Khan Capital | December 2023
Key Takeaways
- The US economy is ending 2023 with approximately 2.5% GDP growth, 3.7% unemployment, and inflation down from 9.1% to 3.1% without a recession, defying the near-universal consensus for a downturn.
- The Fed’s December dot plot projects three rate cuts in 2024, the most significant dovish pivot since 2019, sending the S&P 500 to near all-time highs and the 10-year Treasury yield below 4%.
- The traditional recession indicators (inverted yield curve, declining LEI, tightening lending standards) failed because the post-pandemic economy’s composition was unlike any previous cycle, with supply-side normalisation delivering much of the disinflation.
- Markets are pricing six to seven rate cuts in 2024 versus the Fed’s projection of three, creating a gap that risks disappointment if inflation remains sticky or the economy reaccelerates.
- The soft landing is the base case but not a certainty: CRE stress, rising consumer delinquencies, the “last mile” of inflation, and a $1.7 trillion fiscal deficit represent risks that the current rally may be underpricing.
Against every expectation, the United States economy is finishing 2023 with GDP growth approaching 2.5%, unemployment at 3.7%, and inflation that has declined from 9.1% to approximately 3.1% without a recession. The Fed’s dot plot, released on 13 December, projects three rate cuts in 2024, a pivot that sent the S&P 500 surging to within striking distance of its January 2022 all-time high. The Bloomberg recession probability model, which peaked above 65% in mid-2023, has fallen to 40%. The yield curve, which has been inverted since July 2022 (the longest inversion in history), is beginning to steepen. The consensus that was nearly unanimous 12 months ago, that the Fed’s historic tightening cycle would inevitably produce a recession, has been decisively wrong. The soft landing, long dismissed as a fantasy, is now the base case.
How the Consensus Got It Wrong
The recession call was grounded in history and logic. Of the 14 Fed tightening cycles since 1950, 11 had been followed by recessions. The yield curve, which has inverted before every US recession since the 1960s, signalled danger starting in mid-2022. The Leading Economic Indicators (LEI) index declined for 19 consecutive months. Consumer confidence was weak. Bank lending standards tightened dramatically following the March 2023 banking crisis. Every traditional recession indicator was flashing red.
What the traditional models failed to account for was the unusual composition of the post-pandemic economy. The labour market’s tightness (job openings far exceeding available workers) meant that the cooling process could proceed through a decline in openings rather than a rise in unemployment. Consumer balance sheets, bolstered by pandemic-era savings and locked-in low-rate mortgages, were more resilient than models calibrated on pre-pandemic data suggested. Government spending, particularly the infrastructure and industrial policy spending from the Inflation Reduction Act and CHIPS Act, provided a fiscal cushion that offset the contractionary impact of monetary tightening. And the supply-side normalisation (unclogging supply chains, declining shipping costs, normalising energy prices) allowed inflation to fall without the demand destruction that rate hikes would normally be required to produce.
In essence, the disinflation was partly a supply-side gift: prices fell because supply normalised, not because demand was crushed. This allowed the Fed to achieve a significant portion of its inflation objective without inflicting the economic pain that monetary tightening normally requires.
The December Pivot: Three Cuts Projected
The 13 December FOMC meeting produced the most significant dovish pivot in the Fed’s communication since the 2019 “Powell Pivot.” The Committee held rates at 5.25-5.50% (as expected) but the Summary of Economic Projections showed the median member projecting three 25-basis-point cuts in 2024, bringing the rate to 4.50-4.75% by year-end. Growth forecasts were maintained at a healthy 1.4% for 2024. Unemployment was projected at 4.1%. Core PCE was forecast to decline to 2.4%.
The market reaction was explosive. The S&P 500 rallied over 1% on the day and continued climbing. The 10-year Treasury yield fell below 4% for the first time since August. Gold surged to a record high above $2,100. The Nasdaq posted its best week of the year. The rally reflected not just the rate cut projections themselves but the broader message they conveyed: the Fed believed it had won the inflation fight without breaking the economy, and it was now preparing to remove restrictive policy before it caused unnecessary damage.
