2024 Outlook for the Stock Market and Economy

Key Takeaways

• 2024 is going to be a year of really getting back to basics, really looking at a lot of individual company and sector fundamentals and getting away from a lot of those macroeconomic and behavioral catalysts that we had seen over the past couple of years.
• We do expect that the rate of economic growth will slow not only here in the fourth quarter at the end of last year, but for the next three quarters all the way until the third quarter of this year before then starting to reaccelerate.
• While the stock market itself may be broadly at fair value, we still see a lot of opportunities in individual stocks.
• We expect the Fed to cut starting this year and proceed aggressively over the course of this year heading into 2025, wrapping up cuts by 2026. And that lower federal-funds rate will drive the 10-year Treasury yield ultimately down to our long-term projection of 2.75% down from current levels of 4%.
• On the GDP growth front, we’re pretty close to consensus in the near term, although on a five-year time horizon we do expect a cumulative 3% more real GDP growth than consensus, owing to principally our views on the supply side of the economy in terms of labor force expansion and also productivity growth.
• Inflation has fallen back greatly, and by 2024, we expect inflation to come back to the Fed’s 2% target.
• Our projection is that core PCE will hit 2% year over year by the second quarter of this year.

Susan Dziubinski: Hello, and welcome to Morningstar’s first-quarter 2024 U.S. stock market outlook. My name is Susan Dziubinski, and I’m an investment specialist with Morningstar.com. The U.S. stock market finished 2023 on a high note as the rally in stocks broadened and long-term interest rates pulled back after signs that the Federal Reserve was finished raising interest rates. So, what should investors have on their radars for 2024? Here today to share their outlooks for the market and the economy are Dave Sekera, chief U.S. market strategist for Morningstar Research Services, and Preston Caldwell, chief U.S. economist with Morningstar Research Services. So, let’s begin.

Dave, over to you.

2024 U.S. Stock Market Outlook

David Sekera: Good afternoon, everybody, and thank you for joining us for our 2024 market outlook. So, before I actually get into the slide deck, I just want to quickly address what a return to normal means for stocks and why I titled that for our 2024 outlook. So, in my opinion, I think 2024 is really the first year after the pandemic that we’re going to be past all of the initial disruptions and then all of the dislocations caused by those disruptions from the pandemic. And I think about it really in two waves.

So, the first wave was in 2020 and 2021. So initially we had everybody or at least all the office workers such as myself moving to a work-from-home environment. We had a lot of shut-ins. People were afraid to go back out in public. We saw a huge shift in consumer behavior and especially consumer spending. Spending shifted away from services and into goods. And then we had some of the largest monetary and fiscal stimulus programs in history.

The second wave then ended up being in 2022 and 2023. We saw a lot of those now turn into a lot of dislocations in the market and especially in the economy. So, for example, we had all the supply chain bottlenecks. We had shortages, especially in semiconductor chips. We had inflation really start ratcheting much higher. And then the Fed, after falling behind in the inflation flight, had to then catch up and start raising interest rates very quickly.

And so now when I’m thinking about 2024 and what we expect going forward, we’re seeing a lot of those now really starting to subside. For example, with the Federal Reserve, monetary policy has been on pause. And in fact, we think they’re going to take the foot off the break and start easing monetary policy and getting back to more of a normalized environment. A lot of those supply chain disruptions have now eased. The shortages have also eased. So, I think 2024 is going to be a year of really getting back to basics, really looking at a lot of individual company and sector fundamentals and getting away from a lot of those macroeconomic and behavioral catalysts that we had seen over the past couple of years.

So, let’s turn to our outlook and our valuation here. So first, I’m just going to review our equity market valuation. I’ll talk about sectors, where we see value today, where we see market probably overextended, highlight a couple of our equity analyst team top picks. We’ll talk about valuation by economic moat. I’ll then pass the baton over to Preston, who will review his economic outlook. I’ll take control, review and talk about the mega-cap space. Really, that’s been one of the things that have really impacted the markets the most in how those have swung back and forth over the past couple of years, and then give a brief overview of our fixed-income outlook. And as Susan mentioned, we’ll try and take as many questions as we can at the end.

U.S. Equity Market Valuations

Here’s where we are today. As Susan mentioned, in the fourth quarter, it actually started off on the back foot. In October, interest rates were rising. The 10-year was getting dangerously close to hitting 5%. Stock market was selling off, especially those sectors that were most correlated to interest rates. But the market hit a bottom at the end of October. We saw the Santa Claus rally, which typically comes in December, come early in November. We started seeing interest rates moving back down. We started seeing the stock market move back up. And then in December, that rally continued after the Fed meeting. So, market really interpreted a lot of the commentary by Federal Reserve Chair Powell, really not only indicating that we’re at the point now that the Fed has not only paused but is probably starting to look and think about when it’s going to start easing. So, at this point, as much as the market has rallied, we’re now back to fair value. So, our price/fair value metric, it was at 1 at Dec. 21. So, what that indicates is when we look at all of those stocks that we cover, it’s over 700 stocks that trade on U.S. exchanges, and we compare our valuations of the market cap of those stocks versus our intrinsic valuation, we’re trading right at fair value.

