The Agony and the Ecstasy, one could say. Irving Stone’s famous 1961 novel may have been about the life of Michelangelo and his tortuous experiences while painting the Sistine Chapel, but the phrase easily lends itself to this week’s journey from darkness to light in the US stock market. As we wait for trading to get underway on this Friday morning, all appears well once again, thanks largely to the doings of one company and its continued ability to outdo the ever-higher expectations set by the market.

Hedgies Caught Out

Nvidia, the company that appears to have a dominant position in the market for the semiconductor chips that power all things AI, reported its fourth-quarter earnings after the market close on Wednesday. Heading into that report the market had been in something of a funk. Expectations for Nvidia were sky-high; after all, the company’s stock had risen by more than 200 percent in the past twelve months, and its quarterly sales and earnings numbers within that time had blown the doors off analyst estimates. The AI mania of which Nvidia was arguably the central asset of focus had carried the rest of the market with it, led by seven companies that came to be known as the Magnificent Seven.

Surely it was time for a recalibration, thought the collective wisdom. Nvidia’s stock traded down around nine percent in the three days before its Wednesday aftermarket report. Hedge funds, those incandescently brilliant operators who charge two percent plus a cut of profits for the privilege of riding along in the wake of their shining genius, were collective sellers of Magnificent Seven stocks for five of the six trading days through Wednesday’s close. Meanwhile, the release of minutes from the last FOMC meeting last month appeared to reaffirm the central bank’s intention to sit pat for the time being and not cut rates, lending another minor key note to the already dour tone of the market.

Seemingly Bottomless Demand

Then the numbers came out, and boy did that sentiment do a U-turn. There seems to be almost no end to the demand for what Nvidia sells, which is a graphic processing unit (GPU) platform providing the capability to employ generative artificial intelligence at scale. Data centers, who represent Nvidia’s largest customer base in this segment, bought more than $18 billion worth of these products in the fourth quarter, topping off a year in which sales for this segment grew more than 400 percent. Profit margins were also higher, and forward guidance (one of the biggest concerns among analysts heading into the earnings report) also beat expectations.

The ensuing market rally on Wednesday didn’t just limit itself to US tech stocks, though most of those did fine, especially any that can make a plausible claim to having a good AI story to tell. On Thursday the Japanese Nikkei 225 stock index surged past 39,000 to close at its highest level ever – fully 34 years after its previous record close! The bullish sentiment in the Japanese market, which includes a handful of world-class semiconductor names, traced directly back to that Nvidia earnings report. Softbank, a Japanese firm with a venture capital arm that has had more than its share of troubles in recent years, was a particular beneficiary of the latest iteration of “AI saves the day.”

All was well that ended well, except for all those smart-money funds that sold out of Nvidia and the other AI leaders before Wednesday evening.

Seven, Six, Five or Four?

On its earnings call Nvidia described the current market for GenAI as being at a “tipping point” – a phrase normally interpreted as a moment when a trend moves from linear to geometric expansion. That may or may not be the case, but for the moment, anyway, there does not appear to be any indication that demand for the infrastructure needed to run AI applications at scale is going to diminish.

That being said, it is probably time to revisit that “Magnificent Seven” moniker. The group of companies that drove the market in 2023 has diverged somewhat in 2024, for a variety of reasons. At the moment, only four of the companies are actually ahead of the S&P 500 for the year to date.

Tesla, in particular, has been having a bad time of things, as whatever story it can tell about AI in its value proposition has been overshadowed by the specter of competition from electric vehicle manufacturing in China. Apple has struggled somewhat as well, also in part due to competition eating into its sales in China, one of its most important markets. In fact, only Nvidia and Meta (Facebook), which also had a blockbuster earnings report a few weeks back, are notable outperformers.

In our annual outlook last month we noted that 2024 may be the year when the general halo around AI breaks down into a more sober scrutiny of which companies actually are profiting from it and which ones don’t really have a compelling core use case. That may be starting to happen. For the moment, though, it seems the market will continue to swim along with the established market leaders – as long as they can continue to pull those sales and earnings rabbits out of the hat.

Spare a thought, if you will, for the poor bond market. The fixed income crowd lives and breathes for the certainty of where interest rates are headed, only to be forever buffeted by the crosswinds of conflicting economic data that tear apart the certitude of any directional trends. This week was particularly trying, and most of all for the masses tethered to the “6 in ’24” narrative proclaiming six Fed funds rate cuts in 2024, a narrative which, outside the seemingly impenetrable insular bubble of bond traders and their media boosters, does not exist and has not existed. The culprits this week: two hotter-than-expected inflation reports on the one hand, and a colder-than-predicted number for retail sales on the other.

