“People often say there's lots of uncertainty, but when was there ever certainty in the markets, the economy, or the future? I'm just trying to understand the present.” — Bill Miller
“It's not earnings changes that cause stock price changes, but earnings changes that come as a surprise.” — Howard Marks
“The main thing that experience taught me was a sense of humility and an awareness of the importance of surprise, that is, unexpected things happen.” — Peter Bernstein
Every year, Wall Street's brightest minds release their forecasts for the financial markets and the economy, covering areas such as sector performance, domestic and foreign markets, growth versus value, and bonds versus stocks. Our belief is that there will primarily be one call to get correct—one call to rule them all—and that is whether the US economy has a hard landing (recession) or soft one. Getting this call right can set the tone for everything else and, thus, we devote this article to distilling down the key indicators that will help answer this question and how to adjust client portfolios accordingly.
A year ago, we anticipated that an aggressive central bank hiking campaign could push the U.S. economy into a recession. Currently, the manufacturing side of the economy is in a recession and has seen 14 straight months of contraction. However, the service side of the economy maintained a slight expansion through last year and has, so far, prevented the US from seeing a broad-based slowdown, contrary to our expectations and even the Federal Reserve's own forecast. Due to our outlook, we originally maintained a defensive stance with above-average levels of cash, which was later deployed as our defensive stance eased.
Hard vs Soft Debate's Impact on Stocks and Bonds
There is still a debate among strategists whether 2024 will see a hard landing (recession) or soft landing (growth deceleration). A hard landing typically occurs when the Fed raises interest rates to cool an overheated economy, leading to a recession with a rising unemployment rate. In contrast, a soft landing involves the Fed cooling the economy without substantial labor market erosion. Looking back at economic and Fed rate cycles since the late 1970s, we've had five economic recessions (hard landings) and three soft landings, including the COVID-induced recession. Regardless of the outcome, the Fed tends to cut interest rates, benefiting both short-term and long-term rates for bonds. However, the size of bond returns hinges on whether we have a recession.
In contrast, stocks have a different trajectory. While bonds tend to perform well in either a hard or soft landing, the stock market's performance varies significantly. Since 1980, the S&P 500 has fallen as little as 17% to as much as 57% during recessions, while it has rallied 22-47% in soft landings.
Navigating Hard and Soft Landings
Every hard landing starts out as a soft landing, marked by the Fed's interest rate cuts while the unemployment rate remains stable. This optimism leads to a stock market rally. However, when the labor market deteriorates, the "soft landing hope" turns into a "hard landing reality," causing the stock market to decline. This pattern was clearly shown in the last three recessions (not including the COVID 2020 recession) where stocks rallied after the last rate cut only to fall as a recession loomed. For example, shown below is the 1990-1991 recession where the Fed stopped hiking rates in early 1989 (black line, top panel below) and the S&P 500 (red line, top panel) rallied for over a year while the unemployment rate (black line, bottom panel) remained stable. However, the S&P 500 peaked just as the recession was starting in the summer of 1990 and the unemployment rate spiked higher.
In the next example we see a similar but more condensed pattern around the technology bubble bursting in 2000. Former Fed Chairman Alan Greenspan stopped hiking rates in early 2000, the market rallied for a few months before peaking and rolling over even before the first rate cut. Once the unemployment rate ticked higher, a recession ensued and the bear market accelerated in 2001.
Fast forward to the present, the last rate hike occurred in July 2023, and as the Fed signaled the end of rate hikes, the stock market rallied. Presently, the market anticipates six quarter-point rate cuts by January 2025, with additional cuts in the following year, reaching a low in 2026.
Given the three soft landing examples mentioned above, a similar outcome today equates to the S&P 500 rallying from 4,566 the day of the last rate hike to 5,570 (22%) to as high as 6,712 (47%). Using the 5 recessionary examples above, the range of possible outcomes is a decline of 17% to a low of 3,789 or a 57% decline down to 1,963. The wide range of outcomes underscores the significance of whether a hard or soft landing takes place. Given that the manufacturing sector is still in a recession and the services side of the economy is weakly expanding, we maintain a neutral outlook at this point for 2024.
In the scenario of a soft landing, the market is poised to sustain the positive momentum initiated last year throughout the current year. Drawing from post-WWII data, the first year of a new bull market has witnessed the S&P 500 rallying by over 30%. The crucial objective will be to safeguard client capital in the event of a recession, should one materialize, considering that the market typically experiences an average decline of 33% during recessionary bear markets.
Keep an Eye on the Labor Markets
We are watching closely both the labor market and the manufacturing sector for how things play out. For the labor market, we are watching jobless claims, which come out every Thursday and provide the best real-time indicator in terms of the state of the labor markets. This was the case with the 2000 market peak in which jobless claims (shown in red below, inverted for directional similarity) troughed and started moving higher even before the S&P 500 began to sustainably decline. Jobless claims gave ample warning (yellow box) before the official recession (red box) and hard landing began.
For the 2007 market top, jobless claims did not provide as great a lead time as in the 2000 market top, but they did provide a real-time indication of labor market deterioration just as the market was putting in a major top. Claims were steady for over a year (yellow box) and their breakout to multi-year highs was the shot across the bow as to what was coming.
While employment growth is slowing from roughly 400K a month in 2022 to 225K in 2023, this is expected as the Fed hikes rates to cool the economy. We have clearly seen a deceleration in hirings, but we have not seen an acceleration in firings which is typical of a recession. Since the beginning of 2022, jobless claims have remained in a tight range and until they move up in a substantial and sustainable way, the soft-landing hope remains alive. A clear breakout above 300K would be the tell for us whether a hard landing may be in the works.