Which Stocks Are Undervalued?

Now, the good part is, for long-term investors, we still do see undervalued opportunities in the marketplace today. So, when we break it down by the Morningstar Style Box, I would note that value stocks are still trading at a pretty respectable discount from fair value, trading at about a 10% discount, whereas core stocks and growth stocks trading slightly above fair value at this point. And then when we break it down by capitalization, small-cap stocks are still undervalued. We still see a lot of opportunities for investors in that space, and then also would note that mid-cap stocks are also slightly undervalued, whereas large-cap stocks with as much as they’ve rallied over the past year, starting to move slightly into overvalued territory.

So as far as allocations today, in my view, based on these valuations, I do think investors should still be overweight that value category, probably slightly underweight core and growth, probably more underweight core, in order to be able to pay for that overweight in the value category. And by capitalization, I also think you can probably be slightly underweight that large category in order to overweight the small-cap category and a slight overweight in that mid-cap category as well.

U.S. Equity Market Bounces Back After Brief Selloff

Just taking a look at how our price/fair value metric has performed versus the market over time. Anecdotally, I think this really helps illustrate how our long-term focus on valuation really can help investors identify those times when the market becomes overextended, either too far to the upside or trades down too far to the downside compared to that long-term view. So most recently, you can see that selloff in September and October taking the market down to just under 0.9 times at the end of October, and then rallying right back up in November and December and getting us back to fair value. But you can also see, too, at the beginning of 2022, we noted we thought that the market was overvalued coming into the year that year. Not only did the market then sell off, it actually sold off way too much to the downside, bottoming out in October 2022, getting to some of the most undervalued levels that we’ve seen since the global debt crisis and going all the way back to 2011 when we had the European sovereign debt crisis with Portugal, Italy, Greece, Spain, as well as a lot of concern back then about whether or not some of those countries would default and the impact it could have on the European banking system.

The other thing I would note, too, here is that, in the fourth quarter, we’re starting to see gains broaden out away from just being the “Magnificent Seven.” So, the Magnificent Seven, they accounted for 75% of the market return at the end of June, but by the end of the year was only 52% of the return. And I think that’s going to be a trend, and we’ll talk about that a little bit in the next couple of slides for what we see going forward.

Near-Term Market Risks and Earnings Season

Now, as far as near-term risks to the market, I am watching. We do have earnings starting up at the end of this week with the big banks and then we’ll see how they continue over the course of the month and into February and March. I am concerned that we could see management teams maybe look to lower the bar as far as guidance for the first quarter and for all of 2024. As we’ll talk about, we do expect that the rate of economic growth will slow not only here in the fourth quarter at the end of last year, but for the next three quarters all the way until the third quarter of this year before then starting to reaccelerate. I do think a lot of teams might try and use this opportunity to lower that guidance expectation in the marketplace. And of course, that could drive some negative market sentiment here in the near term. However, if that does occur, that’s probably actually going to be a good buying opportunity and maybe even move into an overweight position in equities just depending on how far the market could potentially sell off.

Q4 Market Performance

Just taking a look at how the market performed here in the fourth quarter, relatively strong in the fourth quarter. I think really the takeaway here is looking at by the different categories, growth stocks still did outperform in the fourth quarter, but they’ve outperformed by much less of a margin than they had outperformed over the course of the full year. And I expect going forward based on our evaluations that we’ll see better returns in the value category and start seeing more of a condensation of the market as far as getting back toward more of a normalized pattern as far as returns by category. Then I’d also note in the fourth quarter, we saw some pretty good performance out of the small-cap category as well as the mid-cap category, both of those slightly outperforming the large-cap category.

Is the Stock Market Undervalued?

And then just taking a look at how our valuations evolved over the course of the year. Coming into the year, we thought the market was significantly undervalued, trading at about a 16% discount to our fair values. At that point in time, we actually were recommending a barbell-shaped portfolio, being overweight, both value and overweight growth with an underweight in core. And we were also then looking for an overweight in that small-and the mid-cap space as well. Now over the course of the year, when the growth stocks really rallied in the first half of the year, we then moved to a market weight in the growth category as it got toward fair value. It went slightly above fair value in the fall. We actually moved to an underweight in growth. And then with the way that the valuations in the market then evened out over the course of the fourth quarter, we’re now looking more for a market weight in growth, maybe slight underweight with more of an underweight in core but keeping that overweight in the value category, and of course, keeping the overweight in the small-cap stocks as well.