Inflation Surprise #1

A word about this week’s Consumer Price Index (CPI) report before we delve into the details: the Fed gives more weight in its deliberations to the Personal Consumption Expenditures (PCE) index than to the CPI number, and as we reported a few weeks ago, the most recent PCE was  quite cheery – the index showed a gain of 0.17 percent in December, translating to a 2.9 percent year-on-year growth rate and continuing a steady downward trend over the past half year or so. So that’s good.

But the CPI also matters, and this week it showed some unwelcome trends both at the headline and the core (ex-food and energy) levels. Food prices were up by 0.4 percent in January, representing the highest monthly gain since June, shelter was up 0.6 percent, and services not related to energy (i.e., most of the services that make up our daily lives like visits to the hairdresser or the nail salon) were up 0.7 percent. To put that another way, many of the categories that make up typical household budgets saw price gains in January well above recent trends. That led to an overall year-on-year gain of 3.1 percent for headline CPI and 3.7 percent for core CPI. Once again, the bond market got a bracing dose of cold water thrown on its rate cut plans, as anything suggestive of higher inflation strenuously complicates any plans by the Fed for a near-term rate cut (and Powell had already signaled at last week’s FOMC meeting that such a cut was very unlikely to be on the table when the Committee meets next in March).

Retail Sales: Bad News Is Good News

Then came the reprieve. A retail sales print on Thursday showed a sharp reversal in January that may be the first clear sign of a slowdown in consumer spending (although, to be fair, it may also have more to do with several severe weather incidents last month than with a more sustained directional movement). Retail sales in January declined by -0.8 percent. The so-called Control Group number, which strips out a few volatile categories and is the retail sales figure that flows into Gross Domestic Product calculations, was down a half percent when it was expected to gain a half percent – a one percent deviation from expectations. That’s bad news if you want to see stronger growth, but it’s good news if (like bond traders) the only thing in life that matters is the Fed cutting interest rates. Predictably, yields in Treasury securities came down and offset some of the rise from the Tuesday inflation report.

Inflation Surprise #2

Alas, the bond market’s reprieve was but a passing moment. On Friday another inflation report came out, this time the Producer Price Index that measures changes in wholesale prices (i.e., stuff going on upstream from consumer-facing activity). Normally the PPI doesn’t get anywhere near the attention the CPI and other consumer figures garner, but this time it was a dead weight on market sentiment. Core PPI in particular deviated significantly from expectations, with a month-on-month gain of 0.5 percent versus expectations of just 0.15 percent (and coming on the heels of the previous month when it actually fell by -0.1 percent. As a result, the 10-year Treasury is back at its highest level since last November (though still well shy of the 5.0 percent peak reached last October).

What to make of all this? Well, from our standpoint it goes along with the message we repeat to our clients on a regular basis: the short term is unknowable, so don’t try to profit from outguessing where interest rates, or stock prices, or barrels of Brent crude oil, are going to be tomorrow or next week. We remain puzzled by why the bond market has consistently tried to outrun the Fed and make up its own bedtime stories about rate cut unicorns. But rather than thinking we know any better, we continue to move incrementally and deliberately in the context of the overall structural likelihood of peak rates and a gradual – subject to those many macroeconomic crosswinds – reduction towards the natural interest rate (which is not easy to pinpoint but is almost certainly lower than where rates are now). And we don’t try to read too much one way or another into any single piece of information. One data point does not a trend make.

Meet the new year, same as the old year…or so it would seem by the price dynamics of the S&P 500 in the early weeks of 2024. On the way to achieving another one of those round-number milestones so beloved by the financial media talking heads, it was the usual mega-cap stalwarts leading the way. Meta (Facebook) and chipmaker Nvidia have been particular standouts on the road to 5,000 for the blue chip index, though Tesla’s Magnificent Seven credentials appear to be at least temporarily suspended as the carmaker has been struggling on a variety of fronts.

Multiple Distortions

One thing that is different between today and a year ago – unsurprisingly given the stonking 26.3 percent total return for the S&P 500 in 2023 – is that stocks are a whole lot more expensive than they were. How expensive, though? That question is a bit tricky, depending on how one is inclined to think about the wild distortions of the pandemic period. Let’s consider the numbers. The chart below shows the forward (next twelve months) price-to-earnings ratio for the S&P 500 for the past ten years.

So, hot or not? We could take a glass-half-empty or glass-half-full approach. On the one hand, today’s NTM P/E of 20.4 times is lower than where it was throughout most of 2020 and 2021, when at one point valuation levels were closing in on the nosebleed territory of the dot-com bubble of the late 1990s. On the other hand, if you take away the pandemic distortion – lower earnings as the economy shut down and higher prices fueled by the Fed’s liquidity shower – the P/E ratio today is at its highest level since 2014.

