Economic Letter

By Patrick Pascal

January 2024

ECONOMY

In 2023, employers added 2.7 million jobs, vs. 4.8 million in 2022. The U.S. economy added 216,000 jobs last month—larger than November’s gain of 173,000—and above the 105,000–110,000 rate that is needed to keep unemployment steady. The rate of unemployment held steady at 3.7%—better than forecasters expected—while the average number of hours worked shrank by 0.3%. Average hourly earnings rose by 4.1% from 12 months ago—also more than expected. As inventories continue to return to more normal levels, hiring might cool down somewhat—lowering wage pressures.

Households have greatly deleveraged since the financial crisis of 2008 and an extended period of historically low interest rates has made the burden of servicing their debt lighter. Strong consumption persists as excess savings, accumulated over the pandemic, continue to support and stimulate our economy. A Bank Credit Analyst report estimates that about $400 billion in “excess” household savings remains and that this can support present rates of consumption into the second quarter. Yet anecdotally, auto and credit card delinquency rates have been slowly rising for nearly two years.

The University of Michigan’s consumer sentiment index soared 14% in December. Expected business conditions surged over 25% for both the short and long run. The Consumer Confidence Index® increased from 101.0 to 110.7 in December and its Expectations Index leapt from 77.4 to 85.6. Such bullishness could fuel inflationary pressure and hinder the Federal Reserve’s efforts.

FIXED INCOME

The consumer-price index increased 3.4% (annualized) in December, well down from a 6.5% rise at the end of 2022. After two years of declines, inflation-adjusted wages rose 0.8% last year. A recent survey of Federal Open Market Committee participants revealed a mean 2024 inflation estimate of 2.4% and a year-end unemployment rate of 4.1%.

Since June of 2022, the Federal Reserve has successfully employed Quantitative Tightening (QT) to shrink its balance sheet. Nonfinancial corporate debt service costs (as a percentage of expenses) fell to the lowest level in over 50 years. Once balance sheet reserves fall back to about 10% of GDP (November at present pace) the Fed will have reached this target. A recession or market liquidity event next year would accelerate the end of QT.

2023 experienced high interest rate volatility as the 10-year Treasury yield fluctuated between 3.3% and 5.0% only to end the year almost exactly where it started at 3.8%. The recent bond rally has been underpinned by rising hopes that the Fed could make up to five 25 basis point cuts by the end of 2024. We believe 2 to 3 cuts of 25 bps is a more likely scenario. 2024 will be a bumpy ride as the pace of U.S. growth and Fed rates continues to shift. We favor short to medium term investment grade bonds, while taking opportunities to extend durations as market conditions warrant.

On Friday, January 5th, U.S. Treasury Secretary Janet Yellen said, “What we’re seeing now I think we can describe as a soft landing, and my hope is that it will continue”. The dual, and sometimes conflicted mandate of price stability and full employment requires deft monetary policy to attain both conditions while also bringing inflation under control.

EQUITIES

U.S. equity markets remained strong in December. Optimistic investors, anticipating lower inflation and interest rates in the months ahead that particularly benefit growth-related companies, pushed prices higher. After rising nearly 15% in two months, the S&P 500 Index presently carries a price-earnings ratio of just under 26. This P/E is slightly above the typical ratio under present macro-economic conditions. Market sentiment and momentum indicators also suggest somewhat overbought equity valuations which may require further confirmation of lower interest rates without a recession and continued rapid development of AI-related advancements.

Much of 2023’s rally was among a relatively few, fast-evolving, AI-related shares. The history of past fundamental technologic revolutions suggests that AI’s full adoption and integration into the world could last decades. If history repeats itself, many of the world’s future AI leaders don’t yet exist and some of today’s sector leaders will not survive. At the advent of personal computers, Apple was founded in 1976 and its initial public offering was in 1981. Twenty years later, after many twists and turns for the company and its peers, the shares had tripled in value. Over the following twenty years, as it leveraged superior technology, management and operations, its share price rose by another 400 times.

Just like with computers, the internet and cell phones, many of the future’s greatest AI participants are presently unknown. The best opportunities may emerge in the years ahead among both present and future leaders in AI development, adoption or utilization. Established tech companies with proven records of innovation and strong management can provide real exposure to AI developments at less risk. Over time, AI will also deliver unprecedented improvements in efficiency and productivity, raising prospects across many industrial sectors that adopt the technology and these ancillary beneficiaries may also offer strong AI related opportunities.