Quarter-to-Date Sector Returns

Quarter-to-date, sector returns, I would note here, everything was up except energy. Energy was the only sector that fell over the course of the fourth quarter with some weakness in the oil markets. And I would say that the stocks that are tied to the economy actually performed the best. So again, taking a look at how those returns panned out, seems like the market is coming around to our point of view as Preston, you will talk about, I think we’ve long been looking for that soft landing here in 2024. So those sectors that almost correlated to the economy performed very well. And of course, some of those sectors that were undervalued performing very well as well, whereas sectors that were pretty fully valued coming into the quarter in the fourth quarter were the ones that did not perform as well, the consumer defensive, the healthcare, were lagging behind what we saw in more of the cyclical sectors.

Year-to-Date Sector Returns

And then looking at returns year-to-date, I think the real takeaway here is looking at those three sectors that we had identified at the beginning of last year as being the most undervalued were the ones that saw by far the strongest gains over the course of the year, technology stocks being up over 59% year to date, that was one of the most undervalued sectors coming into the year, communication services up 55% year to date. Again, that was the most undervalued sector coming into the year. And then consumer cyclicals, also being one of the three most undervalued coming into the year, having very strong returns as well. Those sectors that we thought were overvalued, such as energy, just barely being able to stay in positive territory. And then sectors like consumer defensive, healthcare, utilities, sectors that were fully valued last year, barely keeping positive for defensives and healthcare and utilities actually trading down for the year, which actually is now making that look very attractive to us going forward.

The Magnificent Seven

Getting back to the Magnificent Seven, just want to identify how much these stocks and how much they went up over the course of the year and, of course, because of their index weightings really skewed that overall market return. For the first half of the year when we did an attribution analysis, 75% of the total market return was just from these stocks alone. But we are starting to see them run out of steam. When we take a look at the valuations for those stocks, at the beginning of the year, six of seven were either rated 4 or 5 stars, meaning that we thought they were significantly undervalued. At this point, only Alphabet, the parent of Google, is still undervalued as a 4-star-rated stock. And in fact, we also think Apple has run too far to the upside. That’s not a 2-star-rated stock; the other stocks now being rated 3 stars. So, looking forward, we’re looking for mostly market performance for most of these stocks, still a little bit of upside left in Alphabet and Apple might be actually a good time to be looking to take some profit in that stock today. So again, I do not suspect that these stocks really are going to drive the market anywhere near this year as what we’ve seen last year.

Monetary Tightening Policy Cycle

This is probably going to be the last time I show this slide. So, we’ve highlighted this a number of times, just this monetary tightening policy cycle had been the steepest and fastest over the past 40 years. You have to go back to the ‘70s and the ‘80s to see the Fed move further and faster than what we’ve had at this point. We do think that the Fed is going to start easing monetary policy this year, possibly as soon as the March meeting. So, going forward, we’ll probably start looking at the opposite. We’ll probably start looking at what’s happened in prior Fed cycles as they’ve been easing rates and how fast they’ve eased rates in the past.

Inflation in 2024

Inflation. Inflation is probably going to be our biggest out of consensus call, I think, compared to the rest of the marketplace. Preston will go into this in great depth in his section here as far as how he’s looking at inflation. But I think the takeaway here is just to look at we are expecting inflation on average to be about 2% over the course of this year. We think inflation not only will continue to moderate this year but continue to keep falling into 2025 as well, getting below the Fed’s 2% target. And as far as the economy goes, again, Preston will go into this in much greater depth, but we do expect the high interest rates, restrictive monetary policy, and tight lending is going to continue to keep taking its toll. So, we are looking for slower growth in the fourth quarter as compared to the third quarter, and then slowing sequentially each of the next three quarters until the third quarter before it bottoms out and starts to reaccelerate back up to the upside.

Price/Fair Value by Capitalization and Price/Fair Value by Style

And then I threw two new slides in this quarter. I thought this was instructive, just to show for, by capitalization, how our fair values have compared to each of those capitalization categories over time. So, you can see back in like 2011 through 2016 even into 2018 how tight those different categories were as compared to one another. And you really see the big dislocations starting at the beginning of the pandemic, just how much small-cap stocks really sold off and how undervalued they became as compared to the rest of the market, and then to the upside still lagging behind, same with the mid-cap stocks lagging to the upside here most recently. And then doing the same analysis for each of the different categories of value, core, and growth, showing just how much that value category is still lagging to the upside on a valuation basis. Whereas in the past we haven’t seen necessarily these kind of dislocations in the past other than a couple of other instances, but then usually have largely corrected over time.

