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Fourth Quarter 2023 Client Newsletter

Published 1/11/2024

When we published our 4Q2022 newsletter last January, we got into the prediction game a bit more than usual. We expected 2023 would play out in one of three ways:

  • Door number 1: Back to Normal -The drivers of inflation turn out to have been transitory after all. The Fed realizes they’ve won their war with inflation and pauses rate hikes before having inflicted too much damage on the global economy. Stock and bond markets anticipate a return to the stable growth and low-interest rate regime that precipitated the 2010-2019 bull market. The roaring ‘20s have a belated beginning, and a new secular bull begins. S&P 500 sets new all-time highs in 2023.
  • Door number 2: Consolidate and Confound - Inflation continues to fade, but not quickly enough to keep the Fed from continuing its march towards more restrictive policies. The cumulative effect of their tightening causes sluggish growth and a shallow recession. Investors lack confidence in stocks throughout the year as fixed income offers a ‘good enough’ yield to warrant haven demand. Despite investor gloom, no concerted selling pressure materializes. S&P 500 meanders in the trading range from 2022: much like the consolidations in 2011/12, 2015/16, and 2018/19
  • Door number 3: Optimism is Pointless – At the end of the newsletter, you’ll find a table that details the economic and market declines experienced in prior recessions/bear markets. It’s a choose your own negative outcome adventure. But as you do, keep in mind that the S&P 500 already experienced a -26% drawdown in 2022.  

 Whatever your outlook for the next 12 months, buckle up; it’s likely to be a wild ride.  

We had a positive tilt – two of the three potential outcomes would have been considered a win, especially given the widespread gloom at the time. We were skeptical of the adverse scenario, but it was bleak – a repeat of the 1970s inflation experience, a deep dark recession, or maybe even both, depending on who you asked.

Most of the year was spent in a Consolidate and Confuse environment – interest rates kept setting new highs, multi-decade highs in many cases. Yet, only the goods sector of the economy experienced a contraction in growth. No new lows in the broad market were set, but trading was choppy and securely confined to the range set in 2022.

But then, at the end of October, expectations of receding inflation were acknowledged by monetary policymakers, and the mood in markets shifted dramatically. Interest rates violently reversed their upward trajectory, and equity markets began their march toward all-time highs. The Back to Normal narrative has been in place ever since.

By the end of the year, the S&P500 hadn't fully returned to the all-time high it set on 1/3/2022. But it got darn close – only -0.56% short of the mark. When all was said and done, the recovery in 2023 paired perfectly with the pervasive weakness of 2022. Sometimes, symmetry can be a beautiful thing.

A gripe some will put forth is that the year was dominated by the biggest companies – those with ample cash stockpiles and insulated business models drove the gains in 2023. And it's true – as of writing this note, more than 70% of stocks in the S&P 500 are still more than -10% below their all-time high. Though, that could be viewed as an opportunity.  

Here's how the whole two-year-round trip looks for stocks (S&P 500, Nasdaq Composite), bonds (U.S. Aggregate Bond Market), and commodities (oil, gold).

After two years of markets being stuck in the mud, we prefer to think the consolidation will resolve higher. After all, this experience hasn't been that unique. Since the Great Financial Crisis of '07-'09, markets have endured three other consolidation periods where prices were mired in a sluggish and uncertain range.

We like to keep a positive predisposition around here. Not because we're eternally unworried about what could go wrong but because, as a risk-conscious asset manager, we don't need much help coming up with ideas about worst-case scenarios.

So, in this newsletter, we will review the near misses in 2023 one by one. What could have gone wrong but didn't?

INFLATION IS ENTRENCHED AND INTEREST RATES ARE HEADED HIGHER

Oh, what a difference a year can make – headline inflation for U.S. Consumers entered 2023 at a wickedly high 6.5%, more than 3x the Federal Reserve's stated objective. Markets and financial institutions stood ready to absorb more tough medicine from the Federal Reserve – mainly in the form of much higher interest rates.

But they didn't have to. By the summer of 2023, it was clear that inflation was on a downward trajectory as short-term measures of inflationary momentum dove lower.

Throughout 2023, the goods/manufacturing side of the U.S. and global economy remained in a persistent contraction. A sustained decline in producer and wholesale prices is evidence of that. That's a good thing.

