Q&A With… Scott Colbert, Commerce Trust EVP and Chief Economist

Posted July 25, 2024

Q: For a year that began with some apprehension about a looming recession, 2023 proved quite kind to investors. What, in your opinion, were the drivers of better-than-average returns for those with diversified portfolios?

A: We believe 2023’s positive financial returns were driven by two primary factors:

First, financial markets for much of 2022 had priced in an expectation that the U.S. economy would fall into a recession at some point in 2023. This dovetailed 2022’s poor returns in balanced portfolios –nearly the worst calendar year ever, post-World War II– with the S&P 500 Index down 18%. In addition, the bond market also experienced double-digit declines in 2022, down 13% for the year as measured by the Bloomberg Aggregate Bond Index.

The second was the fact a recession never materialized in 2023 despite several headwinds:

The Federal Reserve’s (Fed’s) rapid increase in short-term rates, which started in 2022, and its material reduction in the U.S. money supply. This was the fastest and most aggressive Fed tightening since 1980. The quick and unexpected failure of four major banks in Spring 2023, including the second-largest U.S. bank failure in our history. An inverted yield curve is now approaching two years old, and there is a rapid decline in the leading economic indicators. Historically, a yield-curve inversion has been a tried-and-true recession indicator, preceding 10 of the past 10 U.S. recessions. This was a perfect setup for a financial market rebound in 2023 that has largely continued, although in a much narrower fashion, over the first half of 2024.

Q: Are there elements within that overall growth that you don’t see as sustainable in the near term?

A: U.S. economic growth has already slowed a bit over the first half of 2024. We expect gross domestic product (GDP) growth to average about 1.7% for the year compared to 2023’s 2.5% growth rate. Driving this slowdown are the lagged effects of higher interest rates that have dampened manufacturing new orders and interest-sensitive industries like autos and housing. Job growth is strong, but slower as compared to last year and paired with cooling wage growth. The Fed also reports a steady uptick in consumer credit card and auto loan delinquency rates in 2024.
While these are clear signals U.S. economic growth is cooling, they are not flashing any warning signs of a recession. Despite the unemployment rate climbing to 4.1% as of June 2024, job growth remains positive, and U.S. banking and financial systems are in a much sounder position than they were prior to the Great Recession in 2007.

One element that has contributed to our current economic resilience has been the fiscal stimulus from the federal government. For more than four years, the government’s response to the pandemic and the subsequent economic recovery has helped push the U.S. national debt to its highest level ever, relative to the size of our economy.

According to the U.S. Treasury Department, the national debt now exceeds total U.S. GDP, producing a debt-to-GDP ratio of about 120%. And with interest rates much higher today than four years ago, the cost to finance this debt also increases. The Congressional Budget Office projects interest on the debt over the next decade will surpass $10 trillion. As debt service begins to squeeze federal spending, we believe the economy will need to rely less on stimulus-driven growth and more on its typical population and productivity growth.

Q: Rates for 10-year T-bills declined about 42 basis points for the year; was the run-up to higher rates heading into 2023 strong enough to encourage significant movement from investors into fixed-income instruments?

A: We’ve seen greater focus on investment-grade taxable and tax-exempt bonds among both private client and institutional investors. A key driver for this has been the interest-rate environment since 2023. Treasury yields reached a 15-year high last year and continue to produce attractive yields today along the fixed-income spectrum. Per Lipper’s weekly fund reports, flows into fixed-income ETFs are at the highest levels they have been in the last five years.

While we do not anticipate interest rates to meaningfully decline over the rest of the year, adding longer-duration assets to fixed-income portfolios may present an opportunity to lock in some of the higher yields currently available.

Q: Given that higher-level investors aren’t as reliant on home values as investment tools, what’s your assessment on how the run-up in mortgage rates and home prices have altered the calculations those investors must make in considering residential real estate as part of their overall portfolio?

A: Housing continues to be in unique territory, with higher interest rates constraining buyer activity while the lack of available single-family units for sale is keeping home prices at lofty levels. At the end of 2023, home affordability reached an 18-year low due to the combination of soaring home prices and a doubling in mortgage rates.

Many investors may feel they can’t afford to move even though their homes have risen in value. Should interest rates start to decline, we may see an increase in inventory that puts some downward pressure on home prices. In addition, time will help heal the supply demand imbalance as new homes are built and a record number of new rental units hit the market in 2024 in some of the country’s hottest housing markets.

Q: Any other issues Commerce Trust would like to comment on?

A: We always remind investors to look at diversification, particularly as the stock market continues to narrow. Commerce Trust believes strong earnings fueled by the mega-cap growth stocks will continue to lead the S&P 500 Index in 2024, with positive returns reaching across multiple sectors. Mid-cap stocks will also likely benefit from broadening performance at the top of the domestic equity food chain, while small-cap stocks are likely to continue seeing modest gains in the current interest-rate environment.

We currently favor domestic equities over international stocks. This is due primarily to the larger concentration of technology-oriented companies in U.S. stock markets than international indexes.

Fixed income markets continue to see higher yields, presenting an opportunity to capture durable yield inside portfolios. Yield spreads on investment-grade corporate bonds have benefited from the improving economic outlook. In addition, we believe the municipal bonds returns look attractive through the rest of the year.

As we consider possible wildcards, markets historically experience greater volatility during presidential election years, with an uptick in market turbulence throughout the campaign season before easing around Election Day. And we’d certainly be remiss to ignore the impact geopolitical tensions could have on the financial markets.