Sector Valuations

With that, let’s just turn over here to sector valuations. Overall, while the stock market itself may be broadly at fair value, we still see a lot of opportunities in individual stocks. In this case, we still see a lot of stocks by percentage of stocks that we cover in that undervalued territory, probably around 35%, 36%, are still 4- and 5-star-rated stocks. However, by sector, while some of the sectors have a high percentage of undervalued stocks, some of the more overvalued sectors, such as industrials and technology, fewer opportunities by percentage of coverage, and now starting to see a higher percentage of that covered now in overvalued territory rated either 1 or 2 stars.

Here’s where we are today as far as price/fair value by individual sector. Let’s just start off to the downside. Technology stocks following that 59% return last year has definitely moved into the overvalued territory in our view, now trading at a 9% premium to our fair value. This is a sector over the course of last year we started off as an overweight, went to a market weight, ended up, I think, going to an underweight at one point back to a market weight and now back to an underweight based on valuations. Industrials also moving into that overvalued territory. And then consumer cyclical kind of same as technology with as much as it moved up last year, now getting into that slightly overvalued territory. So, all three sectors, I think, are probably ripe for investors to look through what you own there, look at what you own on a valuation basis, maybe pare down, take some profits where you can, and look to reinvest that into some of these other sectors that we still think are undervalued. So, communication services, the most undervalued sector, trading at about 11% discount to fair value. And of course, that’s going to be heavily weighted by Alphabet; I believe that’s over 40% of the index. So again, that’s trading at about a 16% discount to fair value. It’s a 4-star-rated stock, so that does skew that overall sector lower, but we do see a lot of opportunities even in more-traditional media and communication names there.

Some of the other sectors that are undervalued, I would note real estate and the energy sector, both trading at 8% discount. So, names that we think are undervalued there. Energy was one of the more overvalued sectors last year. It’s fallen enough. We see enough opportunities here that this would be a good area to overweight today. And real estate, I think, [is also] a good overweight, because a lot of those commercial real estate names got pushed down too far based on concerns of valuation for urban office space. But again, it’s fallen too far that there are good opportunities there.

And then lastly, basic materials and the utilities space. Utilities got pushed out really hard last October when interest rates were going up. Utilities actually got to some of the most undervalued area that we’ve seen since the global financial crisis in 2008-2009. It’s moved up, but we still think that has further to go as well. And we’ll talk about the basic materials sector, a number of different opportunities there. A lot of the agricultural and commodities and the commercial chemicals in that space are undervalued, but also lithium. Lithium was pretty much in a bubble in 2021 and early 2022. That bubble has since popped, but we think it’s popped too far to the downside. So again, we do think that lithium is going to be undersupplied over the next decade. We see a lot of demand coming. So that’s another good name. And now one other area in basic materials I don’t think I’ve highlighted in the past is going to be the gold miners. So, we’ll talk about what we like in the gold miners and why we think there’s upside opportunity there today.

Stock Picks

In our cyclicals, I’ve highlighted here the names that are new from our equity analyst team as far as our best picks for this quarter. So, FMC is a new top pick. That’s a company that’s heavily invested in crop chemicals. So that’s one that we see some upside here in the market trading at a very large margin of safety from our intrinsic valuation. And then Newmont Mining, the largest gold miner out there, I think has a lot of significant upside leverage. So even based on our assumptions today, we think it’s trading at about a 22% discount to fair value. Now it is a no-moat stock, but the reason I like this one specifically is, when you look at our assumptions for gold prices, for the next two years, we assume the gold prices actually come down. They average about $1,865 per ounce through 2025. And then gold prices are modeled to fall even further into the $1,700-and-change range over the next two years thereafter through 2027. Gold, of course, right now is over $2,000 an ounce. So, if gold prices actually were to stay here or even rise from here, I think there’s a lot of upside leverage in the gold miners. And even if gold prices fall down to our expectations in our model, you’re still buying the stock at a 22% discount. So, I do think that one is a very interesting play today.

Hasbro, another new name to the list. That one has been under some short-term pressures, but we do think the market is overextrapolating those short-term pressures too far into the future. And then lastly, Realty Income. Realty Income is a triple net lease provider in the REIT space. This is the one that, actually, when our analyst team has done a correlation analysis with the REIT coverage as compared to interest rates, has the highest correlation to interest rates. Now, Preston will go over his interest-rate outlook, but I would note here is this is the one that we do think probably has the best upside leverage to interest rates coming down. Even if interest rates stay where they are today, again, it’s going to be a high-dividend-paying stock that you’re buying at about a 25% discount to fair value.

