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Q4 2023 U.S. Markets Outlook

Our expectations for the economy, stocks, bonds, interest rates, and more.

Q4 2023 U.S. Markets Outlook
Securities In This Article
Equitrans Midstream Corp
Devon Energy Corp
Johnson Controls International PLC
The Estee Lauder Companies Inc Class A
Meta Platforms Inc Class A

Key Takeaways

  • The U.S. equity market is closer to a 10% discount to fair value. We briefly touched fair value at the end of July before the selloff.
  • We think the Federal Reserve will not be raising rates and that its next move will be cutting rates next year.
  • Among our quarter-to-date sector returns, communications services was probably one of the few sectors that was able to eke out a positive gain, along with financial services. But the big standout, of course, was energy.
  • Taking a look at the economy, we’re looking for very strong growth in the third quarter, but we do think that the economy will begin to start slowing down in the fourth quarter.
  • Inflation is falling greatly in 2023 and should be back to the Fed’s 2% target in 2024 and the following years.
  • In addition to consumers, one of the biggest factors that has kept growth strong in 2023 is the manufacturing building boom with investment in manufacturing structures reaching its highest level since the early 1980s.
  • The market and the Fed are closely in line with each other right now, and Morningstar is expecting rates to come down much faster, mainly because we’re more optimistic on inflation.

Susan Dziubinski: Hello, and welcome to Morningstar’s fourth-quarter 2023 U.S. Stock Market Outlook. My name is Susan Dziubinski, and I’m an investment specialist with The U.S. stock market retreated during the third quarter of 2023 as oil prices rose and the yield on the 10-year Treasury hit a 15-year high. So, what should be on investors’ radars heading into the fourth quarter? 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. Let’s begin.

Dave, over to you.

U.S. Stock Market Outlook

David Sekera: Well, thank you, Susan, and good afternoon, everyone. Thank you for joining us here today. So, I’m going to start off and just provide a broad overview of the U.S. equity market and our valuation. I’m then going to turn to our sector valuations, highlight a couple of differentials there, and then review a couple of top picks by sector. I will then turn to valuation by economic moat, been a couple of changes there over the course of this year as well. I’ll then turn the webinar over to Preston, who is going to go over his U.S. economic outlook. And specifically, this quarter, I asked Preston really to do a much deeper dive into his forecast for the 10-year Treasury bond. That’s really what’s been the most impact on the market, I think, over the past couple of months and specifically the last week-and-a-half. I’ll take control of the webinar. We’ll go over the mega-caps, talk about how those have been impacting the market. I’ll also go over a little bit what we’ve seen with the “magnificent seven.” Then I’ll wrap things up today with a quick fixed-income outlook overview. And of course, at the end, we’ll be happy to take as many questions and answers as time allows.

U.S. Equity Market and Fair Value Estimates

I know we have a lot of new viewers this time around, so I just want to take a moment and talk about how we look at the equity market and how our view is different than what you might hear from a lot of other strategists. So, we cover over 700 stocks that trade on U.S. exchanges. And we have an intrinsic value as assigned by our equity team on each one of those companies. And that is what we consider to be our fair value estimate for each of those individual stocks.

We do a bottom-up analysis. We take a composite of all of those fair values on an intrinsic value-weighted basis, and we compare that to where they’re currently traded in the market based on their market capitalization. And that’s how we come up with that price to fair value. So, if it were at 1, that would mean that the market is trading exactly at that composite. Whereas when it’s trading below 1, that means it’s trading at a discount to that composite. So, as of a week-and-a-half ago, when we did our calculations, we noted that the market was trading at a price to fair value of 0.92. So, that represents an 8% discount to our fair value estimates.

What Is the Stock Market Doing Today?

Now there’s been a lot of changes in the markets just here in the past week and a half. So, I’m going to try and address some of those as we go along. I think the market has fallen, depending on where it is today, 2.0% to 2.5% then. So, I think we’re actually closer to a 10% discount to fair value at this point in time. Now it’s interesting. We actually just briefly touched fair value at the end of July before the selloff. A lot of the selloff has really been driven by increasing long-term interest rates. We’ve also had rising energy prices. A lot of people are very concerned about what oil prices and higher gasoline prices might do to the economy. And I know Preston will review that as part of his overview. And then, we’ve had the Federal Reserve at the most recent meeting, a lot of their commentary, trying to intimate to the market that they think that they’re going to keep interest rates higher for longer. We actually take a different view. We think that the Federal Reserve not only are they going to not be raising rates, we think their next move is actually going to be to start cutting rates next year.

