The most pressing question for the market this year is whether the economy will experience a soft landing, a hard landing, or no landing. A recession would constitute a hard landing. Interest rates and inflation would fall dramatically, but so would earnings. This scenario would likely lead to a pullback in stock prices of at least 10-20%. No landing describes an economy that is like a run-away freight train. Not only does it not slow, but it accelerates, leading to a substantial increase in inflation. The Federal Reserve would have to slam on the brakes by raising interest rates to even higher levels than today. Higher interest rates, and the prospect of the economy screeching to a halt would likely cause the market to sell-off substantially.
We have a little more clarity on how the rest of the year will play out economically. The likelihood of a recession has fallen to a two-year low. What was once a foregone conclusion is now highly unlikely, at least within the next twelve to twenty-four months. That leaves two scenarios as the most likely, a soft landing, or no landing.
The Federal Reserve is attempting to engineer a soft landing, which occurs when the economy slows enough to bring down inflation, but not enough to create a recession. If the Federal Reserve cuts interest rates this year and we don’t have a recession, then they can claim a successful soft landing. Before they can cut interest rates, they want to see inflation stabilize at or below the 2% level. This is something that they hoped to see during the first half of the year, but so far, the inflation numbers are not cooperating.
At the beginning of the year, the expectation was that the Federal Reserve would cut short-term rates by about 2%. By March, after some higher-than-expected inflation reports, the consensus was that the Federal Reserve would cut interest rates three times, or less than 1%. After the most recent round of disappointing inflation numbers, the market expects that the Federal Reserve will only cut rates once this year.
Now, the question is whether the current level of interest rates is high enough to slow the economy. Higher interest rates constrain the real estate market, but they don’t slow the corporate sector as much as they used to. Modern companies are less capital intensive and less leveraged.
Higher interest rates don’t necessarily mean a major pullback in investment spending. The economy is much less sensitive to interest rates than it was in the 1970s and 80s. A less cyclical economy will experience fewer recessions. Earnings growth is more predictable, and the market is less volatile. This supports higher valuations for stocks. A year ago, we were worrying about a possible banking crisis. Fortunately, the FDIC bailed out all the problem banks and what could have been a credit crisis is now just a fading memory.
Manufacturing and agriculture, now only a fraction of the overall economy, were once the pillars of the U.S. economy. According to the National Bureau of Economic Research, the U.S. economy between the 1850s and the early 1980s experienced 30 recessions lasting an average of 18 months, with intervening periods of economic growth averaging only 33 months (New York Times, April 11, 2024).
Today, manufacturing accounts for about $2.3 trillion of gross domestic product. The consumer-driven U.S. economy (health care, nail salons, education, travel), is almost $30 trillion.
Since the early 1980s, there have been only four recessions, lasting an average of nine months, with economic expansions averaging 104 months. The current period of job growth is in its 40th month. The strength of household spending is a key part of why the United States has avoided a recession.
The spread between the rate of inflation and interest rates tells us how much force the Federal Reserve is applying to the economic brakes. Today’s spread is more than 2%. This has been enough to slow the economy in the past, but the greater resiliency of the modern economy makes it harder to constrain. It’s like the brakes don’t work as well as they used to, so you must press on them a little harder.
The 10-Year Treasury Bond is the benchmark for long-term interest rates. When the 10-year rate increases, mortgage rates also increase, which creates a drag on the economy. But the real estate and housing industries only make up about 20% of the U.S. economy, so the economy continued to grow even with mortgage rates quadrupling.
Interest rates are staying high because the economy is growing at a robust pace. We will be boring our grandkids with tales of 3% interest rates. That will be an historic extreme like the 18% mortgages of the early 80s are to us. These higher interest rates reflect an economy that will continue to grow for the foreseeable future. Higher rates also reflect an economy that continues to normalize from the pandemic shock and the Global Financial Crisis of 2009.
This is tough luck for fixed income investors, as bond prices have held steady near their lows of last year. Credit quality is very good, and the healthy economy keeps a lid on defaults. Bond holders are getting the income they expect, but the days of income plus appreciation are probably gone.
The economy will continue to grow absent a credit crisis or external shock. Investors have done a complete turn-around on their recession prediction for this year. The question is how do they perceive the next five years? I don’t think very many investors believe that we could go another five years without a recession, but that may be the most likely trajectory.
For the last year, our stock portfolio is up 32%. The S&P 500 is up 29%. Bonds are up 1%. Earnings for the S&P 500 are expected to grow 11% in 2024 and another 13% in 2025. The stock market tends to price in the economy one year ahead of time. The increase in confidence for 2025 earnings is the main driver of higher stock prices this year.
Over the last five years, the market has traded for about twenty times forward earnings. If we apply that valuation to next year’s earnings forecast of $275, the S&P 500 will be worth about $5,500 at the end of the year. Including dividends, that’s a return of about 8% between now and year-end. It seems that the market still has room to run higher.
I’m guessing that like me, you’re less concerned with next year’s number and are more interested in where the S&P 500 could be five years from now. If we don’t get a recession in the next five years, the market will likely be somewhere between 8,200 and 9,000—approximately 60% higher as we head into the 2030s.