Number of new names on the economically sensitive list. Comcast, again, another name that’s been under pressure. We think the market just has overly negative sentiment in this name. We do think that broadband growth over time will be a benefit for this company and help their operating margins over time. APA is going to be our pick as far as the smaller, more regional energy names for the exploration and production space. But on the large side for the global majors, ExxonMobil is going to be our pick there. And a couple of new names in the industrials space between Allegion, CNH, and RTX for investors to look at. I’d recommend going to Morningstar.com or whichever Morningstar platform you use and do some additional reading on these names and learn why we think the market is misvaluing these stocks today.

And then lastly, moving to our defensive sector best picks, WK Kellogg, Tyson, and WEC are new names this quarter. WK Kellogg, this is one actually Susan and I talked about on our last morning show on Monday mornings. I really think this is an interesting opportunity for investors today, especially investors really to dig in, do some due diligence on this name. This is a stock that I really think has kind of been orphaned in the marketplace today. When I look at the situation here, Kellogg split up last year into two different businesses, into Kellanova and WK Kellogg. Kellanova is the larger of the two. It’s the one that owns the snacks business from the prior Kellogg. That’s the one that has all the high-growth products, all the higher-margin products. It’s a much larger market cap. But the WK Kellogg spinoff, very small company. I believe it’s a billion and change in market cap. It’s the legacy cereal business, a lot of negative sentiment for the cereal as just being a slow growth, very mature business. But we do see a lot of upside opportunity here. It pays a very healthy dividend at this point. And we do think being spun off from the broad company will actually pay dividends for this company in the future. We expect a lot of new product innovation will be able to help this company be able to start generating some better growth over time. And the company is spending a lot of money in operational efficiency improvements today, which we think will pay off and help improve its margins over the next several years as well.

And then in the utilities space, just moving to WEC Energy. This is just one where we think it has some of the best-in-class management, has above average growth opportunities as compared to some of the other utilities. And then it’s a very constructive regulatory environment. So, another good one, I think investors should take a look at today.

Strong Performance by Economic Stocks With Wide Economic Moats

Just wrapping things up by economic moat. Economic stocks with wide economic moats did very well this year, brought it up to now really being at fair value. Still some opportunities in the small-cap and the value space here as well, but certainly not the plethora of value that we saw more than a year ago in the wide-moat space. Some opportunity in the narrow moat and then the better opportunity from a category perspective is going to be in that no-moat space. However, I would note, if you are looking in that no-moat space, just make sure that if you are going to be involved in those stocks, you are looking for stocks that are going to be at a wide margin of safety to their intrinsic valuation. The concern here is that if we do have a recession, those would be the stocks that I would expect to fall the furthest and the fastest to the downside. Having said that, there’s a price for everything. So, there are certainly opportunities to take a look at in that space as well.

I’m not going to go through these names, but I like to do this every quarter, just showing how you can use some of the Morningstar tools in order to help look for new investment ideas for your portfolios and identify stocks that might fit within your risk parameters based on your portfolio. So, in this case, I just look for large-cap stocks, those that we rate with a wide economic moat and really look for those that have a Low or Medium Uncertainty Rating and then just did a rank order on price/fair value for most undervalued on up. Similar analysis for mid-cap stocks, and then lastly looking at undervalued small-cap stocks. Now not nearly as many small-cap stocks have a wide moat. So, in this case, I also include those stocks that we believe have a narrow economic moat. And in this case, you can see, too, there are no wide-moat stocks that we currently rate with a 4- or 5-star rating, but a whole host of stocks here with a narrow moat, with a Medium Uncertainty, and one utility that has a Low Uncertainty Rating.

So, with that, I’d like to turn the baton over here to Preston to do his economic outlook for 2024 and beyond.

2024 U.S. Economic Outlook

Preston Caldwell: Thanks, Dave. Good morning, everyone. So, jumping right in, it was widely expected that the Fed’s rate hikes, the largest in 40 years, would slow GDP growth in 2023 with a majority of economists even expecting recession. Obviously, that hasn’t panned out. While rate hikes have hit housing and a few other pieces of the economy, overall GDP growth has remained resilient owing to several factors, including free spending consumers and also a manufacturing building boom and some other factors I’ll talk about. Yet, despite resilient GDP growth in 2023, we still believe that the impact of higher interest rates has yet to fully play out. So, insofar as Fed policy remains somewhat restrictive throughout 2024 as a whole, even as they start to ease on interest rates, we do expect growth to slow in 2024 before bouncing back sequentially in 2025. You can see that show up in the annual numbers starting in 2026 and 2027, which would be a response to easing of monetary policy. And on the inflation front, after inflation in 2022 reached its highest levels in 40 years with supply constraints combining with excess demand to drive up prices, inflation has fallen dramatically in 2023 because those selfsame supply constraints have alleviated and also the Fed’s rate hikes have moderated demand somewhat. So, as a result, inflation has fallen back greatly, and by 2024, we expect inflation to come back to the Fed’s 2% target.