The glass-half-empty team has another argument to add to this: earnings estimates have been coming down and could be poised to come down further. Last September, analyst estimated that earnings growth for the fourth quarter of 2023 would come in around 7.9 percent. Now, with nearly three-quarters of S&P 500 companies having reported their Q4 numbers, those same analysts are forecasting just 2.8 percent growth when all is said and done. Looking ahead, the current estimate for the first quarter of 2024 is 3.8 percent growth, down from the previous estimate of 8.3 percent. Since earnings are the denominator of the P/E equation a decline in earnings will, all else being equal, increase the P/E number. That’s an argument in favor of “very expensive” and not just “expensive.”

It’s All Relative

Is that it, though? Take the case of high-flying Nvidia. The stock is up more than 40 percent so far just this year, and that’s in the context of a twelve-month price jump of 215 percent. The NTM P/E for Nvidia is 32.3 times, which sounds like a red flashing alarm, right? But if you compare Nvidia’s NTM P/E with that of the S&P 500 itself, it doesn’t look all that dramatic. On a relative basis, Nvidia’s P/E is actually close to its low point for the past five years. Yes, it trades at a premium of 1.6 times to the index, but that compares to more than 3.3 times early last year (and early last year would in hindsight have been a terrible time to ditch Nvidia, as some prominent growth fund managers did). The company’s sales and earnings – and this is also true for a number of the other tech leaders – have consistently grown in mid-double digits over this period as demand for the devices and services that power artificial intelligence has been seemingly bottomless.

So what’s the right answer? Take your pick. We think valuations are expensive enough to potentially constrain upside potential from another wild and crazy bout of multiple expansion, but we also think overall economic conditions are favorable enough to provide at least a modest tailwind to sales and earnings. It’s also possible that none of this will matter and the “vibes market” will find something else to latch onto, for better or worse, from whatever comes out of the opaque soup of narrative, commentary and fanciful conjecture. It’s that kind of a market these days. For us, though, we’ll continue to stick to the basics of free cash flow, sales growth profit margins and all those other boring artifacts.

It is once again that silly day of the year when news organizations dutifully report on the weather forecasting acuity of that beloved groundhog in Punxsutawney, Pennsylvania. The quadrupedal meteorologist apparently signaled an early spring, so three cheers for that. Here’s where we don’t see any signs of an early spring: China. The China Shenzhen A Shares index is rapidly approaching a bear market just from where it started the year; down 19 percent since the beginning of January. The index is already well into bear territory overall, down 35 percent from the latest peak reached in January 2023.

It’s a completely different story in the Asian country whose population surpassed that of China last year. India’s stock market is in ruddy health, as is the overall economy, which has been putting in annual real GDP growth rates over six percent and undertaking reforms that have encouraged new flows of both foreign direct investment and portfolio capital.

The Recovery That Wasn’t

Let’s turn the clock back to 2022, when China was firmly wedded to its unrealistic policy of “zero-Covid,” shutting people up in their apartments and closing shipping ports while the rest of the world was working its way back from the pandemic. Things were so bad as to finally spur widespread protests in the fall of that year, with citizens risking falling afoul of Beijing’s heavy authoritarian hand by coming out in the streets to register their discontent. The government finally backed down and terminated the lockdowns. At that point foreign investors turned into super-charged China bulls, as the above chart shows.

But the optimism was misplaced, and for reasons that the starry-eyed investors should have seen. China’s economy has long been driven by the property and infrastructure sector, which regularly contributes about a third of the country’s total GDP output. It would not be correct to pronounce that sector in freefall; rather, it has been a slow and tortuous decline ever since the giant development firm Evergrande missed its first international debt payments in the summer of 2021. A succession of defaults and near-defaults have ensued, claiming the property sector’s biggest names. Without a healthy consumer sector to offset the property and infrastructure declines, China’s overall economic performance has been subpar. Just this week, the long-running tragicomedy of Evergrande came to a pathetic end when a last-gasp restructuring effort failed and a Hong Kong court ordered the once-and-for-all liquidation of the company.

Davos Man and Hindutva

Over in India, Prime Minister Narendra Modi and his BJP party are almost certain to win re-election when national elections are held this spring. Modi has been in power since 2014, and his rule has been a curious mix of policies. On the one hand, the BJP’s economic policies have been very foreign-friendly, leading up to the implementation of a national sales tax last year that removes a significant load of red tape from international companies wanting to do business in India. And there is an increasing number of such companies, including some of the world’s largest multinationals looking to reconfigure their global supply chains away from dependence on China.

