As we exit 2023, all I can think of is how it was a year replete with dichotomies and divergences.
Focusing on the United States, an unprecedented gap emerged between real gross domestic product growth, which signalled a “soft landing” had been successfully engineered by the Federal Reserve, and real gross domestic income growth, which provided support to the minority view that a recession had arrived.
The same thing is true for employment, where the Establishment Survey showed gains in nonfarm payrolls, and the companion household survey revealed serious cracks in the labour market, showing plunging full-time jobs through the second half of the year.
Not to mention the stock market, where the cap-weighted S&P 500 posted impressive gains for much of the year at a time when the average and median stock represented in the S&P 500 equal-weighted index remained mired in deep correction territory. Even in the bond market, Treasury note and bond yields soared yet again – not because of investor-based inflation expectations, which actually receded this past year, but because of a surge in real interest rates, which reflected the reset to the extended Fed tightening cycle and the promise of “higher for longer.”
All this from a central bank that at the end of 2021 had published a median prediction for the policy rate at the end of 2023 of 1.6 per cent (instead of the 5.5 per cent we ended up at … with Fed chairman Jay Powell playing the role of Lucy and the rest of us taking on the role of good ol’ Charlie Brown).
This past year was also filled with economist after economist dropping their recession call and embracing the “soft landing” or even “no landing” economic narrative.
I sense for 2024 that all this confusion is going to be resolved. We will realize that we were, indeed, in a “soft landing” but then also recognize what “soft landings” really are: the bridge, or transition, from the expansion phase of the cycle to the contraction phase. We will see that a “soft landing” is not a permanent feature, that the business cycle has not been repealed, and that interest rates do matter – but they do operate with lags that are long and variable.
To be sure, rampant debt-financed fiscal stimulus helped extend the Energizer Bunny U.S. consumer in 2023, but that is now in the rear-view mirror. What lies ahead is the resetting of the economy to the damage the Fed (and Bank of Canada) has already unleashed as these central banks do what they do best, which is fighting yesterday’s battle.
When you assess the historical record, every recession has followed the proverbial “soft landing” – think of 1969, 1979, 1989, 2000 and 2007: All were “soft landing” years that were followed by “hard landing” recessions that precious few investors were braced for.
That is my primary concern today – the lack of preparedness for the inevitable downturn. Economists have prematurely declared the death of Mother Nature; just because the recession has been delayed does not mean it has been derailed. To say it hasn’t happened yet and, therefore, it is not going to happen at all is akin to a meteorologist saying that because it didn’t snow in December, winter has been called off. The business cycle has not been repealed, and it is this reality that will dominate portfolio and asset mix shifts in 2024.
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It isn’t just North America. We are seeing a property mess and debt deflation in China that has yet to be resolved. The British economy is stagnating, and Germany, the engine of Continental Europe that has turned to a caboose, is poised to re-enter a recession. Even Japan, with its monetary policy support and super-stimulative currency, appears on the verge of a contraction as well.
All anyone needs to do is take a look at almost every commodity price heading into correction mode or outright bear market, even in the face of supportive supply conditions, which smacks of demand destruction. What happened to all those US$100-a-barrel oil-price forecasts that were being published just a short three months ago?
This downdraft in resource prices, the loosening of global supply bottlenecks, and resource slack re-emerging in the labour market will usher in a further deceleration in inflation that will surprise the legion of bond bears out there.
My forecast is that we will no longer be hearing about “sticky” inflation in the coming year. Whether you are in the “structural” inflation camp, you cannot ignore the cyclical component. The risks of deflation, in my view, are running higher than the risks of runaway inflation.
It is against this backdrop that I fully expect the Fed and the Bank of Canada to reverse course and cut interest rates by more than what is currently priced in.
Just to get to a neutral posture would require at least 250 basis points worth of rate cuts, and this will trigger a reversion to a more normal positively sloped yield curve (a “bull steepener” in bond parlance). With that, the prospect for double-digit returns at the long end of the much-maligned Treasury market after three years of hellish and unprecedented negative returns is significant. (A basis point is one-hundredth of a percentage point.)
That’s a situation not unlike the last time the S&P 500 posted three consecutive years of negative returns from 2000 to 2002, which blazed the trail for a mean-reversion trade out of bonds and into stocks for the following five years. We are at that same point today but in reverse.
Bonds over stocks in 2024, and if you feel compelled to stick with equities in the coming year, stay with what works when interest rates move lower – what I call “bonds in drag”: utilities, consumer staples, health care and telecom services. After all, they command a combined 3-per-cent dividend yield, which is double what you can garner from owning the entire S&P 500 index.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
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David Rosenberg