Consumer price inflation receded at a faster-than-expected rate through 2023. So, despite being above the Fed's target, the 3.35% rate posted in December is still a welcomed reading.

Interest rate markets noted falling inflation data and the Fed's delight in the progress made. Markets now expect that the tightening cycle is over and global central banks will soon begin cutting overnight policy rates. The red projection line below indicates the market expects about 1.50% of rate cuts by the end of 2024.

If inflation is truly over and 5% interest rates will soon be a thing of the past, markets are correct for sniffing out a Return to Normal. The risk is that markets have taken the proverbial mile when the Fed intended to give only an inch.

Stubborn inflation above 3% is a significant risk to financial assets. It's unclear how long policymakers would accept that reality, especially in the latter part of 2024.

RECESSION IS IMMINENT

A year ago, we wondered whether the imminent recession that "should" have started at the end of 2021 was maybe the final pandemic distortion working its way through the financial markets. That's looking increasingly likely to be the case. 

Forecasters predicting a recession in the next 12 months have reverted sharply lower, though despite the reduction, they're still on high alert.

We're reminded of the Thomas Paine quote that 'time makes more converts than reason.' Maybe the remaining recessionistas simply need a little more time to evaluate the data.

If corporate earnings are your guide, look no further than the correlation with the Conference Board's Index of Leading Economic Indicators. When we posted this chart last year, both were in freefall. An earnings recession seemed all but guaranteed.

Strategist Ed Yardeni contends that the LEI correlates highly with the goods economy, while corporate earnings are more connected to a mix of goods/services. Whatever the reason, the current trajectory looks a lot more like an economic reacceleration than an impending recession. 

The 'soft landing' scenario is getting very popular these days. That outcome would see inflation continuing to moderate towards the Fed's target without any deterioration in the real economy. It's a lovely theory.

Unfortunately, the soft-landing narrative is almost always popular in periods preceding a recession. Check out this story count over the decades – recessions are shaded in grey.

If you've tracked our newsletters over the years, you know that we find obsessing about recession calls a bit silly. Instead, we want to focus more granularly on the data, like for the U.S. consumer.

CONSUMERS CAN'T/WON'T CONTINUE TO SPEND

The U.S. consumer is a force of nature. Employed, unemployed, happy, or sad, they spend. Luckily, for now, the bulk of the U.S. population is employed. Though, for some reason, they're also sad. Let's review.

The last time we reviewed University of Michigan Sentiment in a newsletter, the consumer reported a record level of misery. At the time, gasoline prices were out of control, inflation was peaking (though nobody knew it), and the stock market was in the dumps. Some of that has changed now, but the U.S. Consumer is still pretty mopey relative to other historically dour periods.

As pessimistic as survey respondents may be, they show little sign of tiring of the Buy Now button. In solid green, we can see that retail sales in the U.S. are growing at roughly 4% annually. That's on par with the average yearly growth before 2019 – not too shabby! Even in real terms, which removes the impact of inflation, retail sales are still positive, though at the low end of the pre-pandemic range.

Much has been made about the depletion of pandemic-era savings from forgone activities or residual stimulus. Most analysis we come across contends that excess savings will soon be used up, and that might finally be the case. At any rate, low unemployment and sustained wage growth are probably enough to keep consumers spending, even if they don't feel good about it.

U.S. TREASURY FUNDING

In our 3rd quarter note, we broached the topic of the U.S. debt. Typically, we view that issue as too panic-inducing to bother with, especially since it would take barely two keywords into a Google search if you want to find shocking, troubling figures. But, given the trajectory of interest rates, we thought it was time to put the matter on the record.

Refinancing maturing T-bills, the annual budget deficit, and the now higher annual interest expense burdens over the coming year could be challenging. We hope it isn't, but just because we got a positive resolution in the final months of 2023 doesn't mean we're out of the woods. We'll closely monitor investor demand components of treasury bill/note/bond auctions throughout the year.

BANKS ARE FAILING – CREDIT CRUNCH ON THE WAY

Banks with over $542 billion in assets failed in 2023. The largest of any year in history. You'd expect such a year to end in infamy, but most people lived their lives as usual, completely unimpacted. And we probably have the Great Financial Crisis to thank for it.