Those are the policies that make India a welcome guest at the World Economic Forum in Davos every year. Back home, though, Modi is seen by many critics as steadily eroding India’s democratic foundations and pursuing ethno-nationalist policies in favor of the country’s Hindus, who represent about 80 percent of the total population. An example of this was seen last week with the opening of the Ram Mandir shrine in Ayodhya, a Hindu temple on the site of a destroyed Islamic mosque in the state of Uttar Pradesh. Modi used the occasion, bitterly protested by India’s Muslims, to announce a new era for India as a global power and challenger to China for economic pre-eminence in Asia.

India’s accomplishments have indeed been impressive, and so far Davos man and Hindu nationalists have been able to coexist peaceably. But, as is the case in many other parts of the world, domestic unrest and heavy-handed political partisanship have the potential to undermine the positive narrative. It’s worth noting that much of India’s economic engine is located in the southern regions of the country, while the center of Hindu nationalism is in the north.

At the same time, it is far too early to write off China as a twenty-first century incarnation of Japan, the economic sad sack of the last twenty years. Amid all the negative China data late last year came word that the country’s largest electric car manufacturer, BYD, topped Tesla for the number of EVs sold in the fourth quarter. The Asia story is far from over, and it promises to be one of the interesting ones in the months and years ahead.

This week brought with it a couple more pieces of data to suggest that the positive trend the US economy enjoyed throughout 2023 is far from over. The good news this week: Gross Domestic Product (GDP) grew at a real quarterly rate (annualized) of 3.3 percent for the fourth quarter, which translates to a 3.1 percent annual rate for the full year of 2023. That is a much stronger growth rate than economists had expected, and notches yet another win for the US as the world’s best-performing advanced economy.

Today we got the second installment of Goldilocks data (not too hot, not too cold) with the Personal Consumption Expenditure price index. The PCE (excluding food and energy categories) is the inflation metric the Fed pas closest attention to in its monetary policy deliberations. For December, the month-on-month PCE growth was just 0.17 percent, which translates to a year-on-year growth rate of 2.9 percent. That is the lowest level since March 2021, and also breaks the psychological 3.0 percent level.

Consumers Still Having Fun (And Not Paying As Much)

The better-than-expected GDP growth was driven once again by strong consumer spending, with the holiday shopping season also exceeding expectations. Some of the best-performing categories, interestingly, were discretionary areas like restaurants and recreational vehicles. Apart from consumer spending, nonresidential fixed investment and exports were also net positives in the GDP equation.

The decline in inflation, as measured by the PCE, is only partly due to the extended period of monetary tightening by the Fed. Indeed, the pace of consumer spending over the past twelve months by itself would seem to suggest a sticky path for inflation coming down. But remember that one of the key driving factors in inflation when it started to rise in 2021 was not from the demand side but rather from the busted-up supply chains that were still trying to work themselves out of the pandemic. The inflation formula was simple: more money (pent-up demand from the lockdown period plus government stimulus money) chasing fewer goods squeezing through those supply chain bottlenecks. Those problems have more or less righted themselves, so now we have an adequate supply of goods and services to meet the still-brisk demand. The result is inflation inching ever-closer to the Fed’s two percent target.

People Starting to Notice

It seems that the persistence of good economic news may finally be enough to sink into the dour consciousness of the fine American citizenry. In our annual investment outlook, which our clients will be receiving shortly, we talked at some length about the “vibes” economy in which a majority of people expressed anywhere from a moderate to high level of dissatisfaction with the economy, to the point where a not insubstantial plurality insisted (incorrectly) that we are actually in a recession. In our annual report we pointed to one statistic, a consumer sentiment report published by the University of Michigan, that showed consumers being just about as down on the economy in recent months as they were during the recession of 2008 (a much, much worse economic period than today).

Well, lo and behold – the January number for the Michigan sentiment index just came out, and it showed a 13 percent increase from the December figure. That uptick tracks with a Pew Research poll that also came out this week, showing about a nine percent increase in the number of respondents categorizing the economy as “excellent” or “good.” Now, to be fair, that cohort still represented only 28 percent of those polled, so there are still plenty of doubters out there. Perhaps another month or two of Goldilocks-type data will bring them on board. We shall see.

So close, and then so far. That was the story of the Treasury yield curve last October, when the 10-year yield briefly touched a decades-long high of five percent. For an ever so brief moment, it looked like the yield curve, stubbornly fixed in the inverted shape that in the past has been a reliable predictor of an approaching recession, might revert to normal. Then, a prominent hedge fund manager announced to the world his view that intermediate rates would not go any higher. Some more good news about inflation trickled in. Finally, the Fed came out of the December FOMC meeting with a rosier than anticipated view on rates, and the bond market had a jamboree. All of this knocked rates back, and the 10-year fell further than the 2-year. The inverted curve, it seemed, was here to stay.

