Financial markets in 2024: A slow start and strong finish?

Russell Rhoads, Ph.D.

Associate Clinical Professor of Financial Management, Kelley School of Business, Indianapolis

In our 2023 financial forecast, we focused on four factors that were expected to influence stock and bond market returns. We projected the Federal Reserve would not continue to raise rates at the rapid pace witnessed in 2022. We also discussed inflation, the impact of government spending on inflation, a potential tightening of the labor force and other potential unexpected “land mines” on the financial markets. While our predictions for these factors were mostly on the mark, the stock market’s performance this year was a pleasant surprise, as we felt an average return was a best-case scenario.

Factor 1: Rates
In 2023, the Federal Open Market Committee (FOMC) raised the federal funds target rate to 5.25% to 5.50% (from 4.25% to 4.50%), or an increase of 1.00%. This was a substantial move, but nowhere near the increase in rates the market digested in 2022. The 100-basis-point increase occurred gradually with a 25-basis-point hike at four of the seven meetings in 2023 (not including the meeting on December 13, 2023, which hasn’t occurred at the time of this writing). As noted, we expected a slowdown in the pace and magnitude of hikes from 2022. Barring any reemergence of inflation concerns, it appears the FOMC is done raising rates for this cycle.

Factor 2: Inflation
For a variety of reasons, inflation was a major issue in 2022, but aggressive Fed action has inflation somewhat under control. Many market observers are concerned that a second bout of inflation may push the FOMC to tighten further. However, based on futures market pricing, it appears the market does not agree with that outlook. Also, at the most recent FOMC meeting press conference, Chair Jerome Powell inferred that the tightening cycle is over, which stocks welcomed with an upside move. Our inflation forecast is for a drop to 2.2% by the end of 2024, which, if correct, would open the door for expected rate cuts from the FOMC.

Factor 3: Labor
Last year, we noted that the labor market was tight and expected it to remain so. The unemployment rate sits at 3.8%, higher than the 3.5% level seen at the end of 2022 (seasonally adjusted). This figure is up slightly, but does not reflect an economic slowdown, but rather transitional factors. The unemployment rate ranged between 3.4% and 3.8% over the first 10 months of 2023, mirroring the range in 2022. The tight labor market resulted in strikes for higher wages this past year. The strikes were settled with large pay increases, but these concessions by management were for skilled labor. This may lead to higher prices and another bout with inflation in 2024. However, unskilled labor may not have the same leverage that skilled workers do, meaning higher wages could be concentrated in certain industries and not others.

Factor 4: Fiscal land mines
Finally, with respect to “land mines,” we were mostly focused on the Russia-Ukraine war and worried about an expansion of that conflict. The current situation in the Middle East took the world by surprise. Despite the unexpected attack by Hamas, financial markets have taken the conflict in stride and the S&P 500 was higher the first session after the weekend attack. Not even the price of oil reacted as would be expected. The price of oil in October (Hamas attacked on October 7) never surpassed the September high and finished the month near the October low. This price action occurred despite increased tension in the Middle East. An escalation of the conflict, specifically other countries joining the fight, could result in higher energy prices. Conversely, slower economic activity may help keep energy prices somewhat under control.

Looking back on 2023

Stocks performed well in 2023. As of the end of October, the S&P 500 was up more than 9% for the year and the Nasdaq–100 was up more than 30%. The Russell 2000 was the laggard in 2023. This small-cap benchmark was more than 6% lower at the end of October. The 15% difference in performance between the S&P 500 and Russell 2000 is the largest underperformance of the Russell 2000 versus the S&P 500 since 1998.

Bond returns have been mixed for the first 10 months of 2023 after a very difficult 2022. The combined underperformance of bonds and stocks in 2022 had many investors rethinking the 60/40 portfolio. However, the expectation that bonds would offer positive returns in such a low-interest-rate environment should not be considered the end of stock-bond diversification. High-yield bonds are up more than 6% in 2023, while investment-grade bonds are lower by 2%. This follows a loss of 11% for high-yield bonds and 17% for investment-grade bonds in 2022.

We now turn to fundamentals that can be positive or negative for the financial markets. For full disclosure, it was more difficult to find positives than negatives going into 2024, a factor that influences our less-than-bullish outlook for stocks.

Positive fundamentals

The positive fundamentals for stock returns in 2024 include:

• Lower interest rates: Our model indicates there is little possibility of a recession in 2024, but there is a good chance of slowing economic activity. This slowing is expected to lead to rate cuts starting in the second half of 2024. Derivative markets are pricing in the first cut at the July 2024 meeting, with the odds of a cut at 55%. Also, after the November 1 FOMC announcement, the market adjusted to forecast the target rate at 4.75% to 5.00% at the September 2024 meeting, a cut of 0.50%.

