.
Taxable Fixed Income – Dan Himelberger, Portfolio Manager & Fixed Income Analyst
2023 was a year filled with volatility as market participants attempted to predict the end of the FOMC hiking cycle. The FOMC ended up hiking the federal funds rate 100 bps in 2023 before pausing after the July meeting at 5.50%. The uncertainty resulted in a significant rise in 10- and 30-year yields. The 10-year peaked up 126 bps to 5.00% while the 30-year rose 127 bps to 5.11% as of 10/19/23. Both rallied to close the year as the Fed’s dovish pivot during the December meeting led to the expectation that rate cuts will be coming earlier in 2024. You can see the complete movement of the 10- and 30-year Treasuries in the chart below.
Investment-grade corporates and taxable munis benefited from tightening spreads during 2023. The spread on the Bloomberg US Corporate Bond Index tightened 31 basis points to close the year at +99, while the spread on the Bloomberg Taxable Muni US AGG Index tightened 36 basis points to close at +92. These declines helped our strategy, as we maintained a higher weighting to these spread securities relative to the benchmark, which has a larger exposure to Treasuries.
As we move into 2024, we will be looking to bring our portfolios more in line with the benchmark after the significant tightening of spreads and drop in yield. You can expect to see us increase IG corporate and Treasury exposure over time. Our goal is to maintain a higher level of liquidity, allowing for more flexibility while making strategy adjustments going into an interest-rate environment that is expected to transition from tightening to loosening as we advance into the new year. We will continue to take a conservative approach to credit while looking to be opportunistic as attractive deals come to market.
Tax-Free Municipal Bonds – John Mousseau, Chief Executive Officer & Director of Fixed Income
It was a November and December to remember for both bonds in general and municipal bonds in particular. After a vicious selloff in late summer and early fall, the bond markets turned around and yields headed lower. The market was aided by a combination of factors: somewhat softer language from the Federal Reserve, some good news on inflation, and jobs reports that suggested the economy was slowing down.
Here is a chart showing the AAA scale for municipal bonds on June 30th, September 30th, October 31st, and year end 2023. Market yields shot up in sympathy with the selloff in Treasuries in the fall. Municipal bond dealers were very fearful of having unsold balances on deals, so they priced deals 20-25 basis points cheaper than the market to clear the deals. This had the effect of repricing the secondary market, and the market retreated in what could best be described as a negative feedback loop. As we have often discussed, markets revert to the mean, and the rally in bonds was just as vigorous as the sell – you can see that with the drop in yields from the end of October to the end of the year. For the general market, which trades cheaper than the AAA scale, this meant many longer bonds saw yields come down from 5%+ to 4%+ in a very short period of time.
Total municipal bond issuance was $391b in 2023, down about 1.2% but higher than most forecasts. As we go forward into 2024, we think issuance will be tilted toward the second half of the year. Most municipal balance sheets are in decent shape from the plethora of revenues during the Covid period, including federal money, sales taxes, income taxes, and capital gains taxes. However, looking ahead, we think most municipalities will face challenges from an economy that is slowing, as well as from balances that have been run down in due course. We are more concerned about municipal credit in general as we move forward (more from my colleague Patty Healy below).
We believe that tax-free bonds – after the November and December rally – are priced aggressively versus US Treasuries and that the progress towards lower rates will be dependent on continued progress on inflation. The bond market rally late in the year steered many market pundits to predict as many as 5–6 rate cuts in the Federal Reserve’s federal funds rate. We think this is too optimistic and that the Fed will want to see a two handle on trailing inflation (i.e., below 3%), or they would react to a larger downturn in the economy. The chart below shows both the trailing CPI and core CPI going back a number of months, but it also looks at the 3-month and 6-month annualized numbers for inflation. While it is easy to see progress on those fronts, it also appears that progress on lowering inflation is coming at a slower rate, and that is pretty normal as inflation comes down. It takes some time.
As we move forward, we still think that the yields on longer tax-free bonds, at 4% plus, are attractive at a 6.35% taxable equivalent basis without any state taxes, to over 7% when some state tax rates are taken into effect. As we head into the first half of the year, we think the forces to push rates down further will be a little trickier than when rates were 100 basis points higher in late October. But there is still good value overall in the muni market, particularly on the longer-maturity end.
Municipal Credit Outlook – Patricia Healy, Senior Vice President of Research & Portfolio Manager
Headwinds abound for munis in 2024 compared with last year, however we continue to expect the overall credit quality of municipal bonds to be stable. Headwinds include the runoff of pandemic aid, lower real estate values for office space, demographic movement, rebuilding pension and pension-benefit obligations (OPEB) funded levels, and possibly a slowing economy. Then there are the event risk threats of cyberattacks, and extreme weather that need to be addressed through insurance, hardening of assets, and computer training and literacy. All municipalities will be challenged; however, stability should come from factors we have repeatedly mentioned: healthy accumulated reserves, better budgeting and fiscal management, established rainy day funds, improved pension management, and more actions to address climate and cyber risks.
Upgrades continued to outpace downgrades in 2023, and we expect a more stable ratings environment in 2024. No sectors have positive outlooks, with the reversion of airport, port, and toll road outlooks to stable now that many of these issuers are back to or above pre-pandemic levels. Mass transit-related credits still have not returned to pre-pandemic passenger levels and continue to have negative outlooks; and a rethink on how mass transit is financed, possibly to depend more on taxes and government grants, may be on the horizon, though that kind of support would probably be less in a declining economy. The healthcare sector and private higher education continue to have negative outlooks, given the difficulty in hiring and higher wages, and the evaporation of pandemic stimulus funds. Higher education is experiencing declining enrollments and cost pressures. State systems and large, well-regarded colleges and universities with strong endowments have stable outlooks. Many smaller private colleges have had steeper enrollment declines and cost pressures, leading some to even close. State and local governments, school districts, and utilities are expected to continue to be stable.
We will be watching how municipalities budget and address any revenue declines. Will they dip into reserves or reduce spending? Use of reserves is not necessarily a credit negative since they are set aside for a rainy day but should be accompanied by a plan to return to balanced operations. We will also be watching increases in debt and leverage as we expect bond issuance to increase later in the year.
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