What the Market Is Misunderstanding
The soft landing is the base case, not a certainty. The celebration may be premature. The lagged effects of the fastest tightening cycle in 40 years are still working through the system. Commercial real estate is under significant stress, with office vacancy rates at record highs and regional bank exposure to CRE creating pockets of vulnerability. Consumer credit delinquencies (credit cards, auto loans) are rising from pandemic-era lows. The pandemic-era excess savings that buffered households have been largely depleted. A recession has been avoided so far; it has not been permanently prevented.
The “last mile” of inflation will be the hardest. Core PCE has fallen from 5.6% to approximately 3.2%, but the journey from 3.2% to 2.0% will be more difficult. Services inflation, driven by shelter costs and wage growth, is proving stickier than goods disinflation. The disinflationary impulse from supply chain normalisation is largely exhausted. Further progress requires either sustained weakness in demand (which risks the recession the soft landing narrative assumes has been avoided) or productivity improvements that take years to materialise.
The market is pricing more cuts than the Fed is projecting. Fed funds futures are pricing approximately six to seven cuts in 2024, roughly double the three cuts projected in the dot plot. This gap between market expectations and Fed guidance creates a potential source of disappointment: if inflation remains sticky or the economy reaccelerates, the Fed will deliver fewer cuts than the market expects, triggering a repricing of rate-sensitive assets.
The fiscal backdrop is less supportive than it appears. The US fiscal deficit exceeded $1.7 trillion in fiscal year 2023, approximately 6.3% of GDP, an extraordinary figure outside of recession or war. The deficit is providing a substantial fiscal stimulus that is supporting growth but is also crowding out private investment, increasing Treasury supply, and creating long-term sustainability concerns that bond markets have begun to price through a higher term premium.
Implications for Investors
The pivot favours risk assets, but positioning should be balanced. The combination of a growing economy, falling inflation, and imminent rate cuts is the definition of a “Goldilocks” environment for equities. But Goldilocks environments are inherently fragile: they depend on everything going right simultaneously. Investors should participate in the rally while maintaining hedges against the scenarios (inflation resurgence, recession, geopolitical shock) that would disrupt the benign outlook.
Duration exposure in fixed income is increasingly attractive. With the 10-year yield below 4% and the Fed projecting cuts, the risk-reward for intermediate-duration bonds has shifted decisively in favour of the bulls. A recession would drive yields even lower; a soft landing with gradual cuts still supports positive returns. Only a re-acceleration of inflation would produce significant losses, and this is now the tail risk rather than the base case.
The broadening trade within equities deserves attention. The “Magnificent Seven” accounted for the vast majority of the S&P 500’s 2023 gains. If rate cuts materialise in 2024, the beneficiaries will broaden to include rate-sensitive sectors (real estate, utilities, small-caps) and cyclical sectors (industrials, materials) that have lagged the tech-driven rally.
Gold’s breakout above $2,100 is significant. Falling real rates, central bank buying, and geopolitical hedging demand are converging to support gold at its highest levels in history. The soft landing itself is not a bearish signal for gold; it is a bullish one, because it implies falling rates without the economic destruction that could trigger forced selling of gold positions to raise cash.
Conclusion
The US economy has defied the consensus with a resilience that humbled the forecasting profession. The soft landing is no longer a contrarian call; it is the base case, supported by data that shows an economy that has absorbed 525 basis points of tightening without breaking. The Fed’s December pivot, projecting three cuts in 2024, is the signal that the tightening cycle is over and the easing cycle is about to begin. For investors, this is the most constructive macro backdrop since before the pandemic. But constructive is not the same as risk-free, and the risks that would disrupt the soft landing, sticky inflation, geopolitical escalation, the lagged effects of tight policy, are real even if they are, for now, receding.
Related Reading
The soft landing debate played out against the backdrop of Fed Funds at 5.5%. For the eventual rate cut, see The Fed Cuts Rates: First Reduction Since 2020.
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