Equity markets climbed in December as inflation data continued to cool and expectations for less restrictive monetary policy in the future increased. Large company stocks, in the US and abroad, posted mid-single-digit percentage increases. In the US, smaller company stocks stood out as they were perceived to benefit incrementally more from the expectation of lower future interest rates.
In the fixed income market, bonds rose as interest rates along the yield curve retreated. Investment grade and riskier borrowers alike saw their borrowing costs begin to fall. It is true that the default rate is higher for the riskiest borrowers and sectors with long-term, secular problems, but they appear to be manageable so far. Overall, capital markets seem to be holding up.
In December, the Federal Reserve met and held interest rates steady while acknowledging the significant progress made thus far in their inflation fight. The Fed’s own forecast now calls for 3 interest rate cuts this year. In his post-meeting press conference, Fed Chair Jerome Powell discussed the potential for less restrictive policy in 2024 as the rate of inflation declines. The market interpreted his remarks as dovish and asset prices rose into year-end.
One may wonder why US policymakers are forecasting rate cuts if inflation is not yet back at its target. The prevailing theory is that the current interest rate policy becomes more restrictive as inflation decelerates. That explanation seems reasonable enough to us. Inflation has been moderating, and that trend is expected to continue, but easing policy too quickly could lead to a reacceleration. How that plays out over the course of 2024 is, at best, an educated guess.
For those wondering what 2024 may have in store for markets, Wall Street has an abundance of forecasts, and they seem increasingly upbeat. We would remind clients and readers that the prevailing sentiment was pretty pessimistic a year ago. From our perspective, the private sector of the economy has handled higher rates fairly well thus far, but that could change. To us, the question is whether inflation moderates fast enough so that interest rates can start to come back down before the private sector’s ability to tolerate higher rates wanes.