What a difference a year makes. Entering 2023, economists and investors alike were bracing for the threat of a U.S. recession that did not materialize and still hasn’t. To be sure, the risk of a recession in 2024 is by no means off the table as of this writing. However, the case for a “soft landing” has clearly strengthened in recent months amid a still-resilient economy and encouraging signs of cooling inflation (Figure 1).

Notably, U.S. GDP growth has generally remained healthy over the past year in spite of higher interest rates, as have the labor market, consumer spending, and corporate earnings. Meanwhile, the lagged effects of the U.S. Federal Reserve’s (“Fed’s”) aggressive two-year rate-hiking campaign to fight inflation appear to have kicked in at last: The core Personal Consumption Expenditures Price (PCE) Index – the Fed’s preferred measure of inflation – was up just 3.2% year-over-year in November 2023, inching closer to the Fed’s target of 2.0%.

Most of the economic data of late has happily defied the pessimists’ gloomy predictions. The increased likelihood of a soft landing and a “Goldilocks” scenario, where the economy is neither too hot nor too cold, has also improved the odds of the Fed pivoting to interest-rate cuts in 2024. Indeed, the Fed itself signaled as much to the markets post its December 2023 policy meeting.

The greater chance for Fed rate cuts in 2024 is, of course, essentially good news that has been well received by both the equity and bond markets. Nonetheless, we are somewhat concerned about the apparent disconnect that exists between market expectations around rate cuts and the Fed’s actual intentions on that front.

At last check, many market forecasts were baking in anywhere from five to six 25 basis-point cuts in 2024, which seems overly ambitious given that the Fed still can’t declare final victory in the battle against inflation (Figure 2). Accordingly, the Fed’s recent messaging suggests that three cuts is probably a more realistic number. We could see fewer or perhaps even no rate reductions this year if inflation surprises to the upside. On the other hand, markets may get their wish for more if inflation keeps slowing and/or the economy takes a sharp downturn – though it wouldn’t necessarily be a welcome outcome under the latter circumstance.

The point is that, ultimately, the Fed may or may not be able to deliver the elusive soft landing that market participants want and are now widely anticipating. If not, the markets could be vulnerable to dashed investor hopes. The S&P 500 Index, for example, is currently priced for solid 2024 earnings growth based on the assumption of continued economic resilience and an accommodative Fed later this year.

A host of political risks could also garner investor attention in 2024, highlighted by the U.S. presidential and congressional elections in November. Democratic President Joe Biden and Republican candidate Donald Trump look poised to win their party nominations but with questions swirling around both, much could change in the coming months. In any event, we remain concerned that with any election outcome, divisions among the populace and elected officials will persist and present ongoing challenges to effective governance.

A more imminent worry lies in the risk of a full or (more likely) partial shutdown of the federal government in 2024. To avoid that, there needs to be a bipartisan, bicameral agreement between the two parties on appropriations spending fairly soon – a tall order in today’s polarized partisan climate. On a related note, the upward trajectory of government spending and borrowing is problematic:

• The U.S. fiscal deficit has deepened, while government debt as a percentage of GDP has reached staggering levels.
• The debt ceiling is suspended until January 2025, setting the stage for another congressional showdown over the need to raise it.
• Additional credit rating downgrades of U.S. debt are not out of the realm of possibility in 2024.

While these stories will grab their share of headlines, for the most part, we believe retirement investors should tune out the political “noise” and adhere to a long-term portfolio strategy. Figure 3 underscores this lesson, showing the stock market’s strong historical performance during 12-month periods following national midterm elections.

Although the U.S. is not without its own economic and fiscal challenges, it may well be the best place to invest in a global “neighborhood” of houses that are all troubled to one degree or another. European economies continue to grapple with sluggish growth and lingering inflation, exacerbated by the ongoing impact of the Russia/Ukraine and Israel/Hamas conflicts. Japan is steadily climbing out of its decades-long stagflation but still has a ways to go on that recovery path.

Outside the developed world, key emerging markets such as China, India, and Brazil face uncertain growth prospects for 2024 and beyond. Regarding China, domestic economic headwinds are being compounded by declining global exports, stalled foreign investment in the country, and rising geopolitical risks abroad. One source of angst: How might other nations respond if China were to invade Taiwan as feared?

The U.S. is not immune from many of these issues, particularly mounting tensions with China and the two wars raging overseas. However, we believe the U.S. economy and markets may be better positioned than their global counterparts to weather this risk-laden landscape, especially now that the soft landing/falling rates narrative has become more credible. Barring any unforeseen shocks, this may create a favorable backdrop for U.S. equity and fixed income markets, while the U.S. dollar could strengthen versus other major currencies later in 2024.

Moreover, we think the U.S. stands to disproportionately benefit from further innovations and advances in productivity-enhancing artificial intelligence (AI) technologies.

Tucked between large-cap behemoths and nimbler small caps, we view mid-cap stocks as the “sweet spot” of equity investing – and for good reason, because this sometimes-overlooked segment of the market may enable investors to capture the advantages of the other two size categories. Mid-cap companies are often big and established enough to be less risky than small caps, while offering higher growth and return potential than large caps (albeit with higher volatility) in many instances.

In fact, U.S. mid caps boast an impressive track record, having outperformed their U.S. large- and small-cap cousins over the long term. Large caps may provide a safer haven if economic conditions worsen but in the wake of their robust 2023 gains, many of them sport lofty valuations that might not be sustainable. (Read: the “Magnificent Seven” stocks.) By contrast, small caps as a group are cheaper and might get a short-term boost from Fed easing, but they’re not all sound investments. Many U.S. small-cap firms are not profitable, with some even in negative earnings territory, and are approaching a maturing debt wall in the next few years that could prove difficult to refinance – even with the expected tailwind of lower rates.

Thus, now may be an opportune time to add or increase portfolio allocations to actively managed U.S. mid-cap stocks (Figure 4).