Has the U.S. economy avoided a recession and achieved an economic “soft landing”?
It looks like it, given the latest data pointing to a still-robust economy:
- Annualized GDP for the fourth quarter of 2023, adjusted for inflation, grew 3.3%, driven by strong consumption and government spending.
- Consumer confidence, as measured by The Conference Board, registered its best reading in January since December 2021.
- Nonfarm payrolls grew by a larger-than-expected 353,000 in January, while the unemployment rate held at a below-average 3.7%.
- Finally, the S&P Global purchasing managers’ output index (PMI) showed better-than-expected expansion in both the services and manufacturing sectors.
Inflation, meanwhile, remains down from its near double-digit high in June 2022, albeit still above the U.S. central bank’s 2% target.
While the odds of an imminent recession are fading, investors now must grapple with a new question: What comes next?
A 1990s-Style Rebound?
Many investors seem to expect a “V-shaped” economic rebound that accelerates sharply upward from its low point and fosters strong equity returns over the coming two years. That scenario reflects the events of the mid-1990s, when the Federal Reserve last pulled off a soft landing that helped stabilize inflation, avoid recession and set the stage for a strong expansion.
However, Morgan Stanley’s Global Investment Committee believes this forecast may be too ambitious, offering an ill-fitting analogy for two different eras. The economy of the mid-1990s, with stronger household balance sheets and somewhat higher unemployment, featured ample potential for pent-up demand and “slack” in the labor market (i.e., the shortfall between workers’ desired amount of paid work and the amount of paid work available). These conditions helped set the stage for resurgent growth back then. By contrast, today’s relatively weaker household balances and tighter labor market may not offer as much runway for growth.
Or a Return to “Normal”?
Instead, we believe the 2024 soft landing is more likely to feature decent but unexciting growth, with company profits and interest rates hovering near current levels—what we call “sideways normalization.” Here’s why:
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Further gains in profitability seem unlikely.
Corporate margins, while having retreated from stimulus-charged 2021 highs, are already at some of the best levels since pre-COVID. The market may be looking for further margin expansion from here, but that may prove challenging to achieve, as corporate pricing power is likely to weaken and drivers of company performance may grow more business-specific.
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2Interest rates may not fall as quickly or as far as investors might want.
Markets are still pricing in 6.5 Fed rate cuts this year and selling off at the sign of even just a few months’ delay in cuts. Given the potential for higher long-term growth and outsized federal deficits, however, we believe rates are more likely to stay higher than their pre-pandemic averages, which could weigh on stock valuations.
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3Economic growth appears less sensitive than anticipated to changes in interest rates.
This likely cuts both ways: Just as the economy withstood Fed rate hikes better than expected last year, it may not benefit as much as hoped when rates start to decline.
How to Invest
In this kind of a solid but sideways-trending market, we favor investing for quality growth at a reasonable price and expect only modest and select opportunities for investment gains from falling interest rates, versus major broad-based gains across stock indices.
Investors should consider equal-weighted exposure to major U.S. stock indices within the context of highly diversified portfolios. We also encourage active stock picking, and believe that real estate investment trusts (REITs), gold, hedge funds, investments in Japan, emerging markets other than China and select European companies are likely to be outperformers. Also consider allocating more of your portfolio to Treasuries and corporate credit.
