Is There a Catalyst that Could Spark a Slowdown?

Photo Credit: Frames For Your Heart, Unsplash

Weekly Market Recap for January 19, 2024

The Federal Reserve will meet at the end of this month. Economists and Wall Street analysts agree that the central bank will decide not to change short-term rates. We are optimistic that this data will continue to show that the economy is headed toward a “soft landing,” slowing business momentum and easing inflation without a recession. We think the Fed is likely to reduce the federal funds rate at least three times, in one-quarter-point increments, during the second half of 2024.

Since March 2022, the Fed has raised rates by a total of 5.25%. It has been an aggressive tightening cycle, but despite expectations for a more significant impact, the US economy has proven resilient to higher interest rates. With the tightening cycle nearly 20 months old, concerns are growing about a 2024 economic slowdown as the lag of monetary policy moves through the economy and financial system.

How severe might the slowdown be, when could it arrive, and what catalyst could trigger it? We examine several potential catalysts below.

S&P 500 Index (Last 12 Months)

S&P 500 Technical Composite (Last 24 Months)

Debt and Leverage

Subprime mortgages contributed to the 2008 financial crisis as borrowers struggled with their monthly payments, and losses spread across the financial system. However, the debt profile of consumers and corporations is markedly different today after many borrowers locked in low rates during the pandemic. The fixed nature of these loans shields borrowers from the immediate impact of higher rates. At the same time, inflation and strong nominal sales growth allow borrowers with adjustable interest rates to manage the rise in rates. Borrowers may need help with their debt loads if the economy slows, but there is a lot of motivation to make it work and keep their current rate. Otherwise, the rate hikes are a non-event for most borrowers, so it is challenging to envision debt as fuel for a slowdown.

Homebuilder Sentiment Rises for 2nd Straight Month

Monetary Policy Lag

Financial conditions are already loosening as inflation falls to the Fed’s 2% target and the market prices in rate cuts for this year. The Fed is starting to endorse this view and hint at rate cuts if inflation eases, further loosening financial conditions. While there are undoubtedly lagged effects of tightening working through the system, this loosening would start to act as a counterbalance. It would not necessarily offset the lagged impact of already-enacted rate hikes, but it could begin to thaw the rate-sensitive segments of the economy that experienced the biggest slowdowns. Mortgage applications rose in the first few weeks of 2024, and homebuilder sentiment recently rose for a second straight month. Financial conditions, which don’t appear overly restrictive, suggest the lagged effect of tightening will be smaller this cycle, particularly with the above debt profile.

Mortgage Applications Post Another Big Weekly Rise

Financial System Liquidity

During the pandemic, the Fed pumped trillions of dollars into the financial system but has reversed course and pulled nearly $1.25 trillion via quantitative tightening (QT). The looming question is how much excess liquidity the Fed can drain without causing a system-wide liquidity event. Given the size of the liquidity injection during the pandemic, we believe QT can continue to run at the current pace in 1H24. However, the financial system is complex, and liquidity issues can emerge from nowhere. The chart below shows that the financial system may already be feeling the impact of QT. The right graph shows the gap between the effective federal funds rate (EFFR) and the secured overnight financing rate (SOFR). A liquidity event seems more likely than an economic event, although a liquidity event may not occur until 2H24.

Quantitative Tightening is Likely to Make a Bigger Impact in 2024

Retail Sales

U.S. retail sales rose +0.6% m/m in December, marking the most robust growth in three months. Nine of 13 categories rose, with the most significant gains in clothing, general merchandise stores, and e-commerce. Motor vehicle sales rose +1.1%, matching the biggest increase since May, while gas station sales fell for a third consecutive month as pump prices declined. Control group sales, which are used to calculate GDP, advanced +0.8%, the most since July. The data underscores U.S. consumers' resilience, fueled by wage hikes, investment gains, rising home values, and locked-in interest rates (see above). Consensus calls for consumer spending to slow in 2024, but consumers do not appear to have reached their limit yet.

Retail Sales (% Month over Month)

Putting It All Together

After a strong finish in 2023, the equity and credit markets began trading lower in early 2024. Notably, the equity market saw a sell-off despite a resilient macro backdrop. What caused the sell-off? We point to the year-to-date rise in Treasury yields as the catalyst, with the 10-year Treasury yield rising over +0.20% in the first few weeks of 2024. Our current view of the market is that potential Q1 headwinds stem from the market's optimistic rate cut forecast and exuberance rather than an economic slowdown.

We advise investors to focus on industry leaders, especially those consistently generating solid sales, earnings, and cash flow growth. Top technology stocks may be challenged to match last year’s performance, but further gains are certainly possible. Furthermore, companies in the industrial, healthcare, financial, and consumer staples sectors may possess better price appreciation potential. Overall, a high single-digit market advance is conceivable this year, aligning with the historical averages.

Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.

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