GDP - Why A Soft Landing Is So Bullish For The Stock Market

2024-01-16 01:07:44 ET

Summary

• The Federal Reserve is attempting a "soft landing" in the U.S. economy for the second time in three decades.
• Historical data shows that a successful soft landing could lead to positive gains in the stock market in 2024.
• If the economy avoids a recession, the stock market is likely to avoid a sharp correction and could see a rise of 10%-20%.

By Andrew Prochnow

It's been nearly 30 years since the Federal Reserve pulled off the last "soft landing” in the U.S. economy.

Back in the mid-1990s, the Federal Reserve raised benchmark interest rates to fight inflation, much as it has done over the last couple of years. And once inflation was tamed, the Fed proceeded to gradually lower rates back to "normal" levels.

That period is often viewed as a “soft landing," because the Fed successfully raised rates without crashing the economy. The central bank was also largely successful in its goal to rein in inflation.

In 2024, the Fed is attempting to thread the needle on rates and inflation for the second time in 30 years. And this is a critical period for stock market investors, because the stock market has historically responded very differently to soft and hard landings.

As most investors and traders are well aware, the last two hard landings in the economy were the "dot-com bubble" and the "Great Recession," both of which involved sharp corrections in the stock market.

In contrast, the "soft landing" in the mid-1990s produced far more attractive returns in the stock market, largely because the economy avoided falling into recession. That will undoubtedly be a key to success this time around, as well, with the Federal Reserve hoping it can maintain positive growth in the economy during the next 6-12 months.

As it did back in the mid-1990s, the Fed is expected to gradually lower benchmark interest rates in 2024 to help foster a gradual rebound in the economy. During the Fed's December policy meeting, central bankers intimated they will cut rates as many as three times this year.

Today, the current target range for the country's primary interest rates benchmark—the federal funds rate—is 5.25-5.50%. Three rate cuts of a quarter percentage point each would consequently drop that range to 4.50-4.75%.

The net amount of expected cuts—approximately 0.75%—is almost identical to the degree to which the Fed cut rates back in the mid-1990s. From June of 1995 to February of 1996 the effective federal funds rate fell from roughly 6% to about 5.2%.

Importantly, the gross domestic product ((GDP)) of the United States continued to grow during that period. From 1994 to 1997, the lowest quarterly GDP growth rate for the United States was +2%. And when the Fed started cutting rates in the summer of 1995, GDP growth actually surged back toward +4%, as highlighted below.

Road to recovery

Much like in the mid-1990s, the Fed is anticipated to gradually reduce benchmark interest rates in 2024 to facilitate a measured economic recovery. During the December policy meeting, central bankers indicated an intention to implement up to three rate cuts within the year.

Presently, the targeted range for the nation's primary interest rates benchmark—the federal funds rate—is 5.25-5.50%. If three quarter-point rate cuts are executed, this range would consequently contract to 4.50-4.75%. The cumulative magnitude of anticipated cuts, approximately 0.75%, closely mirrors the extent to which the Fed reduced rates in the mid-1990s. From June 1995 to February 1996, the effective federal funds rate declined from around 6% to approximately 5.2%.

Significantly, the gross domestic product ((GDP)) of the United States continued to expand during that period. Between 1994 and 1997, the lowest quarterly GDP growth rate for the United States was +2%. Notably, when the Fed initiated rate cuts in the summer of 1995, GDP growth experienced a resurgence, moving back towards +4%, as highlighted below.

In hindsight, many economists refer to the mid-1990s as the "perfect" soft landing. It's also arguably the "only” successful soft landing that's been observed in modern economic history

In 2024, the Fed is poised to try and pull off another soft landing, and if it does, it will probably be regarded as "perfect," too. Because any rate hike cycle that doesn't result in a recession/depression is likely to be remembered as an ideal outcome.

One of the big things the U.S. economy has going for it this time around has been its resilience. Even in the face of sharply higher interest rates, the U.S. economy has continued to grow. Back in the mid-1990s, the U.S. economy exhibited similar strength, which is why these two periods have drawn so many comparisons in recent months.

If the U.S. economy does avoid falling into recession during the next 6-12 months, it’s highly likely the stock market will avoid a sharp correction, as well.

How the Stock Market Has Historically Responded to Soft and Hard Landings

At the start of a new trading year, most investors and traders are concerned with the direction of the stock market. And based on historical returns in the stock market, it appears that two different scenarios could play out in the coming year.

If the Fed successfully pulls off a soft landing, history suggests the stock market will produce another year of positive gains in 2024.

However, if the Fed fails to pull a rabbit of the hat, and the economy falls into recession, it's highly likely that the stock market corrects at some point in 2024, or early 2025. And that would likely be a pull back of at least 15-20%, as opposed to a garden variety 10% correction.

Looking at the glass half-full perspective, the stock market could rise by as much as 10-20% in 2024 if the Fed is able to successfully pull off a soft landing. That level of return is similar to what was observed during the soft landing in the mid-1990s.

Back then, the Fed first started cutting rates in July of 1995. Six months later, the S&P 500 had rallied by about 11%. And by July of 1996 (12 months later), the S&P 500 was up closer to 19%. Importantly, the U.S economy also held up during this period, producing at least +2% positive GDP growth from 1995 to 1997.

Looking ahead into 2024, the Fed is currently expected to cut interest rates in March. If history repeats itself, the stock market would rally by roughly 10% during the six month period after that rate cut. And by March of 2025, the stock market could rise by as much as 15-20% (from the date of the rate cut).

Alternatively, a hard landing in the economy would almost certainly fuel additional volatility in the financial markets, and probably trigger a severe correction in the stock market. At least that was the case back in 2000 and 2007-2009. During those hard landings the stock market pulled back by -49% and -57%, respectively, as illustrated below.

Importantly, the aforementioned corrections in the stock market were also accompanied by recessions in the U.S. economy, especially in the case of the Great Recession. From December 2007 to June 2009, the country’s real gross domestic product ((GDP)) fell 4.3 percent on a peak-to-trough basis, which was the largest decline in the post-war era .

In comparison, U.S. GDP growth has remained relatively strong in recent quarters, much as it did back in the mid-1990s. Over the last four quarters, U.S. GDP has grown by +2.6%, +2.2%, +2.1% and +4.9%, respectively.

If the economy remains resilient, it's difficult to envision a severe correction hitting the market during the foreseeable future. That said, history doesn’t always repeat itself, and the financial markets can be unpredictable, especially during Presidential election years .

One final consideration is that the modern economy has something big going for it—the recent breakthrough in generative artificial intelligence ((AI)). This technology is so revolutionary that it has stimulated a fresh wave of investment in AI-focused research, software, hardware and services.

By some estimates, new AI investments totaled upwards of $154 billion last year, and will rise even further in 2024. That’s critical, because those funds effectively serve as a type of stimulus for the global economy, providing a much needed shot in the arm.

At this juncture, it’s still extremely difficult to predict which of the aforementioned scenarios might play out in 2024, because many experts were expecting a hard landing last year, and it never materialized. Investors and traders may therefore want to track the current earnings season extremely closely. Because if 2024 earnings guidance starts deteriorating , that may be an early sign that the chances of a hard landing are increasing.

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