Broker Check

UFG Market Review

| January 04, 2024

We had quite a rally in the stock market towards the end of 2023.  Expectations of several cuts of interest rates in 2024 drove this rally.  Indeed, stock market investors cheered Jerome Powell’s, the Chair of the Federal Reserves, comments in the final Fed meeting of 2024 in which he left the door open to interest rate cuts in 2024.  From the Wall Street Journal:

Powell’s remarks and new projections showing Fed officials anticipated three rate cuts next year marked a notable U-turn.  For over a year, he had warned that they would raise rates as much as needed to lower inflation even if that triggered a recession.

The comment about rate cuts was surprising because just two weeks ago, during an appearance at Spelman College in Atlanta, Powell said it was too soon to speculate about when lower rates might be appropriate.

So, how should we think about this in terms of our outlook and allocation?  Let’s separate what we do know from what we don’t.  To what we don’t know, let’s assign probabilities.  Here is a chart showing how I am thinking about the near term.

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Therefore, the information should be relied upon when coordinated with individual professional advice.

What do we know?  Interest rates will either be higher, lower, or at the current level.  From here on, things get fuzzy.  Let’s assume how bonds and stocks might react to each scenario.  The chances of higher interest rates are slim but not zero, and that is good news.  If rates move higher, this is bad for both stocks and bonds.  

If rates remain level, bonds should hold up.  The stock market, however, has already run up in expectation of lower rates.  Let’s assume stock prices reset lower when that doesn’t pan out.

Finally, assume rates do move lower.  In this case, let’s get a bit more granular and determine the reason.  In the optimistic or “Goldilocks” case, the Fed can cut rates because the inflation rate comes down to the Fed’s target of 2%.  The Fed achieved a soft landing by reaching its goal without a recession.  In this case, stocks and bonds should perform well, but stocks will do better.  In a less optimistic scenario, we hit a recession, which brings down inflation because there is not as much spending because more people are out of work.  A recession also allows the Fed to cut interest rates.  In this case, bonds still do well because interest rates come down, but stocks most likely do not.

Now, let’s assign probabilities.  Let’s ignore rates going higher, even though it is possible.  You would only significantly add to stocks if you set a high likelihood to the Goldilocks scenario or if a recession was only mild.  Even then, bonds should still do well.  However, the less probability you assign to the optimistic scenario, the more attractive bonds become.

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