• Yield curve normalization: The yield curve remains inverted, signaling a potential recession, but long rates have been moving higher with the curve approaching. For example, the U.S. two-year yield is now 16 basis points higher than the 10-year yield. This spread was more than 100 basis points in July 2023. If the current trend remains in place, the yield curve should return to contango in early 2024.

• Expected volatility is low: The Cboe Volatility Index (VIX) fell to levels not seen since the early days of the pandemic in January 2020, hitting a 2023 low of 12.82 in September. It has recovered from the September low, but is well below 20.00, a psychologically significant figure. However, VIX futures expiring in the second quarter of 2024 are elevated, indicating financial market concerns for the first half of 2024, matching our expectation that 2024 may get off to a slow start for stock prices.

• Election year: The presidential election occurs in 2024, which has been bullish for stocks with two exceptions since 1980. The first was the internet bubble bursting in 2000 and the second was the Global Financial Crisis in 2008. Although politics in the U.S. have been anything but normal for the past few years, stocks should be higher if no crisis matching 2000 or 2008 occurs next year.

Negative fundamentals

The negative fundamentals for stock returns in 2024 include:

• Slower economic activity: The most recent GDP growth reading (Q3 2023) was 4.9%, stronger than expectations. We currently expect GDP growth to slow to less than 2% by the end of 2024. This should not be dramatic enough to push the economy into a recession, but may weigh on corporate earnings announcements and projections. Although this falls under a negative, if GDP slows faster than expected, it would create the possibility of a rate cut earlier in 2024 than currently priced in by the market. This turn of events would be welcomed by stock investors.

• 2023 stock performance: It was a stronger-than-expected 2023 for stocks, with the S&P 500 up more than 9% and the Nasdaq–100 higher by more than 30%. The Nasdaq–100 performance is noteworthy since technology stocks often outperform before an economic recovery. This may be taken at face value, as any good economic news in 2024 is already discounted by the stock market. Stated more directly, it may take more good news to boost stock prices going forward.

• Valuations: The Shiller P/E ratio is currently at 28.88. This is above the long-term average of 17, but this measure was close to 29 last year and stocks had a strong year. Also, the S&P 500 price-to-sales ratio is at 2.36, also much higher than the long-term mean of 1.69.

• Consumer spending: A good portion of economic growth in 2023 is attributed to a strong consumer, something we did not expect in last year’s outlook. This driver of growth is at risk in 2024, due to slowing economic activity. Other factors that may weigh on consumer activity include higher interest rates and a resumption of student loan payments that commenced in October 2023. Higher interest rates should weigh on large purchases that require financing, such as housing and autos. Delinquency rates for both mortgages and auto loans are already approaching levels not seen since the Global Financial Crisis in 2008-2009. Finally, credit card debt in the U.S. topped $1 trillion for the first time ever in 2023.

• China: China continues to languish, with the Hang Seng Index down more than 13% in 2023. This is in response to a lack of recovery in economic activity. The property sector in China, which at one time represented 25% to 30% of China’s economy, is considered by many market observers to be worse than property markets during the Global Financial Crisis. If this situation worsens, it is likely it will spread to other markets. Finally, interest rates may remain elevated, as China is a very large holder of U.S. Treasury securities. Less demand out of China, or even selling bonds to raise badly needed cash, will push interest rates to higher levels.

Forecast

The S&P 500 and Nasdaq–100 both had solid performances in 2023, while small-cap stocks lagged as reflected by negative Russell 2000 performance. Looking to 2024, there are many risks that negatively impact the possibility of another solid year for stocks. The fundamentals in 2023 do not justify a 30% return for the Nasdaq–100, as investors started to purchase stocks with the anticipation of lower interest rates. Many of those investors may be early and will need to be patient as the rate hike they are hoping for is likely to come late in the second quarter or more likely in the third quarter next year. Small-cap stocks had a difficult 2023, however, this does not necessarily translate to outperformance in 2024 versus the S&P 500. Despite the long-term outperformance of small-cap stocks versus large-cap stocks, there are multi-period years where the Russell 2000 underperformed the S&P 500. In this environment, we expect stocks to be flat to slightly higher in 2024, lagging the long-term average return of 7%. Any economic slowing, increase in inflation or an expansion of current conflicts may result in a negative 2024 for major stock indices.

The market forecast for the FOMC’s target rate is expected to fall in 2024, with a target rate of 4.50% priced in as of late 2023. Although it is tough to argue with the market, we feel like this figure may be aggressive, as there is a very real possibility of another inflation scare which would push this figure higher as the Fed would have a difficult time cutting rates with inflation not completely under control. On the longer end of the curve, the 10-year U.S. Treasury rate should move to slightly higher levels, topping 5% in 2024.