For signs of a soft landing and corresponding resumption in growth, we want to see jobless claims remain rangebound coupled with a recovery in manufacturing activity without a slowdown in the services side of the economy. The most widely followed manufacturing activity report is the monthly Institute of Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI) report where readings over 50 indicate expansion while readings below 50 indicate contraction. Shown below, we chart the ISM PMI (top panel) and the unemployment rate (bottom panel) going all the way back to 1960. The soft landing examples are shown by the green boxes in which the ISM moved back above 50 to indicate a manufacturing recovery while the unemployment rate remained stable or declined. The recessionary hard landings are shown by the red vertical bars in which the unemployment rate ticked up and the ISM fell deeper into contractionary territory.
As mentioned previously, the ISM PMI has been below 50 since November of 2022, contracting for 14 consecutive months. Since last June, it has been range bound between 46-49 and a sustained move into the mid-50s would align with a soft landing into growth scenario while a dip into the low 40s would likely signal a hard landing recession. In addition to the ISM data, we also monitor Federal Reserve Bank PMI readings throughout the month that provide additional insight on the trajectory of the US economy.
Portfolio Position & Strategy
In terms of the fixed income side of the portfolios, we have not moved too far out on the maturity scale for our bonds as we remain concerned about the vast amount of government debt maturing, both here in the U.S. and abroad, that could pressure interest rates higher. For this year, the U.S. will see $9.7T in debt mature and nearly another $4T in debt mature from our G7 partners. Our concern is that demand may not be enough to meet the ballooning supply of government debt, which could, at best, limit the decline in longer-term rates and, at worst, see them rise. For this reason, we feel it is a more probable outcome that short-term rates will likely follow the Fed’s policy rate lower while longer-term rates will likely be more influenced by supply and demand factors. However, should a recession ensue, we remain open to lengthening our bond maturity as deflationary forces may dramatically increase investor demand for bonds and drive their prices higher and interest rates lower.
Shifting to the equity side of the portfolios, we continue to believe that artificial intelligence (AI) will continue to be a dominant theme. Last year, we made major AI-related investments from the “picks and shovels” of AI to companies that developed their own AI models for mass distribution. The explosion of artificial intelligence (AI) is poised to revolutionize our world on multiple fronts, fundamentally reshaping how we live and work. One significant impact is its potential to address labor shortages across various industries. AI technologies, from automation and robotics to machine learning algorithms, have the capacity to augment human capabilities and fill critical gaps in the workforce. In sectors facing shortages of skilled professionals, AI-driven solutions can take over routine tasks, allowing human workers to focus on more complex and strategic aspects of their roles. This not only enhances productivity, but also ensures a more efficient allocation of strained human resources.
In addition to AI dominating the investment landscape this year, we feel that the coming shift in monetary policy throughout the world may finally lift the prices of precious metals. For the last several years, central banks all over the world have lifted interest rates to combat the rise of inflation due to the COVID pandemic response. Higher interest rates increase the opportunity cost of holding a non-interest-bearing asset like gold, typically leads to a higher US Dollar (USD), and reduces the concerns for future inflation as rising interest rates tend to cool the economy and inflationary pressures. Considering the significant surge in interest rates following the COVID-19 pandemic and the strengthening of the USD, it is not surprising that gold has experienced a sideways consolidation over the past three years. However, given its historical correlation with real interest rates (interest rates adjusted for inflation), one might have anticipated a much lower price; and yet it has consistently traded near its record high over the past few years.
The likely reason for this is back-to-back record years of central bank buying of gold in 2022 and 2023. With the continued dramatic purchases of gold by central banks and now the pivot from interest rate hikes to interest rate cuts, 2024 may finally be the year that precious metals shine brightly. We have a strong allocation to precious metals that should benefit if central banks begin to cut interest rates this year as is widely forecasted. The risk for our portfolios is if inflation proves sticky, preventing central banks from easing as aggressively as currently forecasted, which we will be monitoring.
There are other key investment themes we are monitoring that are currently out-of-favor, as these ignored areas are creating exciting value opportunities. As mentioned above, we are waiting to determine if the soft-landing scenario is playing out before increasing our exposure and risk to the stock market by allocating to the attractive areas we are tracking.
Summary
As we navigate the intricate landscape of financial markets, our focus remains steadfast on the critical call of whether the U.S. economy will experience a hard or soft landing. The past year has taught us the value of adaptability in the face of unforeseen events, emphasizing the need for a dynamic approach. Rather than rigidly predicting economic outcomes, our strategy centers on monitoring key indicators in real-time to guide portfolio adjustments. The ongoing debate on hard versus soft landings and their impact on stocks and bonds underscores the complexity of financial dynamics. We maintain a neutral outlook, positioning portfolios based on the pivotal factors of the manufacturing sector and labor market. The careful observation of jobless claims and manufacturing activity serves as our compass in determining the economy’s fate this year.
Our portfolio strategy includes a cautious stance on fixed income maturity given concerns about government debt, coupled with a belief in the continued dominance of artificial intelligence in shaping investment landscapes. Additionally, we anticipate potential shifts in precious metal prices with central banks pivoting from interest rate hikes to cuts. While monitoring inflation risks, we remain open to emerging value opportunities in overlooked areas. As we await clarity on the unfolding economic scenario, our commitment is to remain agile, adaptive, and guided by a forward-looking approach in serving our clients' financial interests.
Should you have any questions regarding our outlook or your portfolio, please do not hesitate to contact your wealth manager.
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Advisory services offered through Financial Sense® Advisors, Inc., a registered investment adviser. Securities offered through Financial Sense® Securities, Inc., Member FINRA/SIPC. DBA Financial Sense® Wealth Management. Past Performance is not indicative of future results.
Copyright © 2024 Chris Puplava
