We are on the watch for further deterioration in the spending power of this lower income demographic—and we expect further pain from rising gasoline prices and resumption of student loan payments. Credit card delinquencies at the aggregate level are not alarming, but they are rising rapidly for lower-income borrowers as borrowing rates hit their highest level on record at 20.7% in May.*
Other “known unknowns” include the duration and impact of union strikes, as well as the chance of a prolonged government shutdown. (At the time of writing, UAW strikes were still ongoing, and Congress had reached a deal to fund the government but only for an additional 45 days.) These policy risks tend to get lots of headlines but have historically had a temporary and modest impact on economic activity. Still, that does not mean they cannot provide another catalyst for profit-taking in the equity market.
When we lay it all out, the balance of risks favors a soft landing for the U.S. economy. We place the highest probability—slightly greater than even odds—on slower but sustained economic growth as we move into 2024. We give a roughly 25%–30% probability to a mild recession scenario, which could see a modest pullback in consumer spending and capex and a roughly 2% increase in the unemployment rate. The probability of a “no landing” scenario has increased in recent weeks. We define a no-landing scenario as economic activity continuing at an above-trend pace and necessitating “higher for longer” interest rates. Ironically, this no-landing scenario may be the worst for equities, since it could result in the Fed overtightening policy and sending the economy into a deeper recession further down the line.
Where the economy meets markets
A constructive economic outlook may seem at odds with our slightly defensive positioning in portfolios. We currently hold a slight underweight to U.S. small-cap and international developed equities versus our long-term strategic benchmark. When we compare the value proposition of equities to safer assets—including cash and investment-grade fixed income—we are hard-pressed to find a compelling argument for taking on added risk at this time. The 10-year Treasury yield climbed to 16-year highs in the third quarter. It is our view that rates will come down over the next 12 months, as growth slows and the Fed begins to cut rates. This argues for an overweight position in investment-grade fixed income.
While we still hold slightly elevated levels of cash as dry powder, cash holds significant reinvestment risk—meaning that if short interest rates come down, return prospects will be much less attractive than if an investor had been holding longer-duration assets. The risk versus return profile for investment-grade fixed income is favorable, as the current yield means that even a moderate 50bps increase in rates from here could still result in positive total returns for bonds. Meanwhile, if rates fall by 50bps or more, total returns could approach double digits. For the municipal bond market in particular, municipalities have solid balance sheets with ample cash, and inefficiencies of that market offer potential for those focusing on sound credit research.
Figure 4: Current positioning
High-net-worth portfolios with private markets*