Q4 Selloff in the Growth Sector

What we also saw in this past quarter is that the sell-off was also focused in the growth sector. Now, growth, we actually are moving that back to a market weight this quarter. That’s been a sector that we’ve seen a lot of volatility thus far this year. For those of you that were part of our outlook at the beginning of the year would note that we were actually advocating for a barbell-shaped portfolio at the beginning of the year to be overweight value, overweight growth, underweight core. I think it was in June, I think that’s when we moved to a market weight from an overweight in growth. And then, in our last quarterly outlook, we then moved to an underweight as growth was starting to get too high on a relative value. So, again, with as much as growth has moved back down, we do think that now is a good time to move back to that market weight. And then, by capitalization, large-cap stocks still remain fully valued, trading slightly above the market at this point in time. And the mid-cap and the small-cap are still more attractive, in our view.

So, how has our price to fair value panned out over time? You can see here over the past couple of years going back through the beginning of 2011, there are a couple of instances where the market really sold off, got to levels that we thought were significantly undervalued. Most recently, last October, we thought the market had sold off way too much in 2022. And it’s actually coming off of those overvalued levels at the beginning of the year. I think we were probably one of the few shops out there that noted that coming into 2022, the market was overvalued. You can see where the market bottomed out during the beginning of the pandemic, as well as going back to 2011 when we had the crisis in Europe, the European sovereign debt crisis, as well as the banking crisis.

The other thing to think about, what’s really driven the market thus far this year, I think about 70% of the total market returns have really been driven by those “magnificent seven” stocks.

I will get to that in a couple of more slides. I would just note of that, this past quarter, I think Alphabet GOOGL and Meta META were the only two that still had been able to post gains at this point. I think at this point, most of those stocks other than Alphabet have run their course. They’re moving up into the 3-star territory. So, we don’t see a lot of further gains coming from there. Looking forward, we’re looking for the market to really broaden out, start moving into some of the other areas that have lagged thus far this year, specifically the value category, we still believe on a relative value basis is the most attractive area.

Earnings Season

Looking forward, we do still expect to see more volatility over the course of this year. I think starting this Friday, we’ll have earnings season starting up with the big banks starting to report. Generally, I think earnings this earning season for quarter three are going to look pretty good. We’ve had a really strong economy here in the third quarter. I don’t think management teams gave overly too high a guidance coming into the quarter. So, I think on the third-quarter basis, we’re going to look pretty good. I’m much more concerned about what the guidance is going to be for the fourth quarter. We do expect that the economy will start slowing here in the fourth quarter. And so, I do think that there could be some volatility over the next couple of weeks. Of course, interest rates and how interest rates move over the next couple of weeks will make a big difference as well.

Here’s what we’ve seen for returns by the Morningstar Style Box over the course of the third quarter and year to date. Of course, with as much as the market has moved over the past week and a half, we’ll start seeing some more negative returns or more negative in that slide on the left. Of course, year to date, we’ve lost some of those gains, but I still think we’re up about 10% to 11% through last night. So, still a relatively healthy return year-to-date, even though we’re certainly well off of those highs that we saw at the end of July.

Here’s how we’ve seen the market move over the course of the year. So, you can see our price to fair value coming into the year. We thought the market was trading at a very substantial discount. It’s much less of a discount at this point in time, but we still think it’s very attractive after we’ve had this pullback over the past month or so. We do still think the value is the best place for long-term investors to be. Of course, going back to that market weight in growth after being an underweight this summer and an overweight at the beginning of the year.

Energy Sector’s Standout Performance

Our quarter-to-date sector returns, looking here, communications was probably one of the few sectors here that was still able to eke out a positive gain along with financial services. But the big standout this quarter, of course, was energy. We did see oil prices surge, I think, about 30% this past quarter. So, when we ran the numbers here, we saw energy up about 12.5%. I would note that I do think that the energy stocks did lag what we saw in the underlying oil prices going up. Last quarter, we had noted that energy was pretty close to full value. It is only trading at a slight discount. So, I do think that as oil prices have gone up, the market isn’t necessarily expecting oil prices to stay as high as they are over the long term.

Looking through some of these other sectors, we do see a lot of the defensive sectors did sell off this quarter. Utilities would be the one that I’m going to talk about a little bit more. That’s a sector that now has gotten to be very attractive, in our mind. It’s the sector that’s very correlated with interest rates. Over the past week and a half, with the 10-year Treasury rising as much as it has, the utilities have just been brutalized and getting down to levels that we think put it on almost a once in a decade kind of level as far as being undervalued compared to our view. Then some of the basic-materials, consumer cyclicals, and real estate markets also selling off. The real estate sector, not only is that correlated with interest rates, but there’s also a lot of pressure there just because people do have so many concerns about the valuation for commercial real estate.

