Navigating Macroeconomic Fog

Consumer spending has been the most resilient driver of growth, due to the strength of the U.S. labor market. At the end of September 2023, there were 9.6 million open jobs available for the 6.4 million unemployed workers in the U.S. labor force.

Even if the U.S. economy remains resilient in 2024, we believe investors will need to adapt themselves to a new market regime. To understand the implications of this shift, it is useful to examine the four historical regimes that U.S. markets have experienced since 1955, after the distortions created by World War II and the Korean War had largely dissipated. 

While the post‑pandemic regime may not align perfectly with any of these prior periods, it will include some factors that prevailed during those regimes. Given the shift away from the structural forces that supported disinflation and lower rates in the wake of the 2008 global financial crisis (GFC), a return to the post‑GFC “new normal” strikes us as the least likely outcome going forward. 

Heading into 2024, inflation risks are skewed to the upside. Energy prices are a concern amid supply‑side pressures. As of third quarter 2023, U.S. wages were still growing at almost a 4% annual rate. If U.S. consumer inflation changes course and reaccelerates while economic growth remains anemic, the risk of stagflation will rise considerably.

Which regime is most likely to prevail in 2024? Recent readings for the fed funds rate and inflation have been closest to the pre‑GFC “old normal.” But the regime second closest to recent conditions isn’t stagflation, it’s the postwar boom.

It remains to be seen how real (after‑inflation) interest rates above 2% will play out in the markets. But we do not believe that high rates will kill the U.S. economy. Rates are high relative to the post‑GFC period, but not relative to capital market history. The federal funds rate exceeded 5% for decades and stock markets still did well. Sticky inflation historically has been good for earnings.

Despite the macroeconomic uncertainties, we see no reason for investors to be excessively bearish. Market segments that don’t trade at nosebleed valuations, such as small‑ and mid‑cap stocks and real assets equities, look appealing on a relative basis. If we see a spike in volatility and a market sell‑off, it could be an opportunity to buy stocks.

However, we also don’t think this is the right time to take large tactical allocation bets. The recent “dis‑inversion” of the U.S. yield curve could augur volatility in both stocks and bonds in the months ahead. We think the best approach heading into 2024 is to remain broadly neutral on risk assets, including equities.

With U.S. interest rates closer to their historical averages, a balanced portfolio could offer diversification benefits as bonds now provide higher income and ballast to stocks. However, interest rates are likely to remain volatile in 2024, so we favor maintaining an overweight to cash or short‑term bonds. These assets currently offer attractive yields with minimal duration exposure and could be potential sources of liquidity if market opportunities arise.

For investors looking beyond the traditional 60/40 stock/bond portfolio, and willing to take on more risk, we also favor alternatives with lower correlations to traditional assets and to areas of the market that could benefit from market dislocations and higher yields, such as private credit.

T. Rowe Price cautions that economic estimates and forward‑looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual outcomes could differ materially from those anticipated in estimates and forward‑looking statements, and future results could differ materially from any historical performance. The information presented herein is shown for illustrative, informational purposes only. Forecasts are based on subjective estimates about market environments that may never occur. Any historical data used as a basis for this analysis are based on information gathered by T. Rowe Price and from third‑party sources and have not been independently verified. Forward‑looking statements speak only as of the date they are made, and T. Rowe Price assumes no duty to and does not undertake to update forward‑looking statements.

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