The Year of Doom Concludes with an Everything (Nearly) Everywhere Rally
The Roaring Twenties Resumes
The "les nouvelles années folles" decade continued its imitation of last century's post-pandemic market action with the taming of inflation, a fall in interest rates, a rally in risk assets, technological innovation, and extraordinary consumption. Equity indexes set records in the last two months of the year, and bondholders saw huge gains as bond yields fell in response to perceived policy accommodation from the United States' Federal Reserve. Inflation in the rest of the world is also on a downward trajectory, prompting expectations of interest rate cuts in most of the world's major economies to rise. Diversification didn't pay as US stocks and bonds dominated their peers in performance.
Losses in 2022 have now been regained, and looking out into 2024, world economic growth looks to be average-to-slightly-better than trend.
Unusually, every asset class in the Global Market Portfolio saw positive returns in the fourth quarter. This is the mirror opposite of 2022, in which nearly every asset class detracted from return. Equity outperformed all other assets in 2023, though all saw gains.
Price appreciation has driven these gains, although corporate profitability has continued to improve. US stocks rose 24%, the Eurozone was up 13%, India 19%, and Japan--long the laggard in equity performance--turned in an impressive 30% performance, a return to form for the erstwhile second-largest world economy. Using Price/Earnings ratios as our value stick, we consider US equities to be vastly overbought, the Eurozone fairly valued, India fairly valued, and Japan still cheap. China's equity markets cratered in 2023, falling 11-14%, depending upon the index. We won't take a victory lap on our calls (here, here, and here) that China's economy is uninvestable, but we don't see any reason to change our outlook for China in 2024, despite some analysts' opinion that China's markets are cheap. These indexes are cheap only in relation to where they traded just two years ago, but they are not cheap from an intrinsic value perspective. For China has done nothing to reverse its demographic trends, its propensity to consume, its preference for saving, its seriously over-levered banks, its unproductive domestic infrastructure investments, its investments in emerging markets, nor, most importantly, its autocratic regime and state-directed economy. Though it has done well to tone down its bellicose rhetoric, it maintains an aggressive military posture toward the Taiwan Strait and the South China Sea, a creativity-stifling total surveillance state, and cozy relations with the world's worst regimes. Neither its politics nor its economics counsel the security of investment there, so we continue to short its markets and hope for the day that it renounces its destabilizing behavior and rejoins the community of nations to build a future that respects international sovereignty, the free flow of trade, and a rules-based world order.*
The US Economy at the End of 2023
We've not yet received final data for the fourth quarter of 2023--we won't get that until February--but we can take account of where things stand as of the most recent data prints to paint an abstract expressionist picture of where the economy is prior to the start of a new quarter and year.
First, consumption in the fourth quarter was decent. As consumption accounts for approximately 70% of the US economy, this is a good sign for things to come: too high, and we could expect increases in inflation; too low, and the depression that some have been forecasting since 2022 may come to pass. As it is, Advanced Retail Sales show moderate expansion.
Often, when economic contraction is imminent, personal savings rates will begin to creep up as consumers worry about employment security, cut spending, and start saving for a rainy day. We see the Personal Saving Rate trending down after having trended up, which signifies to us that concern about employment security has passed, consumers are beginning to believe in the economy, and are comfortable drawing down savings or not adding to them.
Consumer Credit it tightly linked to consumption, as expansion suggests the consumer's confidence in being able to make future principal and interest payments to pay for consumer goods. We see that Consumer Credit contracted in the past months but has recently rebounded. This suggests that consumers are voting up the economy with their pocketbooks.
Bank debt has been on a downward trend, signifying banks' unwillingness to lend, or business' unwillingness to borrow. It is contractionary as borrowed money doesn't get invested in productive uses. This is one of the surest indicators of the efficacy of the Federal Reserve's tight monetary policy. Bank Credit contracted markedly, but has slowed the rate of its contraction. The Fed will watch this measure very closely in the spring as it assesses when is the right time to begin to cut interest rates--if it does so at all (more on this to come after we receive the minutes from the last FOMC meeting in mid-January.)
We also see Capacity Utilization decline, but not descend precipitously. The current level of activity is consistent with non-inflationary growth. It certainly doesn't look to be recessionary. As is evident from the chart below, capacity utilization trends downward before plummeting. It has done over the course of the year, but it is also clear that it can plateau for extended periods of time before falling--or rising once again.
Inflation, about which we've written extensively recently, is on the downslope and in the neighborhood of the Fed's target. The main cause of its elevated level at this time is Housing, which is on a lag. Using current rents to calculate inflation shows that the Fed has already surpassed its target of 2% inflation, and should now pivot toward monetary easing to prevent constraining the economy and causing the recession it has fought so hard to avoid.
Housing Starts are expanding once again as demand for new housing, a derivative of household formation, continues to entice builders to build new housing stock. Although sales volumes and prices remain muted, it's clear that the economy continues to try to repair the generational damage done to US housing stock by the pullback in housing construction precipitated by the Global Financial Crisis.