Here we are at year to date. You can still see that communications, technology, and consumer cyclicals are still up well into the double digits, 30-some percent for communications and technology, 25% for consumer cyclicals. I would note these were the sectors that we thought were most undervalued at the end of last year, and they’ve seen the greatest returns thus far this year. Whereas some of those sectors that we thought were fully overvalued coming into the year are the ones that have struggled the most—utilities, healthcare, and consumer defense being the ones that I would highlight in this case.

‘Magnificent Seven’ Stocks

Of course, you can’t talk about the year-to-date returns without talking about the magnificent seven. We have them listed here. You can see the year-to-date return to the index for each of the individual stocks. Apple AAPL, Nvidia NVDA, and Microsoft MSFT really leading the market being very large returns, both on a combination of just the year-to-date returns that they’ve had but also because they are so large, they do have large weightings within the index.

We think at this point a lot of these stocks have already run their course. If you’ll note, of those seven stocks, six of them were attractive, in our view, coming into the year being rated either 4 stars or 5 stars. So, 4-star or 5-star stocks are those that we think are most undervalued. At this point, only Alphabet is still rated a 4-star stock. Most of these now have gone into that 3-star category. They might still be trading at a slight discount to fair value but still within the range that we consider to be fairly valued. Apple now having risen so much that it’s now moved into 2-star territory. Again, I think Apple is a very good company, very good fundamentals. We rate the company with a wide economic moat. At this point, we just think it’s a matter of valuation that investors are paying too high a price for the future free cash flows that we expect that company to deliver over its lifetime.

Market Fundamentals and Tightening Monetary Policy

Turning a little bit toward some of the market fundamentals, you’ll note here, monetary policy tightening. This has been the fastest and the steepest tightening cycle that we’ve been through I think until you look back all the way to the 1970s and 1980s. So, I do think the market is still trying to understand, try and digest what this might mean for the economy, what this might mean for earnings growth. I’d just note that this isn’t anywhere near as high as what we had seen back in the ‘70s and ‘80s when they were dealing with really high inflation back then.

Some of the other things that we’ve been watching: Headline CPI, I would note that that did bounce here the last couple of readings, but core inflation does continue to moderate and Preston and his outlook, we’ll talk a little bit more about his inflationary outlook. We did adjust our inflation forecast slightly higher, but we are still looking for inflation to continue to moderate over the course of this year and into next year. And I think that will help take some of the pressure off of the Fed as they’ve had to fight inflation over the past year and a half.

Strong Economic Growth Puts Pressure on Earnings

Taking a look at the economy, we’re looking for very strong growth here in the third quarter, but we do think that the economy will begin to start slowing down in the fourth quarter. We’re then looking for three sequential declines in the rate of GDP, bottoming out in the second quarter of next year before the economy then starts to move back upwards. I do think that will put some pressure on earnings over the next couple of quarters. But for long-term investors, we think that not only has the market taken this into consideration, but we think the market is probably actually taking a little bit too negative of a view as we do think that for long-term investors, the market has been pushed down enough at about a 10% discount that we do think it is attractive here.

Sector Valuations

So, let’s move on to our sector valuations. I would just highlight here that there really hadn’t been that big of a change in the percentage of the number of 4- and 5-star stocks at the end of this past quarter. Forty-six percent of the market is rated 4 or 5 stars, meaning that we think that they are undervalued. That’s almost the same as it was the prior quarter at 45%. And we see a slight decrease in the number of overvalued stocks with the market selloff. But again, it’s only going down to 13% from 15%.

Tech Sector Has Sold Off

Looking at the individual sectors here, I’d note that the technology sector has sold off. It’s sold off enough that the price to fair value has dropped to 0.98, so just a little bit under fair value at this point. So, I do think now is a good time to move technology to more of a market weight. We were looking at that as being an overweight. Last quarter, I believe it was trading at about a 7% premium to our fair values. And it’s really a combination of two things that went on this past quarter. One, just the selloff in technology stocks overall brought the valuation for the sector down. But I’d also note we did raise our fair value on a number of different technology stocks. The biggest increase that we had was our fair value on Nvidia. And I’d encourage investors to read our view there with everything that’s going on with artificial intelligence.

Communications Remains Undervalued

Now, communications still remains one of the more undervalued sectors. It was the most undervalued sector coming into the year. But following the amount that we’ve seen it rally thus far this year, it’s actually no longer the most undervalued. The title for that now is going to the real estate sector, which trades a little bit more of a discount than communications. And again, that comes from a combination of rising interest rates, as well as concerns about commercial real estate. Personally, I would still steer clear of office space. I do think that there’s a lot of potential volatility and more downside there. But when we look across a lot of the other real estate sectors, we’re just thinking that the market has brought that entire sector down too much.

