Economic Indicators Point to a Downturn, Yet a Goldilocks Outlook Sparks Excitement

Week In Review – December 1, 2023

Economic Indicators Point to a Downturn, Yet a Goldilocks Outlook Sparks Excitement

In assessing current risks and opportunities in the U.S. financial markets, having an understanding of the current position and anticipated direction of the economy in the coming year can establish a foundation for tactical positioning and risk assessment. While inherently subjective, the following table suggests that the U.S. is currently in a late cycle and is trending towards a downturn.

On the positive side, the direction of the cycle suggests further abatement of inflation, setting the stage for prospective easing policies (lower interest rates). This shift would be a welcome departure from the past 18 months and could support financial market valuations. However, the next stage of the cycle also aligns with deteriorating economic growth, declining corporate profits and earnings, and a fall in credit—historically factors that have weighed on financial market performance.

At this juncture, financial markets seem to be navigating a positive balance between offsetting forces, operating under the assumption of a ‘soft landing.’ In such a scenario, markets anticipate the Federal Reserve (Fed) to maintain its position, inflation to decelerate, and lower bond yields to provide organic support to the economy. Economic growth would decelerate, but not contract, while healthy risk appetites persist. In other words, a ‘Goldilocks’ outlook for financial markets is anticipated, offering opportunities for both equities and fixed income. This outlook gained swift acceptance in November, marked by strong performance for financial assets during the month.

As we move through into 2024 and into the next stage of the economic cycle, alternative scenarios to the “soft landing” cycle must be considered – namely the “no-landing” scenario or the “hard landing” scenario.  The “no-landing” scenario can be summarized by continued economic resiliency expressed in strong employment, consumer spending, and corporate growth and profitability driven by demand growth and pricing power.  This scenario effectively played out during 2023 relative to more subdued economic expectations at this time last year.  The negative implications of the scenario are sticky inflation driven by elevated pricing in segments of the Core Consumer Price Index (CPI) such as core services and shelter and a Fed determined to keep interest rates higher for longer increasing the risk of an eventual deeper downturn.

If the “no-landing” scenario were to materialize in 2024, the rally in fixed income, particularly at the longer end of duration, would likely end, if not reverse.  In equities, volatility would likely increase with valuation multiple pressure and concerns about a more severe downturn as higher rates curb growth expectations and elevate the risk from coming low interest rate debt maturities.

In a potential ‘hard-landing’ scenario, we anticipate a surge in unemployment, a decline in consumer spending, and weakened demand for corporates. This, coupled with disinflation leading to a profit recession from falling prices, may unfold. On a positive note, concerns about inflation would dissipate, creating room for the Fed to implement easing policies.

In this envisaged scenario, high-quality fixed income is positioned for strong performance, while lower credit may face pressure due to rising spreads and default concerns. Equities, particularly cyclicals, could experience collective pressure. Conversely, quality growth and defensive equities are expected to weather an economic downturn more resiliently. Looking ahead, the positive outcome of a downturn lies in the resetting of inflation and prospective growth from a cyclical trough, laying the foundation for the next economic growth cycle.

At Pallas Capital Advisors, we strive to remain on top of the macro investment environment while retaining a longer-term perspective in allocating across asset classes and individual investments. We believe that throughout investment cycles, a balanced portfolio focused on strong fundamentals and quality, combined with reasonable valuations reflecting achievable medium-term expectations, should provide attractive risk-adjusted returns that align with our clients’ financial objectives. Heading into 2024, we perceive opportunities for tactical investment
calls driven by the ever-evolving economic landscape, yet we remain grounded in our strategic asset allocation and selection.

Important Disclosure:

The information contained herein is for informational purposes only, is not personalized investment advice and should not be construed as a recommendation to purchase or sell any particular security, sector or strategy to any individual person or entity. The decision to review or consider the purchase or sale of any security, sector or strategy mentioned should not be undertaken without consideration of your personal financial information, investment objectives and risk tolerance with your financial professional. Past performance should not be considered as an indicator of future results. Investment Advice offered through Pallas Capital Advisors LLC, a registered investment advisor.

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Mark-Bogar

Mark A. Bogar, CFA®, CAIA®
Chief Investment Officer
Pallas Capital Advisors

Stephen Kylander

Stephen Kylander
Senior Portfolio Manager
Pallas Capital Advisors

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The information contained herein is for informational purposes only, is not personalized investment advice and should not be construed as a recommendation to purchase or sell any particular security, sector or strategy to any individual person or entity. The decision to review or consider the purchase or sale of any security, sector or strategy mentioned should not be undertaken without consideration of your personal financial information, investment objectives and risk tolerance with your financial professional. Past performance should not be considered as an indicator of future results.

Investment Advice offered through Pallas Capital Advisors LLC, a registered investment advisor.

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