Of all the factors that could shape the direction of U.S. stocks and bonds in 2024, three stand out: interest rates, corporate earnings and geopolitical events.
Corporate earnings and their derivative, cash-free cash flow, have always been on Wall Street's radar. They are a critical input in almost every model, which calculates the intrinsic value of a company as the present value of future cash flows to stockholders.
Professional traders and investors call earnings the "milk" of Wall Street, a critical driver of the stock's market price in the long term.
Earnings decline in economic contractions and rise in economic expansions, taking stock prices of listed companies for a wild ride. That's why traders and investors try to figure out which direction the economy is heading before placing their bets on equities.
At the end of 2022 and the beginning of 2023, it looked like the U.S. economy was heading into a recession, and that could explain the sell-off in equities, especially in the shares of the smaller companies trading in Nasdaq and Russell 2000.
But the recession never happened. Instead, the U.S. economy remained resilient throughout the year, prompting equity analysts to revise their earnings forecast for the end of 2023. For instance, according to FactSet, which monitors the financials of the S&P 500, the index reported earnings growth of 4.9% for the third quarter of 2023 and is projected to register an earnings growth of 2.4% for the fourth quarter.
And that could explain the rally in equities in the last six weeks.
"2023 may go down in history as the year that defied all odds," Kelly Milligan, who co-founded Quorum Private Wealth, told International Business Times. "At the end of 2022, nearly every expert at the major banks predicted a recession and bear market in 2023. And yet, despite some volatility and selling over the summer, markets logged a largely positive year."
Will the recession happen in 2024? Most likely not, based on macroeconomic data like GDP and employment growth, which support the narrative of a soft landing — a situation of moderate growth and lower inflation — rather than an outright recession.
A soft landing could help listed companies maintain the positive earnings momentum of the last two quarters, a tailwind for equity prices in 2024.
Javier Palomarez, founder and CEO of the United States Hispanic Business Council (USHBC), believes the upcoming earnings season will favor the established giants, particularly the "Magnificent Seven," as they close a 2023 earnings growth of approximately 40%.
"Meanwhile, smaller, growth-oriented companies on the exchange are finding it challenging to keep pace," he said.
Still, interest rates are another driving force for equity prices and asset allocation. They are the discounting factor in the intrinsic value calculation models and a critical driver of the asset's market price in the long term.
When interest rates rise, the intrinsic value of bonds and stocks drops, as future cash flows become less valuable when discounted to the present — especially the intrinsic value of long-maturity bonds and smaller stocks where the pay-off is in the distant future.
By contrast, when interest rates drop, the intrinsic value of bonds and stocks rises, driving market prices of bonds and stocks higher.
In both cases, expectations come into play, with traders and investors placing their bets ahead of the actual move in interest rates.
That could explain the market performance of stocks and bonds in the last 15 months.
Traders and investors rushed to sell Treasury bonds, corporate bonds, and mortgage-backed securities (MBS) at the end of 2022 and early 2023, as interest rates were on the rise, and reversed course in the last couple of months, as interest rates headed the other direction.
Lower interest rates could be a tailwind for both stocks and bonds in 2024, provided that the U.S. economy weakens enough to help bring inflation closer to the Fed's 2% target, but it doesn't slide into a recession hurting corporate earnings.
While lower interest rates bode well for stocks and bonds in 2024, there is always geopolitics, which could change the game. For instance, the continuation of the Russia-Ukraine war and the escalation of the Middle East war could revive supply chain issues, spoiling the central bank's efforts to contain inflation.
Then there's the ongoing tensions between China and the U.S. and its allies in the South China Sea, which widen the rift between Washington and Beijing. It could hurt the top and bottom lines of large U.S. companies with a large presence in China.
And there's the wild card of the U.S. elections, which could magnify these tensions.
Meanwhile, the recent rally on Wall Street makes market analysts skeptical about 2024. Milligan is one of them.
"As many of us get ready to wind down for the year and enjoy the holiday season, the markets spent most of November and early December signaling major rebounds," he said. "While it's common for stocks to rally in December (the so-called Santa Claus rally), we saw even more optimism this year thanks to signals that the Fed may cut rates as many as four times in 2024."
But Palomarez is optimistic about U.S equities.
"The resilience of large corporations in our current economic climate stems from their abundant resources and flexibility when it comes to risk-aversion strategies, allowing them to seize opportunities with less relative risk to their bottom line," he noted. "As we move forward into 2024, I'm optimistic that our economy will reach a point that enables small businesses to invest, grow, and achieve increased profitability."
