A Cycle for the Ages

By: Liz Young · December 15, 2023 · Reading Time: 15 minutes

Business cycles are one of the few things we know we can count on to repeat over time. My 2023 outlook included a section titled, “respect the cycle,” as a reminder to be aware of the market’s typical behavior during different points along that timeline. Whether we are in the early, mid, late, or recessionary phases of a business cycle is subjective and something investors spend arduous amounts of time trying to figure out.

We can count on the cycle repeating, but we can’t count on how long each phase may last. The title of last year’s outlook was “This Ends One Way or Another”. It was referring to the end of the fight against inflation, the debate over whether or not we would have a recession, and if the market could break through the resistance levels that had been haunting it at the end of 2022. Clearly, I was wrong, it didn’t end in 2023. Many of the questions we were asking then, we are still debating now (with the exception of those late 2022 market resistance levels, which were more than transcended in 2023).

I remain confident that we are sitting in the latter part of the cycle and at some point, there has to be a turn. What I’m less confident about is how it has to happen. There are painful ways to get through this and palatable ways. The current state of economic indicators and market divergences leave us in as much of a heated debate over recession/no recession (urban dictionary would call it “hard landing/soft landing”) as ever before. But one thing is indisputable, this is a cycle for the ages.

It’s Been a Long Year… for Bears

Bearish sentiment was easy to come by at the beginning of 2023. Not just bearish sentiment on the stock market, but also pessimism over the Fed’s ability to control inflation, the economy’s fortitude to withstand rate hikes, and consumers’ willingness to spend as they embarked on a second year of high and still rising prices.

Despite a moment in March during the regional banking crisis when it felt especially precarious, most things held up well, or at least didn’t blow up into the catastrophe many expected. I was certainly on the cautious side of the fence and did not expect the protracted late-cycle behavior we’ve seen.

Inflation came down faster than anticipated, much to the delight of markets as rate-sensitive sectors soared. There were fits and starts throughout the year, but the runaway performance of large-caps versus small-caps was remarkable. Enthusiasm over AI drove a blistering rally in a handful of names, and market bifurcation grew. It is worth pointing out that this type of return pattern, with large-caps outpacing small-caps, is characteristic of markets late in the business cycle.

A bigger story than stock market performance in 2023 was that of inflation. All four major measures of inflation continued their descent closer to the Fed’s 2% target, but haven’t reached it yet. Nevertheless, markets decided that the Fed is done hiking rates and expect cuts to begin in the first half of 2024. More on that later.

The celebration over lower inflation is warranted, as it has been public enemy #1 since mid-2021 and the cumulative effects are pinching household finances. The drop in energy prices and goods have led the path downward, but there remains some stickiness in services inflation and shelter that prevented the Fed from signaling the “all clear” even after this much progress.

As a result of the movement in inflation, and the market’s swift re-pricing of rate expectations, Treasury yields had a doozy of a year. After the October CPI print (released on November 14) that was cooler than expected, 2-year Treasury yields saw an intraday drop of 24 basis points. We thought that was colossal… until December 13 when the Fed pivot sent them down more than 30 basis points. That marks the seventh day of double-digit basis point drops since the beginning of November. Those are eye-popping moves in short-term Treasurys, which are traditionally thought of as stable, even boring, instruments for investors.

They were anything but boring in 2023, and drove mortgage rates above 8% in October, a level we haven’t seen since spring of 2000.

In my opinion, volatility this high in Treasury yields is not a comforting sign. Although a drop in bond yields means a rise in bond prices, a swift drop in the short-end of the curve due to cooling economic data is usually what happens just before the Fed cuts rates. The possibility of this resulting in a soft landing is still alive, but I remain skeptical that the optimism can persist through 2024.

Wrapped in Contradictions

It would be too easy and too obvious if all the signals said the same thing. But the opposite extreme isn’t fun either, the plethora of counterpoints for every point can leave investors with their heads spinning. And that’s where I think we are right now, wrapped in contradictions.

If 2023 was so unpredictably positive, what will 2024 bring?

One thing for sure is that it will begin with a continuation of mixed messages. For the remainder of this piece, I’ll outline a collection of data I find especially important to follow, some of it positive, some of it negative. On balance, I still see the cons outweighing the pros, but I also recognize that there are good things happening out there, both in markets and in the economy.

Nagging Negatives

Since so much of investing is based on an uncertain future, it’s important to focus on more concrete data when and where possible. One of those datasets is the ISM Manufacturing Purchasing Managers Index (PMI). The nice thing about this index is we have a clear threshold of “good” or “bad”. Any reading below zero in the chart signals contraction, anything above zero signals expansion. The Manufacturing PMI has been squarely in contraction territory since late 2022.