Comparing our views to consensus: On the GDP growth front, we’re pretty close to consensus in the near term, although on a five-year time horizon, we do expect a cumulative 3% more real GDP growth than consensus, owing to principally our views on the supply side of the economy in terms of labor force expansion and also productivity growth. And on inflation, you can see that consensus is eventually expecting inflation return to that normal of 2%, but we’re expecting it to happen even faster and even dip below the Fed’s 2% inflation target a bit over 2025 to 2027, as you can see. And so, in our view, that more rapid fall in inflation will push the Fed to cut rates by further than the market and consensus are currently expecting.

Interest Rates in 2024

Our views on interest rates here: This chart shows annual averages for key U.S. interest rates. And as I mentioned, we expect the Fed to cut starting this year and proceed aggressively over the course of this year heading into 2025, wrapping up cuts by 2026. And that lower federal-funds rate will drive the 10-year Treasury yield ultimately down to our long-term projection of 2.75%, down from current levels of 4.0%. And of course, we were as high as 5.0% just a couple months ago. That will be needed to drive lower borrowing costs throughout the economy, including a fall in the 30-year mortgage rate, which we expect to ultimately fall to 4.25%, just a bit above prepandemic levels. That will be needed ultimately to sustain a broad economic recovery, I think in housing to even prevent housing from taking another leg down, not to mention actually recover, a substantial fall in mortgage rates is needed. Most new homebuyers right now I think are banking on being able to refinance a couple years down the line, and so, if that option diminishes in possibility because the Fed doesn’t ease monetary policy substantially, then I do expect homebuying demand to diminish further.

GDP Growth Outlook

So, zooming in on the near term: In the third quarter, we saw GDP growth surge to 4.9%. Now there were several temporary factors at play. We saw inventories contribute 130 basis points, which is very large and obviously won’t repeat next quarter. Government spending also contributed 100 basis points to growth. Throughout this year, actually, government spending has been a substantial tailwind, with a little over 50% of that actually coming from state and local governments. One area that isn’t usually highlighted I’d say—so state and local governments were still running a slight surplus last year at 0.7% of GDP in 2022, and they flipped to a deficit of 0.8% year-to-date 2023. And so that’s more of a normal level in terms of state and local government budget balance. So that’s one factor that played out in 2023 to help push up growth, and that won’t repeat in 2024 because it’s played out. Likewise, nonresidential-structures investment was up 16% year over year as of the third quarter and so that helped to support private fixed investment despite the contraction in housing. That nonresidential-structures investment is driven by this manufacturing building boom, which has been spurred by the Chips Act and the IRA. And that’s a factor that’s going to plateau in impact, and so it won’t continue to push up growth going into 2024.

In the fourth quarter, we expect 1.7% real GDP growth quarter over quarter. The Atlanta Fed’s GDP now is at 2.2%. Consensus is about 1.1%. So, growth should normalize in the fourth quarter. And then, in 2024, we expect growth to slow. Not only will the factors that I mentioned propelling GDP growth in 2023 subside, but also I expect consumers to get more conservative in the effects of high interest rates to play out in a variety of arenas. So, for example, commercial real estate is a great example where really the impact of high interest rates on building of commercial real estate structures has yet to register at all. But credit growth in commercial real estate is in the midst of slowing and so that will have a negative impact on commercial real estate projects over the next year.

Labor Market Performance and Forecast

Turning to the labor market: Actually, disregard the top bullet point on this slide because we had a jobs report just this last Friday, and nonfarm payroll employment growth actually was 1.3% in the last three months, three months ending in December. So that’s a slight slowdown from the 1.7% in the prior three months. So, we’re still seeing job growth trend down barely. It’s not the downtrend that we saw in 2022. However, that doesn’t mean that the slowdown in job growth is starting to cease. We do think that with GDP growth slowing down further in 2024 that that will cause job growth to slow further. And indeed, we’re already seeing employers cut back on hours. Average hours per worker is down about 0.6% year over year. And so eventually the cutback in hours will reach the end of its rope and employers will likely increase the amount of layoffs, which has remained very low thus far.

Turning to our labor market forecast: The slowdown in GDP growth that we’re expecting for 2024 will generate a modest uptick in unemployment averaging 4.2% that year and also in 2025. We think unemployment will peak at about 4.5% in the fourth quarter of 2024. So that is quite mild compared to historical increases in the unemployment rate. It’s not surprising given that we don’t expect a recession to happen. However, insofar as unemployment does remain slightly elevated in 2025, that will be one reason that the Fed will continue to cut in 2025 in our view even as GDP growth starts to reaccelerate again. On the wage growth front, looking at the bottom chart, our composite measure of wage growth showed 4.7% year-over-year growth in the third quarter. So that’s consistent with inflation at 3.2%, if we assume 150 basis points of productivity growth. So, by the time we get to the end of this year, and we have further slowdown in the labor market, that should be sufficient to push wage growth all the way back down to normal, back down to a level that’s consistent with 2% inflation.