At the same time, Total Construction Spending is a bit on the lower side.
Housing cost is still the largest single impediment to broader prosperity in the United States. It comprises a disproportionate amount of total household wealth and is the single largest cost that workers' paychecks go toward. Low-rate thirty-year mortgage financings on high-priced homes will root homeowners to the spot, reducing their geographic and economic mobility. That's a long-term bad for an economy that relies upon its dynamism for its long-term growth. If the United States can build more housing stock, and if the generational shift toward renting continues, then perhaps this pressure can be released; until then, it is an area of high concern.
Durable Goods Expenditures are slightly positive and looking a bit weak. Big ticket items tend to increase substantially during the early phases of an economic expansion. Given that the US economy is closer to the end of this business cycle than the beginning, this is to be expected. It's important to note that, after years of spikiness, it looks like we're back to a to a more normal regime. The COVID-19 goods-buying bonanza and supply chain disruption is clearly now in the rearview mirror.
Business Investment has come in softer as Captains of Industry have been more reluctant to add to productive capacity. That said, it is still positive and indicative of expansion. Volatility in this measure is usual during periods of transition between parts of the business cycle. Business investment is highest during late boom/early recession periods. This is typically the case when the business cycle is tipping into depression and businesses are reticent to make investments whose return is uncertain. This type of behavior can become self-fulfilling, as one business's spending is another business's income.
Lastly, we'll visit statistics on employment, as these are the indicators most likely to condition spending and therefore growth. First, Initial Claims data have been healthy. Employers don't appear to be under pressure to let go of workers to allay cost pressures.
Meanwhile, Continued Claims have ticked up slightly, reflective of the cooling in the labor market we've seen over the past months, and which has given the markets so much confidence that the Federal Reserve's campaign of interest rate hikes is at an end.
The Unemployment Rate, on the other hand, ticked down a bit lower. Why such a low level of unemployment hasn't contributed more to wage inflation is still a bit of a puzzle, but it does make us question as to whether full employment and price stability are as opposed as they have supposed to be until quite recently.
The number of Job Openings to Unemployed Persons continues to decline, signifying cooling in the market, but not the erosion of Labor's negotiating leverage in setting the clearing price of wages. Wealthier workers, though, mean more consumer spending, which should contribute to higher levels of economic growth as long as wage increases can be passed along in consumer prices. Though pricing power has come in since early on in our recent inflation saga, it doesn't look like consumers are balking, and corporations certainly aren't taking a hit in their profit margins.
All things considered, our dynamic factor model points to an economy that is still growing, although at a slower pace than in the third quarter. Though we can see pockets of weakness in the economy, these are in interest-rate sensitive sectors, and would respond positively to Federal Reserve monetary policy loosening. Growth looks to be clocking about 2.9%, with an upper range of 3.4%, and a lower range of 2.4%. That's still quite healthy, but it behooves us to remind you, Faithful Reader, that the highest economic growth in the business cycle occurs at its end.
There's still a fair measure of uncertainty to contend with in these numbers. That our leading indicators don't all point in the same direction is evident in diffusion indexes, which track the dispersion of the economic signals we use to forecast growth. We can say that the economy is and has been slowing--but it has come down from a truly torrid pace, and that it is lower now than it has been, does not mean recession or depression is just around the corner. In fact, there's nothing in the indicators that suggests substantial weakness ahead; the opposite is true. We therefore conclude that if something is to knock the US economy off the rails, it will be an unpriced exogenous event.
It is for this reason that uncertainty remains somewhat elevated, perhaps reflecting the not-insignificant political risks that still pose threats to global growth in 2024. But the future is always uncertain. Just don't tell that to the US equity market, which has priced in supernormal growth as far as the eye can see.
And so, twelve months after what looked like a recessionary year, we find ourselves with solid economic growth, quiescent inflation, and more-or-less stable political regimes. Election years in the United States tend to be pretty uneventful for markets, but as one American political party appears uncommitted to governance or unable to govern, risks remain. Likely such nonsense is already priced in. Given the policy differences between the two likely candidates for the American Presidency, we should expect some volatility in asset prices as the election nears, although we do not think that this will be a substantial threat to markets. The tail risk, as always, is one that is lurking somewhere in the shadows. Fortunately, given the irrational exuberance of US Equity investors, the cost of hedging against these risks is quite cheap. And as we like to remind our clients, it is when everyone is greedy that it best pays to be fearful.
All the best to all of our clients, readers, and sometime sparring partners in the New Year. We hope that 2024 brings you prosperity, health and peace. If you like what you read here, contact us to be added to our newsletter, which we'll be issuing by email in the coming year. If you would like to become a client, we would welcome the opportunity to meet to discuss your goals and constraints for investment, risk management, and corporate and strategic finance.
*We would actually settle for it becoming a giant Singapore, but if one would hit the mark, one must aim a little higher.