The underappreciated bullish case for 2024

Summary:

• We outline six reasons why U.S. economy can continue to perform, and equities can remain supported. How growth and rate cut expectations evolve will be key to monitor.

• An abundance of fear over recession and reflation continues. Given our outlook, these risks are best played allocating equities over fixed income and cash, with a tilt to US equities.

• We see tactical opportunities in long duration, dividend-payers such as banks, and small caps, and like gold and USD as hedges.

The U.S. economy and S&P 500 surprised positively in 2023, and we begin this year with encouraging signs that tailwinds can continue in the year ahead. We outline six reasons to stay bullish in 2024 despite well-known risks to the economic and market outlook. Indeed, two wars and several major elections are fueling geopolitical uncertainty, inflation rates are still elevated, and interest rates have sharply risen, yet the U.S. economy has proved resilient, and global growth is showing early signs of recovery. Even Canada has performed better than feared lately as the labour market remains supported.

1. U.S. recession fear is still too high.

One important reason risk assets rallied in 2023 is because expectations were too bearish. While expectations have improved relative to a year ago, consensus continues to expect weak economic growth. US real GDP growth expected in 24Q1 and 24Q2 remains below 2%, despite a stronger than expected Q4 (3.3%) and current Q1 tracking 2-3%. Consensus recession odds have fallen since a year ago but remain elevated near 40% odds (source: Bloomberg, WSJ). Overall, for the past six quarters U.S. growth expectations have been too weak, and modest expectations for 2024 mean there is room for further growth upgrades in coming quarters. Recession fear among investors can explain why cash remains on the sidelines and has yet to be invested (see Figure 1).

Figure 1: Recession and inflation fears keeping cash on the sidelines

2. US outperformance is not transitory.

Against still bearish expectations, we expect US outperformance to continue (see Figure 2). Resilience in US growth limits global recession risks by supporting demand, particularly in Canada, Europe, and China, where growth remains weaker but closely tied to US activity.

US consumers still have the healthiest balance sheets and are the least exposed to high interest rates. Layoffs remain low. Fiscal stimulus continues to support business investment. But most importantly, inflation has cooled despite strong growth, and is likely to slow further this year, paving the way for rate cuts. The start of cuts insulates the more vulnerable consumers and businesses while allaying recession fears, supporting capex, and limiting layoffs. Outside the US, there are also signs that growth is bottoming on the back of improving trade flows and business sentiment.

Figure 2: 2024 real GDP growth expectations underpinned by US upgrades

3. Disinflation trends should continue.

Inflation has failed to reignite despite a tight labor market, strong growth and continued fiscal stimulus in the US. Goods inflation has normalized while services inflation is stickier but also trending lower, likely led by shelter costs this year. Supply chains have played a large role, but rate hikes have also helped cool demand and keep inflation expectations anchored. Fear of a second wave of inflation is overplayed against the current supply-demand backdrop and still tight monetary policy. The 1970s offer a poor comparison but, if anything, tell us that reflation requires a significant commodity shock. That is what we are watching the most. We also note that, unlike commodity-driven inflation, services inflation rhymes with a strong economic backdrop and rising revenues and profits.

4. Don’t fear record highs in the S&P 500 given current fundamentals.

S&P 500 hit a new record on January 19^th, 2024, and has risen to more than 10 record highs since. Looking at returns since 1950, after recording a new high S&P 500 returns are positive more than 60% (Source: Bloomberg Terminal, authors calculation, February 29,2024) of the time over 6 and 12 months.

Moreover, equities are a trending, productive asset linked to economic growth, making it difficult to underweight for long-term investors, especially when recessions fail to materialize. In this cycle, fundamentals underpinning recent US equity performance are the end of rate hikes, the potential start of insurance cuts, falling inflation, rising growth expectations, strong breadth, and strong earnings.

The end of Fed rate hike cycles generally sees a rally in equities (see Figure 3). Since 1970, the S&P 500 returned 7% in the first six months after the last rate hike. Since the Fed’s last hike in July, S&P 500 returned 6% through January, slightly below the median of past cycles. Cross asset performance has been similar as well, with fixed income returns also positive.

Figure 3: Equities usually rally after the end of Fed hikes

5. Fed insurance cuts are bullish for equity returns.

The Fed usually starts cutting rates within 12 months of the last hike. Insurance cuts (or a limited number of rate cuts motivated by normalization or a growth scare rather than a recession) see positive equity returns during the first two years after the first rate cut (see Figure 4). Unsurprisingly, cutting cycles (or significant cuts in response to a recession) generally don’t see positive returns but equities regain their footing meaningfully after a year. In general, the fewer the rate cuts, the stronger the returns for equities.

This matters because we see greater scope for insurance cuts this year amid resilient growth and falling inflation—a backdrop that is not only positive for earnings expectations, but cushions equity valuations, which are sensitive to inflation shocks.

Figure 4: Insurance cuts are bullish for equities

6. Seasonals and US elections support a positive year.

When S&P 500 returns are positive in January, returns are positive for the rest of the year more than 80% of the time since the 1930s, yielding 11% on average (see Figure 5).

Returns during presidential election years are like those in non-election years, but returns are larger when an incumbent is running (see Figure 6). In 2024, the US election is likely to be a race between two incumbents (Trump and Biden). We note that the track record of both candidates proved to be positive for equity markets in the near term after they were elected.

Figure 5: S&P 500 annual performance when January returns are positive

Figure 6: Stronger returns during years of incumbent elections

Summary: Overcoming the tall wall of worry

The six points above are supportive of risk assets, and we think these forces could continue despite an abundance of fear. The resilient US economic outlook could support further outperformance of equities over fixed income and cash and continue to favor US equities. We see tactical opportunities in long duration¹ and a potential rotation to dividend payers, banks, and small caps, i.e., equities most sensitive to recession fear and rates risk. Gold and USD are ideal hedges. Both outperform in recession and reflation scenarios but can also perform in our more optimistic scenario.