Utilities Are Becoming More Attractive

I’d also note here that utilities, when we ran the numbers here a week and a half ago, were definitely becoming much more attractive than what we had seen. The utilities sector has really fallen over the past, I think, week and a half at this point. I think if you look at the Morningstar Utilities Index, I think year to date we’re down about 18% thus far. Now, utilities, of course, are going to be very correlated to interest rates. And we have seen interest rates rise; the 10-year is now up to about 4.80%. I think it was about 3.80% at the beginning of the year. The 30 basis points from 4.50% up to 4.80% have occurred really just in the past week and a half, and we’ve seen a lot of those other interest rates rise since the Fed meeting on Sept. 20.

So, with the utilities, I’d note with as much as they’ve sold off, they’ve actually sold off more than even the U.S. Treasury 30-year bonds. And I do think utilities, when we look at where they’re trading now compared to where they’ve traded over the past decade, I think our team noted there’s only been two other instances—in 2009, and again, at the beginning of the pandemic in 2020—that utilities on a price/fair value basis have been as undervalued as they are now.

Energy Is Moving Toward Overvalued Territory

And then, lastly, I’ll just note the energy sector, while it’s not terribly overvalued at this point, based on how much it has risen over this past quarter, it is starting to move into that overvalued territory. I do think there are a lot of good places there where you can probably look to start taking some profits, sell some of the stocks there, and take some of that off the table. We expect oil over the long term will decline.

Taking a look at some of our best picks by our different sectors, I just note the ones here that we’ve highlighted are new to the list. International Flavors & Fragrances IFF is a new one to the list. This is a stock that’s been under a lot of pressure that we think the market is misreading what’s going on there in the short term. They really have two parts to their business. They have some cyclical and then some more defensive types of chemicals that they sell. We’ve seen the cyclical ones being under pressure, whereas the defensive have held up. We do think that the cyclical part of that business has been pushed down and will normalize over time. So, that would be one that I’d highlight there.

Charles Schwab SCHW is another stock that we’ve noted a number of times over the course of this year that we think the market has too negative of a long-term view on. And probably the biggest change here in the banking sector is going to be Wells Fargo WFC. So, we actually swapped in Wells Fargo for Citigroup C, which had been on the list for quite a while. Now, Citigroup is still undervalued, and I think it’s actually still slightly more undervalued than Wells Fargo. But I would note that Wells Fargo does have a wide economic moat. It is a company that we think is further along in their turnaround process and has a stronger profitability profile than Citigroup. So, that was the change that we made this quarter.

Among economically sensitive sectors, again, it’s hard to find value in that energy sector. If you are looking for energy exposure, specifically in oil and gas, I would highlight Devon Energy DVN. That’s a new 4-star stock added to the list here. And within the energy sector, we still think a lot of the services companies and a lot of the pipeline companies remain undervalued. Our pick there would be Equitrans Midstream ETRN. A couple of other stocks like Johnson Controls JCI, a narrow-moat stock, high-quality company, Medium Uncertainty, trading at an undervalued level. Norfolk Southern NSC is another one I think is interesting. When you look at that, rarely has that stock ever traded at a discount, much less into that 4-star territory. Again, it’s a company with a wide economic moat and a couple of different moat sources there. Again, Warren Buffett certainly likes the rail sector as well. So, I think this would be a good one for investors to take a look at. And then, lastly, Snowflake SNOW, a new one to the list. So, with Snowflake, I do think that is a good play on artificial intelligence. They’re a data management provider that hosts enterprise data on which the artificial intelligence models are run. So, we do think that one has a good platform for future growth tied to AI.

Rounding out the list here in the defensive sectors. Now, the top picks in the utility sector are unchanged. But even over just this past week and a half, we’ve seen a lot of other stocks move into the 4-star from the 3-star territory and some 4 stars now moving into that 5-star territory. So, I certainly would recommend taking a look at whichever Morningstar platform you use and look for some opportunities there. And then, the last one I’ll highlight here would be Estée Lauder EL. Estée is one of these ones where it’s rarely ever traded at this large of a discount to our price/fair value. In fact, over the past 10 years, this may actually be the first time I believe that it’s traded in a 5-star category.

I’m going to whip through here by economic moat. I just would highlight that you can use the Morningstar platform and some of our different tools here to do some different screenings to help identify some of these high-quality companies. Specifically, if you’re looking for those that have a lower or more Medium Uncertainty, these are ones that we think are trading at very deep discounts for as high-quality companies as they are. So, we’ve done this depending on what you need for your portfolio by large cap, by mid-cap, and on small cap. I would just note here for the small-cap stocks that we also included those that had a narrow economic moat. As you imagine, a lot of small-cap companies, it’s very difficult for them to be able to earn a wide moat under our methodology.

So, with that, I’d like to go ahead and turn it over to Preston so he can review his economic outlook.

