Is Knowing What's Priced In*
After a class at Columbia Business School this past term, I was chatting with a friend and former colleague of mine that came to speak to the class about investing in markets, and he reminded me of something that I had forgotten. At our mutual former employer, our daily newsletter on the markets used to begin every year the same way, and that was by re-stating what should be but isn't always so obvious:
The most important thing in markets, and the thing that a lot of people forget to do, is to first understand what is already priced in. Only by knowing what the market expects can you decide whether the markets are right or not, and this--along with estimating fair value and assessing what is likely--is a precondition to generating excess return.
If your assessment of fair value and judgment about probability agree with what the market has priced in, then you can't deliver excess return because your return will be the market return. And that's fine, since when the market is rational, taking what the market gives you is the rational decision. However, sometimes the market is irrational and we should bet against consensus; but we can only do so if we first understand what Mr. Market thinks is the value of things.
goodstead's mandate doesn't require us to beat the market, but rather to produce superior risk-adjusted returns. It is this remit that compels us to understand and take a view on how risk is priced. So, let's jump into what the market expects 2024 to look like from the perspective of major markets and tradable instruments, and next week we'll discuss another of the most important things: knowing what you own, and why you own it.
Interest rates in the United States are the most important interest rates in the world, as the US dollar is the currency of international trade and foreign reserves. All rates are set with reference to them, as the United States enjoys the world's deepest capital markets, a function of the strength of and confidence in its institutions on the part of the world's market participants. Current expectations show that the consensus is that short term-rates will remain high relative to current history, with a cost to borrow for two years currently priced at about 4.4%. The three-year rate hovers just above 4%, and the cost of borrowing for five-to-ten years is just below 4%. The yield curve remains inverted, which has in past been interpreted as a signal that recession is imminent. For the curve to return to normalcy, short- and mid-term rates would have to drop, or mid- and long-term rates would have to rise. As the Federal Reserve's overnight rate is currently set at between 5.25-5.5%, this would indicate that the market believes that rates will fall between by about a percent or a percent-and-a-half over the next couple of years, that inflation will revert to levels that markets grew accustomed to prior to the War on COVID-19, and that productivity growth will revert to trend.
When we look at yield curves for sovereign debt more broadly, we can see that very little term premium is available. The US, UK, German and Australian yield curves are inverted, while Japan, China and India show a modest term premium. Lending long doesn't pay, and it would seem that slowing growth for the aforementioned Western economies is priced in.
Credit Spreads for Corporate and High Yield issues are still tight. 97-99% of the excess return to corporate credit comes from the embedded equity exposure, so what spreads are really reflecting is a low equity risk premium.
In our year-end review last week, we briefly discussed equity returns for major markets. We now update that review with current pricing to understand how the markets see prices evolving over the next twelve months. First, returns to all market capitalization segments in the United States show exceedingly modest expectations for gains in 2024, with the S&P 500 gaining 2.79%, Mid-Caps gaining 2.02%, Small-Caps gaining 3.27%, and the Russell 2000 gaining 2.95%. Compared to 2023's gains, these are quite meager and don't seem to compensate the investor for taking equity risk. Given the run up in prices, expected returns should be lower, as the Price/Earnings ratios suggest--or, as our favorite yardstick for equity returns, the Earnings Yield (the Earnings/Price ratio) suggests. Using trailing twelve month's earnings, the S&P 500 is still quite expensive at a P/E of 22 (an E/P of 4.57%), and the Russell 2000 is no deal either at 27.08 (3.69%).
Rebasing major equity markets and plotting their futures contracts against each other over the coming year, we can see that current expectations are for drawdowns in all markets save China, and there only a very modest gain. The equity markets, like the bond markets, have priced in economic recession for Europe in 2024, but also for the Emerging Markets.
Commodities and Gold
Industrial commodities point to increased demand toward the middle of this year, then tailing off toward the end of the year. This is consistent with slow growth in the first half of 2024, and then an increase in demand concomitant with expected central bank easing.