Get ‘Em While They’re Hot

As has become the norm, the bond market took whatever the Fed said and doubled down. The December FOMC median best guess about the Fed funds rate in 2024 was three cuts for a total of 0.75 percent; the market immediately priced in six cuts for lopping 1.5 percent off the overnight rate. FOMO was back in full, with money managers and financial media talking heads insisting (for something like the 978^th time in this monetary tightening cycle) that this was the “absolute last time” to lock in attractive yields for high-quality securities. Seasonality played a role, with a robust “Santa Claus rally” spilling over from stocks into the bond market (itself something of an oddity, since risk assets and safe havens normally move in opposite directions). Anyone who hadn’t seized the opportunity to get ten years’ worth of coupon clipping at five percent rushed to lock in their fortunes when the 10-year dropped below four percent.

Yet Another Repricing

Stop us if you’ve heard this one before. The bond market thinks there is a pony out back, runs outside and finds that the barn is still empty. January opened with something of a hangover after the fizzy good cheer of the December rally. Cooler heads were starting to actually think about why, exactly, the Fed would deliver six rate cuts in a year where, as far as we can see right now, there is a rapidly decreasing chance for a recession, inflation still has a possibly sticky “last mile” to go before it gets to the Fed’s two percent target, the jobs market is still healthy and – not an insignificant consideration for a politically cautious institutions like the Fed – it’s a particularly contentious election year. Rates have gone back up and, as the chart above shows, the 10-year yield is once again inching back towards the 2-year. The difference between the two yields is around 0.2 percent today; it was around 0.5 percent at the height of the December rally, and the spread has been as wide as one percent in the time since the curve first inverted in the summer of 2022.

RIP, Great Predictor of Recessions

So where does it go from here? Let’s revisit that observation we made a few paragraphs above: the presence of an inverted yield curve has long been viewed, correctly, as a harbinger of recession. A year ago that made sense, when the consensus opinion was that 2023 would bring a cyclical recession as a result of the most dramatic monetary tightening policy since the early 1980s. But the recession of 2023 never happened. It does not appear to be on the horizon as far ahead as we can see in 2024 as well. Unless conditions suddenly change (which is always a possibility), it would seem reasonable to assume that the 2-10 curve will at some point crawl back to its normal upward-sloping shape. While we think that incremental moves in this direction represent the most logical near-term path, we have seen enough of the bond market in the past year to not assume that logic has anything to do with it. We continue to gradually extend duration in our portfolios, believing that there is little more upside to be concentrated at the short end of the curve, but the best advice we can give as far as fixed income in general is concerned is to proceed with caution.

As we normally do this time of the year, we are sharing with you our outlook for the economy and markets in 2024. For our clients, you will see this week’s commentary again as the executive summary of the Year Ahead report you will receive from us in a couple weeks or so from now.

The Economy: Slower, But Still Growing

The biggest economic story of 2023 was about something that didn’t happen. There was no recession in the United States or, for that matter, in the global economy at large. Against the predictions of most mainstream economists (ourselves included), the American consumer put the pedal to the metal and spent, spent, spent. The jobs kept coming, month after month. Gross Domestic Product rose in the third quarter by an annualized rate of 4.9 percent, a pace way above historical trends. All this happened while interest rates kept going up and consumer prices kept going down. In the early days of 2024, it looks increasingly likely that the Fed’s monetary tightening program, begun nearly two years ago, will result in the often hoped-for but seldom achieved “soft landing.”

The economy’s better than expected situation could prove to be a tailwind for risk assets this year; however, there are plenty of potential challenges that could trip up performance as well. Businesses will have to deal with the twin obstacles of a likely slowing pace of demand, and of a loss of pricing power as inflation continues to recede. There is also the chance that China’s ongoing economic troubles reach a critical point this year. Finally, the geopolitical landscape looks to be anything but ordinary. More than two billion people in more than seventy countries are likely to cast ballots in nationwide elections this year, the most ever. Some of these will be highly consequential, and arguably none more so than our own presidential contest this November. Meanwhile, destructive wars rage on in Ukraine and the Middle East, and Taiwan is never far from the mix when the question of the next major flashpoint comes up. In short, there are reasons to be optimistic this year, and there are also reasons to be cautious.

Here is how we see the year progressing (as always, please remember that these views are subject to change, based on imperfect and incomplete information, and may not correspond to actual outcomes). The economy will continue to grow, although at a slower rate than in 2023. In our opinion the two big macroeconomic stories of the year will be (a) the ongoing strength in the labor market, with the unemployment rate not likely to rise much above four percent; and (b) a continued decrease in consumer prices with the core Consumer Price Index falling below three percent by the end of the year. If this happens, it will constitute a textbook soft landing.