U.S. Economic Outlook

Preston Caldwell: Thank you, Dave. So, just to set the stage, after one of the fastest economic recoveries in U.S. history in 2021, we saw GDP growth normalize in 2022, and growth was also buffeted by the impact of oil price shocks and the Fed’s rate hikes. Now, it was widely expected that the Fed’s rate hikes, which were the largest in 40 years, would slow GDP growth in 2023. But that hasn’t panned out so far. While rate hikes have hit housing activity, the rest of the economy largely seems hardly affected, and overall GDP growth has been propelled upward by free-spending consumers as well as a manufacturing building boom. Yet despite all of this, we still believe that the impact of high interest rates has yet to fully play out. And so, we expect growth to slow in 2024, before bouncing back in 2025 and following years as the Fed eases monetary policy.

Inflation Is Falling in 2023

Looking at inflation on the bottom chart, inflation in 2022 reached its highest level in 40 years as supply constraints combined with excess demand to drive up prices. But those selfsame supply constraints are alleviating, and the Fed’s rate hikes have moderated demand somewhat. As a result, inflation is falling greatly in 2023 and should be back to the Fed’s 2% target in 2024 and the following years. Specifically, the price spikes in energy and durable goods and other areas have been progressively unwinding, and we ultimately expect that process to last for several years.

Comparing our forecast to consensus. On the GDP front, the top chart, we’re similar to consensus in the near term, although, on a five-year time horizon, we expect a cumulative 3% more real GDP growth than consensus, owing to greater optimism on the supply side, particularly labor supply expansion via greater labor force participation. Looking at inflation on the bottom chart, we’re more optimistic than consensus on the ability to bring inflation back to 2% in a timely fashion. And as a result, that’s the biggest factor that’s driving our belief that the Fed will cut rates in 2024 and 2025 faster than the market currently expects.

Will the Fed Cut Interest Rates in 2024?

Turning to interest rates in more detail, we’re again expecting the Fed to cut rates very aggressively over 2024 and 2025, bringing the fed-funds rate from over 5% today to actually below 2% by 2026.

Ultimately, I would say the biggest reason is that housing is the biggest engine of cyclical movements in the economy, and lower mortgage rates will be needed to drive a sustained recovery in the housing market. In fact, if mortgage rates remain where they’re at right now at very high levels, I would say we’re in for another leg of a housing downturn, which will be quite severe. Fortunately, we expect the Fed to course correct and bring mortgage rates down to a level that will not only avert a greater housing downturn but even start to drive a recovery in that sector and also to avert distress in the rest of the financial system that could evolve if rates remain quite high. And our long-term 10-year Treasury yield projection is 2.75%, and we expect to get there by 2025, as you can see, we’ll actually perhaps be a little bit under it. That’s driven largely by our assessment of long-run trends in U.S. interest rates. I’ll talk more about the drivers of that later in the presentation.

Expect Rapid GDP Growth in Q4

Zooming into the near term. Right now, the Atlanta Fed’s nowcast is projecting growth to surge to 4.9% in the third quarter, GDP growth on a quarter-over-quarter annualized basis. Our expectation is a bit lower at 3.9%, but that’s still a quite rapid rate of growth. What I would say is to not overreact to these quarter-to-quarter fluctuations in the growth rate because GDP growth is always noisy, and that’s certainly been the case in this pandemic and postpandemic recovery. We saw in the first half of 2022, for example, a negative rate of GDP growth, which some people said was the start of a recession, but we argued that that wasn’t the case. And indeed, things bounce back quite quickly, and the year-over-year rate remained positive during all of 2022.

So, I would say specifically, part of the reason why the third quarter will be strong is net exports and inventories, and those are very volatile components of growth, likely to move in the opposite direction in following quarters. And then also consumption has been strong in the third quarter, but we are expecting consumption growth to weaken over the next year as consumers become more conservative. You can see our GDP forecast in the bottom chart where we’re expecting GDP growth to eventually weaken below 1% for the first three quarters of 2024 and in sequential terms before starting to reaccelerate again, especially heading into 2025 when we think the impact of eventual Fed rate cuts will start to strengthen the economy again.

Recent Strong Consumption Growth and Declining Household Savings

More detail on the consumer situation. Consumption growth has been quite strong recently, and commensurately, we’ve also seen the household savings rate be very weak. The household savings rate, the personal savings rate, has been just 4.3% in the last three months on average, well below the prepandemic average of 7.4%. And that likely reflects the fact that earlier during the postpandemic recovery, we had a large accumulation of excess savings, driven by the fiscal stimulus and other factors, and now those excess savings are getting spent down. But the stockpile of excess savings, as you can see on the bottom chart, is depleting. Now, the question is, when will it run out? That depends on what savings rate you use as the baseline. If you use the 2019 savings rate, then this excess savings will be depleted by the end of this year. But regardless, I would say with those stockpiles getting smaller, that should gradually steadily weigh on consumption and induce households to become more conservative and normalize their spending patterns.