But this is one of those very debatable points, with the counterpoint being that a manufacturing PMI in contraction does not always result in recession. Additionally, the services PMI isn’t in contraction, and our economy is more dependent on services than manufacturing. Both of those points would be true. And the counterpoints in response would be: More often than not, prolonged contractions in manufacturing PMI are coupled with recessions, services PMI did briefly dip into contraction in December 2022, and recessions have happened when services very briefly dipped into contraction (e.g., 2020).

See the conundrum of contradictions?

Some of the data is more difficult to contradict, however. And that’s the data that keeps me up at night, the pieces that can’t be ignored. One piece that has haunted me all year, and will continue to haunt me into 2024 are the deep and persistent yield curve inversions.

There’s not just a curve inversion in one place, the curves are inverted in all of the cases illustrated above, and have been for over a year. These aren’t minor inversion either, they’re indisputable, and lasting inversions that send a signal of lower short rates in the near-to-medium term.

The only thing to debate is why short rates would come down (i.e., why the Fed would cut rates). Will they be able to start cutting rates to simply normalize policy? Or will they start cutting rates because economic data cooled too quickly and concerns over a contraction were mounting? Or worse, because of some sort of event that risks spreading into other parts of capital markets?

My bet is on one of the latter possibilities, though I’m not as convinced that it has to be a big event as I was in 2023. The economic strength has shown that, if nothing else, we won’t cool off without a fight. It’s very possible we see a more gradual and orderly grind lower in multiple indicators, but the question of how far down they go remains the most important one.

Regardless, at some point in 2024 the Fed is likely to start cutting rates. The issue is, it’s not the hikes that usually getcha, it’s the cuts.

Even if we leave the recession debate aside and only focus on markets, this chart shows the frequency of market bottoms that happen around or after the Fed starts cutting rates. Despite all of the rhetoric that accompanied the hiking cycle, the complacency and optimism that’s surrounding the possibility of cuts could end up being off-base.

Interestingly, the period of time between the last hike and the first cut — which is where I’m assuming we currently are — tends to be ok for markets, as shown below. And the average amount of time between the two is 105 trading days (roughly five months). If the last Fed hike was in July 2023, we’re right at that five month mark with no cut to be found. Safe to say this waiting period will be longer than average… and another reason this cycle is one for the ages.

As of this writing, the futures market is expecting the first cut to happen in March 2024, followed by five more cuts before the end of the year. That has moved considerably in the last few months — in late September the first cut wasn’t expected until July 2024.

This is one of the growing contradictions I see in markets today. If stocks are rallying and broadening out to represent higher chances of a soft landing, why would we expect cuts to start sooner than before? What’s more, all the chatter about “higher for longer” has quieted down as rates fell and stocks rose. The risk with pulling cuts forward and assuming yields will continue to fall is a possible resurgence in inflation or labor data that might cause markets to rethink the timing and reverse some of its 2023 rally.

Promising Positives

Let’s turn to the positives. For all the consensus expectations of a recession in 2023, GDP growth held up surprisingly well. It’s expected to slow down in Q4, but the first three quarters were a good showing, especially from the consumption component in Q1 and Q3. Given the cumulative effect of inflation (see the “Bet on the Consumer” section later), most had expected consumer spending to take a hit, but it too, held up better than expected.

The pace of GDP growth should slow from here, both because the readings for 2023 were above trend (trend is thought to be between 1.5-2.0%) and because of the lagged effects of monetary policy. The Fed has stated on numerous occasions that they expect a period of below trend growth as a result of tightening. The intention is to slow growth but not stop it, and we’ll see how that unfolds in 2024, but for now markets are encouraged by the data.

Another promising element has been, and continues to be, positive earnings surprises for S&P 500 companies. Although we were technically in an earnings recession (defined as two or more consecutive quarters of negative y/y growth) until Q3 2023, the results came in above estimates every quarter and perhaps more importantly, the earnings expectations for 2024 are strong.

Whether the high expectations for 2024 come true or not is yet to be seen, but as things stand, markets are buoyed by the prospect of strong and rising margins in the new year.

Perhaps the most supportive economic data is that of the labor market. Things are cooling, but there’s been no big breakdown. The labor market matters for two very big reasons: 1) consumers will keep spending as long as they’re not worried about their jobs, and 2) it’s the second part of the Fed’s dual mandate.

Part of the problem that began in 2021 was an overheating labor market with too many job openings and not enough employees to fill them. The ratio of job openings to unemployed workers reached a high of 2.0 in March 2022. That ratio has come down to 1.3, which takes some of the pressure off of wage costs for companies yet keeps the job market attractive for available workers.

There are positives, to be sure. Momentum in the stock market and a broadening of the rally into year-end is all the confirmation many need to declare a soft landing almost a lock. My concern is that the optimistic economic case and the level of stock market valuations seems dependent on many of these variables staying as strong as they currently are through 2024, and I’m not convinced that will be the case.