A soft landing, though preferable to a recession, is still what it says: soft, as in, not a period of robust growth. That will make for challenging conditions for businesses. A combination of softer demand and lower inflation will make it more difficult for businesses to achieve strong top line sales growth. With limited room for top line upside, these enterprises will need to find ways to achieve operating efficiencies to shore up their profit margins.

This spotlight on ways to improve profitability in the absence of strong sales will center around that other big story of 2023: artificial intelligence. Last year we witnessed an abject fascination by investors with the emergence of generative AI, popularized by accessible platforms like ChatGPT. This year, we expect the market will be a bit more discriminating about the hype, and more interested in the practical question of what generative AI can do for businesses as they attempt to grow profits in a slowing economy. This brings us to an analysis of what the equity market may have in store for us this year.

Equities: Proof Of Concept For AI

Equities in 2023 largely boiled down to seven words: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. These were the “Magnificent Seven” – the mega-cap tech stocks that for much of the year accounted for the entirety of the S&P 500’s price appreciation. The common thread between all these companies was artificial intelligence. Early last year, AI burst into the public imagination in a way that it had not previously, largely due to the arrival of generative AI platforms like ChatGPT and Dall-E with their user-friendly applications for the eerily prescient generation of textual and visual content. Investors quickly latched onto the Magnificent Seven as they all had features of GenAI at the core of their value propositions, with Microsoft and Nvidia perhaps the most prominent beneficiaries due to the former’s early embrace of GenAI progenitor OpenAI (not a publicly tradable company) and the latter’s dominant position as the supplier of the graphic processing units that enable GenAI applications to run.

We expect 2024 will be a different environment for AI, one less about hype and more about proof of concept. Beyond the novelty of AI-generated college essays or Impressionist paintings, the focus will shift to what businesses can do with GenAI to improve efficiencies and shore up profits. This is likely to be a particularly important issue this year as companies face a macro environment of cooling demand; operating efficiencies could potentially offset slower top line sales growth. But first, these businesses will have to show conclusively that these potential efficiencies exist.

Outside of large cap US equities, we do not see a compelling set of reasons to aggressively extend positioning. Our reasons for staying underweight in US small caps, non-US developed and emerging markets are structural, and nothing of recent note has changed our thinking.

Fixed Income: Less Drama, Please

If it took seven words to describe equity markets in 2023 (see above), it took just one word to encapsulate the bond market: Drama! Normally the most boring place in a diversified portfolio, offering safety and perhaps a predictable stream of income, the bond market was all over the place last year. The yield on the 10-year Treasury note, which plays a critically important role in investment markets as the “risk-free rate,” went up and down by greater magnitudes of percentage change than equities throughout much of the year. What made the bond market’s gyrations particularly puzzling was that the Fed was giving crystal-clear guidance throughout the year about its intentions with regard to interest rates. “Higher for longer” was the message reprised over and over again. In March, when an abrupt spate of insolvencies at several prominent banking institutions briefly raised fears of a full-scale banking crisis, the Fed continued to insist that it wasn’t done with raising rates. Yet the bond market immediately priced in a spate of rate cuts that were never going to happen. The same thing happened on two or three other occasions – traders furiously bought bonds and drove yields lower, the Fed came out and said “higher for longer” and yields spiked back up.

The central bank appears to be at the end of its monetary tightening program, and that could portend a somewhat calmer year ahead in fixed income. The short end of the yield curve in particular should not contain too many surprises. The Fed may cut rates a couple times, but then again it may not, depending on whether the economy is running hotter or colder than what is now the mainstream view of a middle-of-the-road soft landing. In the middle of the yield curve, assuming we manage to avoid a recession, the persistent inversion between 2-year and 10-year maturities should revert to a normal upward-sloping curve at some point, but how and when that happens is still very much up in the air. We think a wide range of yields from around three percent to five percent is appropriate for maturities within the 2-10 year band, and that should give investors a chance to lock in positive purchasing power, potentially for a number of years to come.

Concluding Thoughts

We always tell our clients that we are not in possession of a crystal ball any more than anyone else is. We do foresee a great deal of uncertainty around elections, particularly as our nation’s attention starts to fixate on the upcoming election during the primaries this spring and when the parties hold their conventions this summer. Markets may experience short-term fluctuations up or down during this period and in the immediate aftermath of November 5, but we believe it would be foolish for one to think that the timing, magnitude or direction of any such move could be capitalized on for tactical portfolio gains.