The Inflation Reduction Act, Chips Act, and Manufacturing Building Boom

In addition to consumers, one of the biggest factors that has kept growth strong in 2023 is this manufacturing building boom with investment in manufacturing structures reaching its highest level since the early 1980s as of the second quarter. Now that’s been driven mostly by semiconductor manufacturing along with clean energy such as new battery plants for electric vehicles. All of that stimulated by the legislation, the Inflation Reduction Act and such, and the Chips Act that we’ve seen over the last year that has provided very lucrative subsidies for manufacturing plants in these areas. So, all of that is having the desired effect of creating a surge in manufacturing investment and that will probably plateau from here on out. So, the effect on the growth rate—we won’t see continued incremental effect on the GDP growth rate from here on out as things plateau at an elevated level of building. And then, we’ll start to see this likely run in the opposite direction sometime in probably 2025 or 2026 when these projects start to wrap up. At that point, spending will start to fall. But by that time, I would say, the effect of Fed rate cuts will be propelling a more broad-based pattern of economic growth and cushion any negative impact from lower spending from the factory building.

Bank Lending

I mentioned earlier, looking at the bottom chart that, the effects of Fed rate hikes that have happened over the last year or so have yet to fully play out. And in one way we can see that is in terms of bank lending. So, bank lending growth is decelerating. It has been since the start of this year, but that’s a very much delayed reaction to the impact of rate hikes. That still has a long way to play out. Growth in year-over-year terms is still in positive territory, including for commercial real estate. And that’s certainly not likely to persist. I mean, positive growth is not likely to persist. We’re likely to see an outright contraction in credit at some point within the next year. And so, that will continue to weigh on the economy as banks pull back their lending.

Expectations for the Fed and Interest Rates

Looking at the top chart, this shows our expectations for the fed-funds rate compared to what the market and the Fed are expecting. The market and the Fed are really pretty closely in line with each other right now, and we’re expecting rates to come down much faster, ultimately, mainly because we’re more optimistic on inflation. We think inflation will come down faster than the Fed is currently projecting. So, that’s really the biggest factor driving our view on rates in the near term. And despite some positive reports on inflation, we’ve seen a huge rally and a huge increase in bond yields, looking at the bottom chart, in the last several months, particularly longer-dated yields. And if we break, let’s say, the 10-year Treasury yield apart, we see the real 10-year Treasury yield, the inflation-adjusted, or the TIPS, yield has accounted for most of that increase. That real 10-year Treasury yield hit 2.4% yesterday, which is actually above the 2003 to 2007 average of 2.1%. I think that’s very significant because that was what I would say is a kind of a maximal level for what the real 10-year yield could sustainably be in order to sustain normal economic growth, because we were in the midst of a housing bubble during that period, which was driving the economy upward despite fairly high real rates. So, I don’t think that we can sustain a real 10-year Treasury yield that’s higher than it was during the housing bubble. I think as these high interest rates continue to filter through into the economy and balance sheets continue to strain under the heavy load of this very high interest burden, that that’s progressively going to weigh on growth, perhaps due to outright episodes of financial distress which have yet to fully materialize. And all of that will push interest rates down.

If you have access to the Morningstar platform, I did a very lengthy piece about a year ago, talking about the drivers of our interest-rate forecast. And one thing that I looked at was, what has driven the long-term decline in interest rates over the last 40 years. Because we’ve seen real interest rates fall by several hundred basis points compared to where they were in the early 1980s. And the factors that have driven that are long-term factors such as aging demographics or increasing income inequality and a slower rate of technological progress, which reduces the desire to invest. And all those factors by and large are still in place. Those long-term trends have not reversed course. Certainly, aging demographics have continued to march in the same direction over the decades. And that hasn’t changed. So, I see little reason to think, given that these long-term forces remain in place that we’re going to reverse the trend of low interest rates that was in place throughout the entire 2010s. I think right now markets are deceived by the strength of the near-term economy.

Core Inflation Is Falling

More detail on inflation. We’ve seen the headline CPI at 3.7% year over year in September, down sharply from its peak levels. And more importantly, we’ve started to see progress on the core inflation front because initially the CPI had been driven down heavily by falling energy prices while core inflation, that is prices excluding food and energy, had remained stubbornly high. But now, we’ve seen core inflation, core CPI, at 2.4% annualized in the last three months. If we look at the bottom chart, that kind of tells the story of what’s happened. So, toward the beginning of 2023, we saw core inflation excluding shelter, or housing prices, in other words, go very low. But because shelter inflation continued to go higher, core inflation remained stubbornly high at that time. And then, toward the spring of 2023, we finally saw shelter inflation come down. And yet, we had a rebound in all other components of core inflation driven by durable goods, for example, among other areas. But now, we’re finally seeing all the components of core inflation move down in concert. And that’s something that we expect to sustain going forward.

