While it may feel like we are in a “higher forever” world with respect to stock prices or interest rates, we know this scenario is implausible, if not impossible. Amid a backdrop of low volatility mixed with investor enthusiasm (especially around anything to do with artificial intelligence) and better-than-expected economic news, the S&P 500 Index closed the quarter at a new high—its 22nd record high over the course of the quarter. A cut in the Fed Funds rate did not materialize as anticipated, and the Fed appears to be in no hurry to cut rates.

Views are mixed with respect to the trajectory of both stocks and short-term rates. Lone voices have suggested that the Fed’s next move could be a hike, but the more widespread expectation is for a cut, with the market assigning a roughly 50% chance at the Fed’s June meeting. With respect to stocks, some see continued increases given strong earnings and a healthy economic outlook, while others float a “bubble” theory, especially with respect to some large growth stocks. Compelling evidence is presented to support both the economic nirvana/soft landing view, as well as the hard landing scenario that is not as rosy.

The Factors That Drove the Global Economy in 1Q24

The U.S. economy grew at a healthy 3.4% annual rate in 4Q23, slightly up from the initial estimate of 3.2%. Consumer spending, especially in health care, was a key driver in the quarter’s gain, as was federal and local government spending. First quarter GDP forecasts are mixed, with 2% being an average. The Atlanta Fed’s GDPNow forecast was 2.3% as of quarter-end. The median projection from the Fed for full 2024 GDP growth is 2.1%, a notable increase from the 1.4% median expectation in December.

As expected, the Fed held the Fed Funds rate at 5.25% – 5.50% at its March meeting. Its median expectation for year-end Fed Funds remained unchanged at 4.6%, implying roughly three cuts in 2024. Market expectations are similar at roughly three cuts, down sharply from the six expected just a few months ago. Statements from Chair Jerome Powell as well as Governor Christopher Waller indicated that they are in no hurry to cut rates and are willing to wait to see more evidence that inflation is waning. This is not a surprise given that we have not yet seen widespread evidence that the economy is weakening.

Consumers are also feeling pretty good about current conditions, according to the University of Michigan Index of Consumer Sentiment, which revealed a March print that was the highest since December 2020, beating expectations and up nearly 30% over the past year. However, the Conference Board’s Consumer Confidence Index declined slightly in March, falling short of expectations. Notably, while the Present Situation component rose, the Expectations component fell to 73.8; a level of 80 or lower has historically signaled a recession in the next 12 months.

Inflation surprised to the upside in February; +3.2% year-over-year with services sectors being the key drivers over the past year. The Core measure was up 3.8%. Notably, after four consecutive months of declines, the energy index rose 2.3% in February (month-over-month). Gasoline prices were up 3.8% and WTI Crude closed the quarter at $83.20, up from $71.70 at year-end. The Personal Consumption Expenditures Price Index, the Fed’s favored measure, rose slightly from 2.4% to 2.5% (year-over-year) while the Core PCE fell slightly from 2.9% to 2.8%, the lowest level in nearly three years. “Supercore” inflation, which includes services but excludes energy and housing and is viewed as a proxy for labor costs, slowed in February but is up 3.3% over the last 12 months.

The labor market remained tight. Non-farm payroll gains were 275,000 in February and the three-month average was a robust 265,000 despite downward revisions in the first two months of the year. Unemployment was 3.9% and wage growth was 4.5%.

While the preceding paragraphs paint a seemingly rosy scenario for the economy, if inflation does not reaccelerate, there is also evidence of cracks that would thwart the soft-landing scenario. The commercial real estate sector remains under pressure, lending has sharply slowed, and the lagged effect of higher rates has not yet fully materialized. There is also a notable difference in well-being across income levels, which could have implications for the most important part of the U.S. economy: consumer spending.

According to Federal Reserve data, the delinquency rate for credit card loans for all commercial banks ticked up to 3.1%, a steady increase from the all-time low of 1.5% in 3Q21 (delinquency rates were helped by stimulus payments during the pandemic). The New York Federal Reserve publishes a Quarterly Report on Household debt and credit, and its March publication noted that “both auto loans and credit cards have seen particular worsening of new delinquencies, with transition rates now above pre-pandemic levels.” Savings have also been depleted for those with lower incomes. The bottom 20% income bracket lost 18% of deposits (inflation-adjusted) between 4Q19 and 3Q23 while the top 20% gained 13% (Source: JP Morgan Guide to the Markets). A recent Household Pulse Survey from the Census Bureau showed that for those with less than $50,000 in income, nearly 80% were “moderately” or “very” stressed by recent price increases and over 25% said paying for normal household expenses was “very difficult.” These issues feed the hard landing narrative, which is not currently the prevailing view but merits consideration.

Of note from overseas, Switzerland became the first central bank to cut interest rates; the Swiss National Bank cut its policy rate 25 bps as inflation fell to 1.2%. And Japan moved in the opposite direction! The Bank of Japan (BOJ) raised interest rates for the first time since 2007 and became the world’s last central bank to end its negative interest rate policy. From -0.1%, the BOJ raised its overnight interest rate to a range of 0.0% to 0.1%. Inflation in Japan climbed to 2.8% (annual) in February, up from 2.2% in January. Core inflation (excludes fresh foods) was also 2.8%, above the central bank’s 2% target for the 23rd consecutive month.

In China, factory output and retail sales beat expectations in January and February, but the property sector remains under pressure. In the first two months of the year, China’s National Bureau of Statistics showed a 7% gain in industrial output in the first two months of the year with retail sales rising 5.5%. On the downside, the value of homes sold by the top 100 developers plunged nearly 50% in the first quarter (year-over-year). China targets growth of about 5% this year but signals continued reluctance to use deficit spending for economic stimulus.

‘Higher for Longer?’ How Long?

Callan’s own Jay Kloepfer summarized it well, “So while the Fed removed ‘higher for longer’ from its outlook language in the fall of 2023, the economy and the capital markets have put the notion back in play.” Competing views exist with enthusiasts for the soft-landing scenario and solid financial market returns highlighting robust earnings, a resilient consumer, strong labor market, and moderating inflation that will enable the Fed to gradually cut rates. The less sanguine view notes sticky inflation that calls rate cuts into question, commercial real estate woes, rising loan delinquencies, and stress in lower income brackets. Geopolitical worries and a growing deficit are cited by both sides as potential sources of volatility and uncertainty. As usual, Callan recommends adhering to a disciplined investment process that includes a well-defined long-term asset-allocation policy.