As has been the case in recent years, our asset allocation weights in 2024 will be divided between fixed income and equity asset classes for the most part representing liquid, relatively high-quality names (governments, agencies and investment grade corporates on the fixed income side, US large cap stocks for equity allocations). We do not see a compelling reason to venture into more exotic terrain as the year unfolds. Our approach to delivering long-term value for our clients is based on equities for growth, fixed income for safety, and keeping security selection decisions as simple as possible within the context of prudent diversification (Occam’s Razor – don’t make things any more complex than necessary to arrive at an informed conclusion). Our 2024 allocations will reflect an outlook based on a moderately positive environment for equities and more stable conditions for bonds than was the case in the past two years, implying incremental repositioning of fixed income away from short-term floating rate to intermediate fixed-coupon issues. As for all the things out there known and unknown that could trip up our assumptions, we believe we will be in a better position to countenance them if we refrain from making aggressive bets too far in one direction or another. We have little doubt that there will be surprises in store.

The first week of 2024 served up a bevy of data about the health of the US labor market. The main takeaway is that there are still jobs aplenty in our economy, nearly two years into the most dramatic monetary tightening program since the early 1980s. The December report published this morning by the Bureau of Labor Statistics showed 216,000 payroll additions last month, with the unemployment rate holding steady at 3.7 percent. Hourly wages rose by 0.4 percent, which is more than the 0.1 percent increase in the Consumer Price Index last month. In fact, hourly wages for the full year 2023 rose by 4.1 percent, while headline inflation for the same period was 3.1 percent (we use the headline inflation numbers here rather than the core number which the Fed focuses on, because for actual people the energy and food components excluded by the core index are rather important ones).

Coming In For A Soft Landing

There are several things worth noting about this chart. First, you can clearly see that fewer jobs were created last year than in 2022. That is, in fact, just about exactly what the Fed hoped would happen: a cooler jobs market but one still showing gains every month. Second, the unemployment rate remains below four percent. The current level of 3.7 percent is just a few ticks higher than the 3.4 percent level achieved back in April, which in turn represents the lowest rate of joblessness since 1968. The median unemployment rate for the US economy since 1950 is 5.5 percent.

At least for the moment, these jobs numbers add to the mounting evidence that the Fed has managed to engineer that fabled “soft landing” of economists’ dreams. At some point it may even sink into the sensibilities of disgruntled American citizens (only 14 percent of whom, according to a recent survey, think the economy is doing at all well) that things are actually okay. Yes, the price of eggs is higher than it was in 2019, but so are their incomes, as attested to by those BLS wage numbers. Inflation continues to trend lower, the recent holiday shopping season proved resilient, and 2024 appears to be starting off on the right foot. At least for now.

The Market’s Take

All well and good, one might say, but how will markets react? Don’t we have a “good news is bad news” problem in which better economic growth implies interest rates staying higher for longer and thus disrupts all those rate cut hopes that have kept stocks and bonds humming along so nicely for the past couple months? Perhaps, though it’s worth noting that US stocks are up this morning in the wake of the jobs report, reversing earlier declines in futures markets. The bond market does seem to be rethinking some of the exuberance that followed the most recent Fed policy meeting in December, but in our opinion that exuberance was never warranted in the first place. If the Fed does pull off the soft landing and we get through the tightening cycle with no recession, that should be favorable to risk asset performance this year. It’s early yet, and the first few days of the new year have not been particularly rosy for stocks (which is not necessarily surprising, given the barnstormer of a finish to 2023). But so far, so good as far as the economy goes. Next up: fourth quarter earnings. We’ll have more to say about the challenges companies will be facing this year in forthcoming commentaries.

It’s the last trading day in 2023, and it’s fair to say that the year turned out better than most of the pundits had predicted. Now, of course, the pundits are busy with their prognostications for the year ahead, including specific calls for US equities and other asset classes that will likely reach their sell-by date well ahead of December 2024. While it is always wise not to put much stock into a single prediction (you might as well go ahead and try to guess who will win the World Series next year), it can be useful to see the range of scenarios envisioned by the market pros. At least one of them, after all, is likely to be close to reality, from a combination of disciplined analytical reasoning and dumb luck.

So what do the experts see as they stare into their crystal balls? Well, JPMorgan Chase doesn’t expect to be popping any Champagne. Their call for the S&P 500 at 2024 year end is 4,200, about a 12 percent decline – yes, decline – from the 4,783 close on December 28. At the other end of the spectrum, Goldman Sachs predicts a market close of 5,100 a year from now, representing a tidy but not barnstorming gain of 6.7 percent from yesterday’s close. According to the FactSet data compilation from whence these estimates come, the median estimate from the pros is for the blue chip US equity benchmark to register a 6.0 percent gain next year. That’s a pretty safe call. Of course, a year ago those same mavens were predicting a troubled 2023 for US equities and look what we got instead – a nice little gain of 25 percent thanks to a combination of no recession, AI mania and Jay Powell’s Christmas present of a Fed pivot on December 13.