Now, with all that said, we did hike our inflation forecast just a bit compared to where we were a month ago. And that’s driven by, first, oil prices, where I will note I haven’t updated this chart for the market movement of the last couple of days. We have seen an oil price correction in the last several days. So, some of this rally in oil prices has unwound. Nevertheless, I wouldn’t be surprised to see oil prices head back up again in the fourth quarter of this year, given these production cuts from Saudi Arabia and Russia that we’ve seen that have helped to drive up prices. But regardless, I would say, if you look at the futures market expectations, they remain backward-dated so that markets expect that oil prices will decline 10% to 15% over the next year. And so, in line with that, we do think the long-run trend will be to ease energy prices.

But the factor that remains very much in play is vehicle prices where we have hiked our expectations a bit for vehicle prices over the next several years, affecting the durable goods category. And that’s recognizing these auto worker strikes that we’ve seen where the direct effect from the strikes is not likely to be large because I don’t think these strikes are going to last for that long and they haven’t targeted a wide array of plants at this stage. But the wage increase agreement that they’re likely to come to is going to entail a large increase in labor costs for automakers, and that will help to propel vehicle prices a bit higher than we had expected previously.

Inflation Forecast

With all that said, though, looking at our overall inflation forecast, you can see we’re expecting massive declines in durable goods prices over the next several years as supply chains continue to normalize. Likewise, we expect food and energy to generally be a negative impulse as conditions normalize in those sectors. And also, housing. Housing has been the final leg of high inflation that has sustained the inflation rate upward in 2023. Turning to this slide, this top chart here, this has to do with how the housing component of the inflation index is constructed where it responds with a lag to what market rents are doing. In other words, by market rents, I mean the rents that new tenants are paying for new apartments. That runup in market rents has driven a delayed response in the CPI shelter component. But now that the gap between those measures is closing, we’re starting to see CPI shelter to accelerate and that will continue over the next year. We should see CPI shelter growth return entirely to normal. And of course, we don’t think that market rents will reaccelerate again given the ongoing high rate of additions to the housing supply as well as overall weak housing demand given high interest rates.

Wage Growth Outlook

Turning to wage growth, at the bottom chart, that would be another factor that could drive sustained high inflation. But we do see looking at our composite measure of wage growth, a downward trend in wage growth. It hasn’t returned fully back to prepandemic normal levels yet, but we have seen about 100 basis points in wage growth reduction since mid-2022. And despite all the news articles about labor unrest, even if all the auto workers go on strike, only about 0.3% of the U.S. workforce will be on strike. And that’s actually a far cry from the heyday of union activity in the 1950s when in a typical year 3% to 4% of U.S. workers might have been on strike. So, it’s still quite small compared to the size of the U.S. economy.

I’m going to skip this slide here and turn it back over to Dave.

Sekera: All right. Thank you, Preston. I appreciate it. Just to give you some warning here, Preston, I’m seeing a lot of questions coming in for you. So, catch your breath, get yourself a drink of water, and I’m going to run through these slides relatively quickly just so that we do have enough time to take a lot of these questions because a lot of them are really good.

Mega Stocks Mimic the Magnificent Seven

As far as looking at the mega-cap stocks, as you know, a lot of these are also going to be some of the same that are the magnificent seven. You can see coming into the year, a lot of the mega-caps, which were 4 and 5 stars, have moved up. So, again, Alphabet still being one of the few that’s at that 4-star level. Same thing with Bank of America BAC. Looking forward, at this point, Alphabet is the only one that we consider to be a mega-cap. Now, my definition of mega-cap is $250 billion in market cap or greater. So, that’s why we saw Bank of America fall off this list as its market cap no longer makes that cutoff. I’d just highlight two others for people where their market cap isn’t enough to be deemed a mega-cap: Salesforce and [Thermo Fisher Scientific] TMO would be two that I would note that are 4 stars right now whose market caps don’t make it, but I do think are attractive.

In the mega-caps where they had come into the year being overvalued to star-rated, pretty much all of these have well underperformed the market year to date. So, where does that leave us today? A handful here. The one I would highlight was probably going to be Eli Lilly LLY. That’s a stock that’s really taken off thus far this year. That stock is very leveraged to one of their weight loss drugs, which certainly has been doing phenomenally as far as the amount of sales. I would recommend reading Damien [Conover’s] research here and why he thinks this stock is overvalued at this point and is probably a very good time to be selling some shares and locking in profits here and a number of other companies here that have dropped off the list.