In 2008, when Lehman Bros. failed, they were not technically a bank, but their assets totaled more than $750 billion in the months before their demise. In the immediate aftermath, policymakers did next to nothing to provide relief. In hindsight, that episode likely taught regulators to act quickly and forcefully in the face of significant liquidity events.

On the weekend of Silicon Valley Bank's failure the Fed and FDIC worked together to make a plan. The blue line below represents the emergency credit extended to secure deposits at the failed bank, until the FDIC could take control. That policy was short lived as designed. The red line represents the term facility put in place to backstop the rest of the system.

The usage of that industry-wide term facility is still expanding. The impending closure of that facility in March gives some analysts pause. However, there shouldn't be much cause for concern if the deposit flight situation has been contained. Given the size of the facility's uptake, the final resolution to the drama does bear watching.

When the banking system stops lending, credit crunches happen. When credit crunches happen, recessions happen. So, when banks started failing last spring, it stood to reason that a credit crunch was on the way. Would the banking collapse be the proximate cause of the anticipated recession? Well, not yet. Here's some data on loan growth.

Depending on the end use, loan growth rates have either flatlined or returned to a pre-pandemic normal. We think a big part is that anybody who wanted or needed credit had already obtained excellent terms when rates were absurdly low in 2020-2022. However when those loans come due and the demand for credit expands again, we'll see how much appetite banks/investors have for credit.

THE WORLD IS AT WAR

Geopolitical issues are always scary and hard to integrate on a personal level. But for markets, lost global trade, destruction of critical infrastructure, or access to raw materials tend to be all that matters. At the outset of the Ukraine/Russia war, it became immediately apparent that the supply dynamics for many natural and refined resources had changed overnight – natural gas, oil, grains, fertilizer, selected industrial metals, etc., were suddenly unavailable. Prices, as they often do in commodity markets, moved violently higher.

Despite the lack of resolution in that conflict, global markets have normalized. And when catastrophe struck in the Middle East in October, and seemingly every month since, global markets braced for contagion. Yet, there has been little effect on global energy markets or supply chains.

In the U.S., we're effectively energy-independent. We export an almost unimaginable amount of liquified natural gas to the rest of the world, and we produce nearly enough crude oil to satisfy our annual consumption. There's little doubt that our supply position is holding down domestic energy prices.

A widening of the Middle East conflict or a global growth boom could change that overnight, but check out the chart.

The New York Federal Reserve Bank publishes a global supply chain stress index that considers both the ease of movement within supply chains and the costs associated with activity. And the paralysis inflicted by the pandemic has been alleviated for more than a year.

Blockades in the Red Sea are driving container shipping prices from Asia to Europe higher. Eventually, if the bottleneck sustains, we could expect some shortages. Still, paradoxically, the longer the delays are sustained, the better-prepared supply chains will be to deal with those shortages.

EARNINGS RECESSION

Were three years of high inflation a gift to corporations? No, I'm not going to rant about corporate greed and profiteering off the stimulus-driven demand surge. Instead, I'm wondering if the period of supply chain stress taught corporate managers to be more ruthless with cost management.

Maybe they've learned to do more with less. Typically, coming out of recessions, that's how it goes - companies get lean and mean to survive the down-cycle, then revenues return, and boom – profit margins explode higher. Sure, productivity enhancements over the past 30 years have played into sequentially higher margins, but that's arguably the case now too. Have a look.

So, what if companies didn't need to go through a traditional lean and mean period like a recession to find religion on expense control? And what if revenue never retrenched lower due to a persistent tailwind from consumer inflation? That'd sound like a pretty good recipe for higher corporate earnings.

And after a stagnant 2023, it looks like analysts are getting geared up for just that.

The standard caveat is that 2024's numbers will likely be revised lower throughout the year. Yet even a mid-single-digit growth rate for S&P 500 earnings could be enough to fuel upside comparable to past breakouts from multi-year ranges. The green/yellow/red lines represent some Wall Street targets for the S&P 500 at the end of this year.

Ed Yardeni is currently the most bullish strategist out there, in green, his target of 5400 would equate to a gain of roughly 12%. The yellow bar represents J.P. Morgan's year-end target, the lowest on the street at 4200, representing a loss of about -12% from current levels.

We hope this note has helped round out some of the data and narratives present in markets today. Want to discuss our outlook in greater detail? Give us a call.