We generally refrain from putting a hard number out there ourselves, because in our experience even getting the fundamentals right (the economy, earnings, monetary policy) doesn’t ensure a predictable market outcome. And getting the fundamentals right is notoriously difficult, as most experts found out in 2023 (see: The Recession of 2023, inverted yield curve etc.). What we do think is going to matter a great deal next year, though, is corporate sales and earnings performance. Now, it may sound facile to state that “earnings will matter” – but much of the time they don’t matter much from a stock price performance standard; or they matter, but other things matter more to the collective mind of the market.

Next year, though, businesses will likely be facing two distinct challenges to their financial prospects. First, the economy is likely to be growing at a considerably slower pace than the roughly three percent real GDP growth in the cards for 2023. Slower end-user demand implies lighter sales volumes. Second, the continued good news in slowing inflation means weaker pricing power for businesses. When both volume and price are weaker, the logical outcome is…well, lower sales. Already, during the Q3 earnings season, we have seen consumer-facing companies lower their forward guidance in light of expected “macro uncertainty” – corporate earnings call-speak for weaker consumer demand.

Sell-side analysts have been taking note of the downbeat guidance. The consensus outlook for Q4 earnings per share growth, according to FactSet, is 1.38 percent. That is down from a consensus outlook of 8.08 percent as of September 30, a sizable decline. Much will depend on companies’ ability to employ productivity measures to improve profit margins. Improvement at operating profit levels can offset weakness in top line sales – but the efficiencies will have to come from somewhere. Maybe all that AI hype from this year can translate into tangible productivity – but that is still more conjecture than clearly demonstrated use cases.

So earnings will matter. We will leave you with that as our parting observation. Meanwhile, we wish all of you a very Happy New Year and a joyful and healthy start to the year ahead.

As the year winds to a close, one of the big stories has been something that didn’t happen. That, of course, is the much-predicted Recession of 2023. It seems increasingly likely (though by no means a guarantee) that the economic downturn that did not happen this year will also not happen next year, putting Jay Powell in pole position to pull off what very few of his predecessors have – the “soft landing” at the end of a monetary tightening program. Here’s what that soft landing looks like in numbers: unemployment close to its recent lows at 3.7 percent, monthly job creation at a modest but still positive rate, Q3 real gross domestic product growth at 4.9 percent (a pace not likely to be repeated any time soon) and a holiday shopping season that so far seems to be exceeding expectations.

The test for Powell and his Fed colleagues was to accomplish this while at the same time bringing inflation down. On that front, today’s Personal Consumption Expenditure report was one of the best inflation prints to date. The PCE is less well known than the Consumer Price index, but it is the measure the Fed pays closest attention to as a gauge of consumer price trends (as usual, the Fed focuses on core inflation without the volatile categories of food and energy). The annualized core PCE reading for November was 3.2 percent, the lowest level since May 2021.

Even better, the month-on-month change in the core PCE was just 0.06 percent, well below the 0.2 percent predicted by economists. The month-on-month number is important because it tells us what has been happening with prices most recently. The answer seems to be: not going up by very much. In fact, the headline PCE number (which includes food and energy) actually fell by minus 0.07 percent month-on-month, bringing annualized headline PCE down to 2.6 percent. If this trend continues, it might actually start registering with Americans dissatisfied about the economy that, well, things are not all that bad (according to a number of surveys, a healthy plurality of our fellow citizens are firmly convinced that we are already in a recession, all the evidence to the contrary notwithstanding).

We will get a more realistic read on overall economic growth when the Q4 GDP report comes out in late January. The 4.9 percent number for Q3 (based on the third revision) was driven by consumer spending and inventory investment, and the latter number in particular is not likely to put in another barnstormer in Q4. But economists have been slowly revising their assumptions upward over the course of the past several months, and the median Blue Chip Consensus estimate is now just around 1.2 percent. The GDPNow tracker run by the Atlanta Fed predicts that Q4 GDP will come in at 2.7 percent, largely due to an expected increase in private business investment.

There are still plenty of unknowns in the mix. One of the challenges, in fact, is how businesses will adjust to weaker pricing power as inflation continues to come down. This morning Nike, a useful benchmark for consumer discretionary trends, gave a downbeat estimate for future macro conditions as weaker demand and less ability to raise prices implies flat or negative sales growth. The company is focusing on cost controls and improved efficiencies to shore up profit margins in response to weaker sales.

Then again, a downbeat macro demand outlook may be the excuse the Fed needs for the rate cuts the market (and, as of last week’s FOMC meeting, the Fed itself) expects to see next year. If month-on-month inflation numbers continue coming in at or below 0.1 percent, as with today’s PCE report, the central bank will have some leeway to soften its interest rate policy without worrying about another spike in consumer prices. That would be about as smooth a soft landing as possible, were it to come to pass.

For those of you who are celebrating Christmas this weekend, may it be a very merry one full of joy and laughter with friends and loved ones.