A bit more detail on consumption: So that’s been one major factor helping to keep GDP growth strong in 2023. Consumers have actually decreased their savings rates down below prepandemic levels. They saved just 4% of their personal income in the third quarter compared to a prepandemic rate of 7.4%. And so that’s been facilitated by the fact that consumers saved so much back early during the pandemic. So, they built up these stockpiles of excess savings. Now how much excess savings are left is dependent on how you model excess savings. There’s many different methodologies, ways to do that. But looking at the bottom chart, if we take the 2019 savings rate and extrapolate that forward, then the amount of excess savings has dwindled substantially and will run out sometime by mid- to late 2024, this year. If that turns out to be correct, then we’ll see savings rates very likely rise substantially over this year. Even if it’s not correct, I do think consumers will—if there’s more excess savings, given that those are estimated to be concentrated among higher-income households, nonetheless, I would expect consumers to still increase those savings rates at least somewhat in 2024. And that’s going to be one major factor that will slow consumption growth and thus overall GDP growth.

Will the Fed Cut Interest Rates in 2024?

So, on inflation, we saw the CPI at 3.1% year over year. In November, that’s down precipitously from 8.9% at its peak in June of 2022. Much of that decline has been driven by energy. Energy prices, of course, spiked in 2022 owing to the fallout from the Ukraine war, among other factors, and they’ve come back down substantially this year. But we’re also now starting to see substantial progress on core inflation, in other words, stripping out food and energy prices, which is important given that core inflation is generally seen to be a better measure of inflation’s underlying trend. So, we saw core CPI inflation at 3.4% annualized in the last three months. Actually, core PCE inflation was just 2.2%. So, as a reminder, the PCE is a separate index. It’s the one that the Fed focuses upon and really is our focus as well because it represents a broader sample of consumer spending. The reason why core PCE is running lower than core CPI right now principally is because the PCE has a lower weighting to housing because it includes more consumer spending. And actually, core PCE was just 1.9% annualized in the last six months. So, really, we’re getting quite close to being able to declare victory on the inflation front from that perspective. And our projection is that core PCE will hit 2% year over year by the second quarter of this year. So, once you’ve hit your inflation target on a year-over-year basis, that’s a long enough string of success that I think the Fed will feel quite comfortable cutting rates aggressively throughout the second half of 2024.

More on our inflation forecast: We’re expecting durable goods deflation to continue over the next several years as this impact of normalization of supply chains plays out. Housing inflation, which has remained high this year, we expect to normalize next year and further in 2025. Housing inflation recently was 6.7% year over year. But if we look just at rent growth among new tenants, it was up only 2.7% year over year. So, housing inflation is kind of a weighted average of lagged new tenant rent growth. And so, as long as that remains in place, which it should given the expansion in housing supply, then it’s really inevitable that housing inflation returns to normal.

We’re expecting our first cut in March, which is now the market consensus. We’ve expected this March cut for quite some time. And now just recently within the last month or so, the market has come around to our point of view. We expect one skip in May, but then cuts in June and every other meeting through the end of this year. In the near term, our views are, as you can see, expecting a 3.75% to 4.00% target range at the end of 2024—that’s right in line with what the market is now expecting. But there is still a divergence between our view and the market going into 2025, where in our view, inflation remaining still below the Fed’s 2% target—or pushing below the Fed’s 2% target and unemployment being slightly elevated. I think all of that will cause the Fed to continue to cut throughout 2025 and eventually push rates essentially back down to prepandemic levels. We have seen bond yields fall substantially, the 10-year going from around 5% back in early November to now at about 4%. But that loosening of financial conditions, as we call it, will only persist as long as the Fed continues to, or really actually starts to loosen monetary policy, because that expectation of lower federal funds rates is what is driving bond yields lower.

Year-Over-Year Real GDP Growth Versus Inflation

Actually, just in the interest of time, I’m going to skip these sections right here. I’m going to wrap up with this slide right here. Here, we chart year-over-year real GDP growth versus inflation, and we graph four different economic regimes. So, our base case is a soft landing. As you can see, our forecast put us into soft landing territory, which entails positive real GDP growth, even while inflation goes back to the 2% target, and we’re expecting that to unfold over 2024 and 2025. Now, what I will say is that a year ago, everyone was worried about stagflation, that is inflation remaining high, even as real GDP growth shrank. That scenario clearly has been invalidated by the fact that inflation has come down so much, 300 basis points, even while real GDP growth has accelerated this year. And that’s been driven by supply side expansion. But there still is some risk of two scenarios relative to our base case.