Fixed-Income Outlook

Let’s wrap it up with a quick fixed-income outlook. Of course, a lot of the fixed-income market has had some very poor performance with the rise in interest rates. To be honest, these returns here are already outdated over the past week and a half just as much as the 10-year has risen. But I think more importantly thinking about what we expect going forward, thinking about the 10-year Treasury, at this point, it’s always hard to know in the short term how much more the yield could rise. I’m not a technician, but taking a look at the charts here, it does look like the market does want to maybe try and test that 5% level. But for longer-term investors, we do think that rates will be coming down over time. If we’re looking at Preston’s forecast for 2024 of 3.25%, it’d be a 150-basis-point rally in the long end of the curve. That certainly would be a huge boost to fixed-income returns next year as well. I do think now is a good time to certainly be moving further and further out on the yield curve. We were looking for being shorter in the yield curve, more in that mid-part of the yield curve earlier this year. But with as much as rates have gone up and our expectations for them to come down, I do think it’s good to get longer in yield, especially because if we are right and we do have the fed-funds rate starting to come down early next year, I would expect that those short-term rates come down very quickly. So, again, good time to be locking in a lot of these longer-term yields.

The Corporate-Bond Market Has Outperformed This Year

Then let’s wrap up here with a quick look at the corporate-bond market. Now, the corporate bond market has outperformed thus far this year. A lot of that is due to the extra yield that you get because of the corporate credit spread. Through Sept. 25, we had seen in the investment grade market the Morningstar US Corporate Bond Index tighten 19 basis points. So, that helped offset some of the rise in yields. And then, in the high-yield market, we saw them tighten 85 basis points to 394. I know that’s backed off over the past week as well. I think we’re about 425 right now.

So, thinking about where corporate bonds should be going forward. Now, we are starting to see some more bankruptcies out there, but the bankruptcies that I’ve seen have been more either in the private markets or among middle market and smaller companies. We’re not seeing a pickup in bankruptcies yet in the public markets. As far as the economy goes and thinking about how that impacts not only defaults, but also potentially credit downgrades, we could see some pickup in downgrades as the economy slows over the next couple of quarters. But again, we’re not forecasting a recession. So, I wouldn’t expect to see a huge increase in the number of downgrades. And while we will see a pickup in the number of defaults, we think that you’re getting paid well enough in the high-yield market right now to be able to accommodate a slight pickup in the number of bankruptcies. So, again, while we’re certainly less attractive than what we were at the beginning of the year as far as the excess credit spread that you’re picking up here, I do think you’re getting appropriately paid at this point in time.

Dziubinski: Well, I’d like to thank Dave and Preston for their time this morning. And thank you, of course, everyone for joining Morningstar’s fourth-quarter 2023 US Stock Market Outlook webinar. Have a great day.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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About the Authors

David Sekera, CFA

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Dave Sekera, CFA, is a strategist, markets and economies, for Morningstar*. He provides comprehensive valuation analysis of the US stock market based on the intrinsic valuations generated by our equity research team. Sekera’s research identifies undervalued and overvalued areas across styles, capitalizations, sectors, and individual stocks.

Before joining Morningstar in 2010, Sekera worked in the alternative asset-management field generating capital structure, risk arbitrage, and catalyst driven investment recommendations. His other prior experience includes identifying buy/sell and long/short recommendations for a proprietary trading book and conducting portfolio risk management. He has over 30 years of analytical experience covering every part of the capital structure within the securities markets.

Sekera holds a bachelor's degree in finance and decision sciences from Miami University and holds the Chartered Financial Analyst® designation.

Please note, Dave does not use either WhatsApp or Telegram. Anyone claiming to be Dave on these apps is an impersonator. He will not contact anyone on these apps and will not provide any content or advice on either app.

* Morningstar Research Services LLC (“Morningstar”) is a wholly owned subsidiary of Morningstar, Inc

Preston Caldwell

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Preston Caldwell is senior U.S. economist for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He leads the research team's views on U.S. macroeconomic issues, including GDP growth, inflation, interest rates, and monetary policy.

Previously, he served as a member of the energy sector team, covering oilfield services stocks and helping to craft Morningstar's long-term oil price forecasts.

Caldwell holds a bachelor's degree in economics from the University of Arkansas and earned his Master of Business Administration from Rice University.

Susan Dziubinski

Investment Specialist
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Susan Dziubinski is an investment specialist with more than 30 years of experience at Morningstar covering stocks, funds, and portfolios. She previously managed the company's newsletter and books businesses and led the team that created content for Morningstar's Investing Classroom. She has also edited Morningstar FundInvestor and managed the launch of the Morningstar Rating for stocks. Since 2013, Dziubinski has been delivering Morningstar's long-term perspective and research to investors on

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