A Bet on a Soft Landing is a Bet on the Consumer

There is no such thing as a strong U.S. economy without the U.S. consumer. Therefore, if we are to avert recession and muscle through a slowdown without stopping, the consumer must hold up. Personal disposable income is a critical component that drives the consumer’s ability to spend, and it’s up 6.2% this year, outpacing the latest CPI print at 3.1%. Moreover, average gasoline prices are down from $4.36/gal in September to $3.68/gal as of December 12.

It’s true that inflation has slowed down, but it hasn’t turned negative, it’s simply growing at a slower pace. That means the cumulative effect of inflation over time is still rising, which is ok as long as wages are also rising to absorb those higher costs. Wages have risen considerably since inflation began in earnest, but the increases in non-negotiable costs for consumers have risen as much if not more.

To this point, consumers haven’t slowed spending in any concerning way. Retail sales growth remains solid year-over-year, and holiday shopping has posted good results thus far. But over time, the cumulative effects of increasing costs are taking a toll and consumers are feeling the pinch.

One of the ways we can monitor how extended consumers are is by looking at how they’re paying for their spending. The story had been for a long time that pent-up savings was able to support much more spending without putting consumer balance sheets under stress. That may be true in some cases, but if there’s so much cash sloshing around, why have delinquencies started to tick up?

Another concerning piece to this puzzle is the rapid growth in revolving credit balances, which despite decelerating since 2022 is still up 9.3% y/y as of October — that’s higher growth than anything we saw during the last economic cycle. Additionally, this year has seen record use of buy now, pay later services for holiday shopping. Together, these could be signs that consumers are getting stretched, and if we need spending to hold up in order for the economy to hold up, this is a trend that deserves a watchful eye.

The bottom line is that as long as the labor market holds up, consumer spending is likely to remain healthy. Therefore, a bet on a soft landing is a bet on the consumer. And a bet on the consumer is a bet on the labor market. This is partly why so much attention has now shifted from inflation to jobs data.

The last employment report of 2023 came in stronger than expected, which is a good thing for workers and likely a good thing for spending in the near-term. We’ll close out the year with the 22nd consecutive month of an unemployment rate below 4%, the longest such streak since the late 1960s.

Despite the recent move back down to 3.7%, the unemployment rate had been slowly inching upward. Hiring has slowed, and job openings have fallen, though they remain above pre-pandemic levels.

Perhaps the most important takeaway from the chart is that once a turn upward in unemployment begins, it tends to keep going and pick up steam along the way. There is a turn happening in the data, ever-so-slightly. If the increase in the unemployment rate continues to move higher, consumers are likely to get nervous. This may be the single most important economic data point to watch in the first half of 2024.

The Power of Positioning

Until we know the resolution to the nagging negatives above, and whether or not the labor market can support another strong year for the consumer, the focus will remain on market momentum and the durability of rallies.

In that vein, it appears that the funeral for the 60/40 portfolio has been canceled and diversification lives to see another day. In November, the 60/40 blend posted its second-best month since 1991.

The returns were driven meaningfully by fixed income, and investors who have piled into Treasuries over the past year finally enjoyed a move in the right direction. This is what many are referring to as a big part of the “everything rally”, which is fun but usually fleeting. If the 60/40 portfolio does its job, even in the case of an equity drawdown, the correlation between stocks and bonds should again turn negative, with fixed income serving as a ballast through the storm. I’m optimistic that if we do see a storm in stocks, Treasuries can provide that support.

The key component to watch in the first half of 2024 is money market balances. Investors flooded into money markets throughout 2023 to capture the 5%+ yield with little to no risk. If rates remain high, it’s unlikely that we’ll see a huge outflow, but as Fed cuts come closer into view and rates fall, investors will have to decide if the yield in cash instruments is more attractive than the capital appreciation opportunity in other assets.

Absent a recession or increase in fear, this could serve as a boost to equity markets that tips a rally into a more convincingly durable territory. If, however, we see money market balances hold steady or grow, it likely indicates hesitation in risk-taking.

No matter the outcome, this is a data point that sits at extremes, which is always a reason to maintain a watchful eye. Extremes in most, if not all circumstances, do not tend to last very long.

That’s a Wrap

As we wrap up one of the more surprising years in markets, I can’t help but get excited for what 2024 may bring. Another new year in a cycle for the ages, and one that’s sure to bring more surprises. That’s what makes this whole thing so challenging. But if it were easy, it wouldn’t be any fun.


Want more insights from Liz? The Important Part: Investing With Liz Young, a new podcast from SoFi, takes listeners through today’s top-of-mind themes in investing and breaks them down into digestible and actionable pieces.

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