One is a major recession scenario, where the impact of Fed rate hikes plays out suddenly with great force. And then the other is an overheating scenario, where there is no further impact of Fed rate hikes. And we also see consumers become increasingly optimistic, even as right now, they’re spending as if they’re very optimistic, but there’s room for sentiment to increase further, maybe even asset markets become overheated, and you see a rebound in housing despite high interest rates that would make the overheating scenario play out. So, there’s still two possible scenarios that we see that risk our base case. But right now, we’re quite confident in the soft landing scenario playing out.

So, with that, I’ll wrap up my section. Be on the lookout: I’ll be holding a full hour-length webinar dedicated to my economic views on Feb. 27. And with that, I’ll turn it back over to Dave Sekera.

Sekera: Great. Thank you, Preston. Now, in the interest of time, I do want to get through these next couple of slides as quickly as I can. I see a lot of questions, some really good questions here coming in from the audience. So please feel free to keep putting those in. We will get to as many of those as possible.

Mega-Cap Stocks Look Undervalued

Just taking a look at the mega caps, I think just the real quick takeaways here, looking at those that were most undervalued coming into 2022, and in fact, high correlation with a lot of these mega caps here being with the Magnificent Seven, how much they’ve run up, only a couple of them are still being undervalued at this point. The new names to our list from last quarter, a number of pretty high-quality names now that are in here. I think that with the Magnificent Seven last year really taken all the oxygen out of the room a lot of institutional managers just trying to keep up with the market rally, probably moving money and rotating out of some of these high-quality but maybe lower-growth names into the Mag Seven has left these behind. Exxon, J&J, Pepsi, Thermo, all wide-moat stock companies that I think are very high-quality that are probably worth taking a look at today.

Overvalued Stocks

On the overvalued side, those stocks that we identified as being overvalued coming into 2023 for the most part have all sold off. The one I’d really highlight here is going to be Eli Lilly. So, Eli Lilly up over 50% year-to-date. Again, this is a stock that really ramped up much higher because of its weight loss drugs. A lot of market excitement as far as the total addressable market size for those weight loss drugs. And I would note, too, when I look at our model and I talked to Damien, who covers this name for us, in his model, he even says, his assumptions he thinks are higher than the average consensus for the weight loss drug. But even then, it’s still a 2-star-rated stock, still trading well above our fair value estimate. So, if this is a name you’re involved in, I do think now is a good time to at least take some money off the table, lock in some of those profits at this point. Other than that, Home Depot being the only other one to the upside, everything else having traded down.

A couple of new names to the list. Broadcom, again, that wasn’t one of the Magnificent Seven, wasn’t quite large enough to make the cut there, but again, a stock that really rallied high last year, now moving into that overvalued territory. Costco, great company, strong name, wide economic moat, but again, we just think the market is overextended. Netflix and Accenture being the other two others.

Fixed-Income Outlook

And then just wrapping up with a quick fixed-income outlook. Returns last year, much more normal than what we’ve seen after the worst bond market ever in 2022. And using Preston’s interest-rate forecast here, and for people that are interested, we did publish our 2024 Bond Market Outlook a couple of weeks ago. That’s available on whichever Morningstar platform you use. But again, mid-last year in our midyear outlook, we did note that we were starting to recommend moving to a longer duration profile in fixed income. We still believe that being in the longer duration is probably the right part of the curve to go. A lot of the reasoning behind that is that we do expect interest rates will deaccelerate, come down this year and into 2025 and 2026. So, I think it’s a combination of two things: One, you’re able to lock in what we think are relatively attractive rates in the longer end of the curve today, plus, over time, as interest rates come down, you’ll get better price appreciation in those longer duration bonds.

Corporate Bond Market

And then lastly, just looking at the corporate bond market. Really not all that enthused about corporate bonds. I think it’s probably a neutral, at best, at this point. Last year, we saw a lot of attractive opportunities, both in investment grade and high yield. Investment grade has tightened 18 basis points. We’re sub-100 spread in investment-grade today. High yield, 338 as of Dec. 21. Again, I think you’re getting paid an adequate amount based on our economic outlook, but I don’t think you’re getting any excess return at this point. I think you’re getting paid for the downgrade risk and default risk. But there’s really not a lot of extra upside here from credit-spread tightening at this point in time. And then I do like to add this just to give you a perspective over the long term how the Morningstar US Corporate Bond Market Index, the spread has averaged over time, where we are today, and then a similar chart for the high-yield market. So, again, very few times have we really traded much tighter than this. I do think it’s an area that it’s probably a neutral at this point in time, but I certainly wouldn’t be overweight either investment grade or high yield at this point in time.

Dziubinski: I’d like to thank Dave and Preston for their time today and thank everyone for joining Morningstar’s first-quarter 2024 U.S. stock market outlook webinar. Have a great day.