As China is the world's largest consumer of both Copper and Aluminum, as much as anything else, future pricing suggests the recovery of industrial demand there toward the middle of the year.
Turning to energy markets, we see a generally stable market for the year. Oil has been volatile lately due to concerns over geopolitics and Saudi and Russia's concerns over receiving too little per barrel. The United States has stepped into the market in a big way to become the world's leading producer, reducing the upward pressure created by Russian and Saudi production cuts. The market expects supply and demand to remain pretty stable through December. (Oil is a commodity that comes with storage costs, so the future price is typically lower than the current, spot price.)
Natural Gas, on the other hand, is pricing in elevated demand. Natural Gas prices are highly seasonal, as production increases in the summer months, and demand increases in the winter months. Its future curve therefore transitions from backwardation to contango on a seasonal basis, with higher prices in the winter and lower prices in the summer. We can see that natural gas demand is elevated through September, indicating an unusually high expected demand.
Lastly, Gold, the anti-commodity, anti-financial asset, is priced in the futures market to increase in value at a linear pace over the next four quarters. Gold's price responds to three primary factors: changes in real interest rates, economic pessimism and drawdowns in confidence in the financial system, and extremes of inflation. Gold is currently priced to return about 3.82% this year, which is likely attributable to the increase in real yields that the market expects. With inflation trending downward, and central bank interest rates expected to follow, real interest rates decline, and accordingly the opportunity cost of holding an asset with neither cost of carry nor carry return therefore falls. While the state of global affairs remains somewhat unsettled--war in the Middle East, war in Eastern Europe, a closely contested presidential election in the United States, economic uncertainty in China--these do not seem to be contributing to a rise in gold prices. If substantial risk premium were being priced in for these matters, then we would likely seem them in energy commodities, too. As inflation is trending down around the globe--Europe saw inflation continue its decline today--it is unlikely that inflation concerns are driving the expectation of appreciation.
Lastly, we take a look at the expected change in exchange rate against the US dollar of representative currencies. We've rebased prices to 100 so that the magnitude of expected change is easier to see. Overall we don't see much change priced in over the coming year: EUR, AUD, GBP, CAD, RMB and INR are expected to remain in a range. JPY is set to strengthen considerably against the dollar, while MXN and CHF are set to weaken. The dollar is slightly down against a trade-weighted basket of currencies, priced to weaken slightly in the first half of 2024, and then gain in the second half of the year. Overall, the dollar is priced to be down by the end of 2024, which is consistent with expectations for moderate global economic growth.
Nonfarm Payrolls Come in Stronger than Expected, Point to High Rates for Longer
This morning we received the monthly non-farm payrolls report. Consensus expectations were for gains on par with November's, minus the re-addition of striking auto workers. Forecasts of 170,000 new jobs were beaten handily by healthy gains of 216,000.
Despite the additions, unemployed remained at the historically low rate of 3.7%. Unemployment is still lower than what is generally accepted to be the natural rate of unemployment in the United States, or that level of unemployment below which wage pressures rise and contribute to inflation. Although the rate of unemployment is still quite low by historical standards, it has been for some time now, and wages, while higher, have shown signs of moderating.
Importantly for the inflation picture, wage gains were muted, coming in at 4.1%.
Late in the business cycle we expect employment to be at or above capacity, for employment growth to be at a peak. At this point, it's tough to see where additional workers will come from if not from immigration or un-retirement. There's room in sectors such as manufacturing and financial services to add workers, as these sectors shed workers in the past year.
All in all, this is a solid jobs report, doesn't look to be inflationary, and should encourage the Federal Reserve that its monetary policy continues to hold growth at non-inflationary levels that don't also spell layoffs for workers. We'll be receiving more data on the state of growth over the coming weeks which will tell us more about the trajectory of growth, and whether monetary policy is too tight and calls for loosening. This jobs report, however, does not add to the balance of evidence on that side.
*With a nod to one of goodstead's intellectual heroes, Howard Marks.