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.

For almost the entirety of the Fed’s monetary tightening program, the relationship between the central bank and the bond market has been like that of a mother insisting that her child eat his vegetables before he can have dessert. The market wants to skip the vegetables and go straight to the cookie dough ice cream. Well, on Wednesday this week Fed chair Jay Powell looked at the kid’s plate, saw that it still had vegetables on it, but decided to bring out the ice cream anyway.

Here Comes Santa Powell

Yes, the pivot has arrived. Wednesday’s meeting was a “dot plot event” in which the members of the Federal Open Market Committee make their best guesses as to where key numbers in the economy will be for the next three years, including the Fed funds rate. These are the Summary Economic Projections. On Wednesday, bond investors skipped over every single estimate in the SEP to focus on one single collection of dots – those representing where the Fed funds rate will be in 2024. Lo and behold, the median estimate was 4.6 percent. Translated into market-speak, that suggests three rate cuts of 0.25 percent each are now the base case for the Fed’s planning purposes. Needless to say, the market was off and running for all manner of investable assets.

Game-Day Audibles

To say that the Fed’s pivot was unexpected would be an understatement. As recently as last week, Fed officials were hammering away at the same points they have been making for many months: the fight against inflation is far from over, and rates are going to stay higher for longer. In fact, with financial conditions having eased significantly over the course of the broad-based November rally, the thinking was that if the Fed pulled any surprises at all, they would be of the hawkish rather than the dovish variety.

So what changed? Not much seemed to be different in the rest of those SEP dot plots, representing Committee members’ guesses about the labor market, GDP growth or longer-term inflation, from what they were in September. There was one notable change, though. The inflation estimate for 2023, i.e. the year that ends in just 16 days, was lower than the September estimate. Part of that was due to a better than expected reading from the Personal Consumption Expenditures index a couple weeks ago. Part of it, though – and this was in Jay Powell’s own words at the post-meeting press conference – was a softer number from the Producer Price Index that came in the same day – Wednesday – as the FOMC meeting. In other words, according to Powell, a few Committee members came into work on Wednesday morning, read the PPI report, and promptly revised their inflation outlooks down. A game-day audible, so to speak. Sometimes those work. Sometimes they will seem in hindsight to have been misguided.

The Puzzle

So what does all this potentially mean for the markets? The sugar high won’t last forever, though we think it’s likelier than not to give an added boost to the positive seasonal vibes historically associated with December. The S&P 500 is just one or two good days away from surpassing its last record high, set on January 3, 2022. We will not be surprised to see the benchmark index close out the year in record territory.

Going into next year, though, the picture is a bit foggier. Both the stock market and the bond market have rallied strongly for seven weeks now. By some technical positioning measures they are at their most overbought levels in more than a decade. Weekly equity inflows are at their highest levels in two years. That could potentially lead to a pullback of sorts in January, and perhaps give investors pause to think through what all this really means.

For one thing, are those rate cuts actually going to happen, and if so, why? Bear in mind that the SEP numbers do not represent policy decisions; they are nothing more than best guesses and they are subject to change. Here’s the thing: the Fed will tend to be more aggressive about rate cuts when (a) inflation is convincingly under control; and (b) the risk of recession is high. Right now neither of those conditions apply. The November PPI number notwithstanding, core consumer inflation is still well above the Fed’s two percent target.

As for the broader economy, it is still growing, even if the pace is likely to slow considerably from the third quarter’s blistering 5.2 percent real growth rate. In other words, the evidence is not yet in that the economy needs even one, let alone three, rate cuts in 2024. The bond market, ahead of its skis as always, has already priced in not just three, but six rate cuts next year. Some caution is merited.

Then there is the added X-factor for 2024 in particular, which is that it is an election year, and the Fed as a rule errs on the side of caution when the political cauldron is aboil, so as not to invite accusations of favoring one side or the other.

All of this is to say that, while we will be perfectly pleased to see the end of the monetary tightening program, we remain considerably less convinced than Mr. Market that the days of easy money and good times for low-quality assets are back. 2024 is likely to have plenty of tricks up its sleeve.

There are still 23 days to go before calendar year 2023 rolls to an end. That leaves plenty of time for surprises of a good or not good variety to make themselves known to the market. In terms of things we do know, though, there really is just one more big news cycle to go, and it started today.

Jobs, Jobs, Jobs

No, the Bureau of Labor Statistics report this morning was not a barnstormer of the ilk we get sometimes, those surprises with half a million new jobs announced or the lowest unemployment rate since Lyndon Johnson was president. But still – here we are, twenty months into the most draconian monetary tightening program since the early 1980s, and the economy is still pumping out those jobs. 199,000 new payroll gains, to be precise, according to today’s BLS report. And, for good measure, the unemployment rate unexpectedly dropped again, from 3.9 percent to 3.7 percent (which by the way is only 0.3 percent higher than the 3.4 percent low for this cycle, which does in fact match the LBJ-era low). As always, there are various anomalies that skew the monthly numbers one way or another, a prominent one this time being the 30,000 auto industry workers who came back onto the job after the end of the recent UAW strike. But that was public knowledge ahead of this morning’s report, and the 199K was still 24,000 more than economists had predicted according to FactSet, a market research company.

Next Up, Inflation and the Fed

Two more big-ticket events will round out this news cycle: the Consumer Price Index report next Tuesday and then the Federal Open Market Committee decision about interest rates on Wednesday. For the CPI report, economists are looking for a month-to-month change of 0.3 percent in core inflation (i.e., excluding food and energy). That would translate to a year-on-year core inflation rate of 4.0 percent, which is still twice as high as the Fed’s two percent target. Investors would like to see the month-on-month number come in lower; the PCE inflation report that came out a couple weeks ago showed just a 0.16 percent month-on-month gain, which gets us closer to that two percent year-on-year number.

The Fed is likely to keep rates where they are. But what they say after the FOMC meeting matters a great deal, because once again the bond market has been merrily going its own way without listening to any Fed official who repeats the “higher for longer” mantra. As we have discussed in recent commentaries, the bond market sizzled through November as traders resurrected their persistent fantasy of successive rate cuts in 2024.

For the Bond Market, There’s Always a Pony Out Back

Current bond market levels indicate that investors have priced 1.25 percent worth of rate cuts into their outlook for 2024, a number we regard as sheer madness. Assuming a cut of 0.25 percent each time, that would mean the Fed would be cutting rates five times – five! – in a year when the economy is still growing (as far as we know now), inflation is still well above target, job growth is healthy even though off its highest levels and, to top it all off, 2024 is an election year in which the Fed is likely to be more cautious than usual in doing anything with interest rates that could be criticized as politically favorable to one side or the other (note to Fed: you’ll get criticized by the politicos no matter what you do, so just do the right thing).

Why does the bond market keep doing this? We have seen this “fight the Fed” mentality all throughout the rate tightening cycle. All the while, the Fed has meant it when it says “higher for longer.” Why is it going to be different this time? Spoiler alert: it likely won’t be different this time. Next week awaits.

Market pundits are fond of fairy tales, and perhaps none more so than the story of Goldilocks and the Three Bears. Goldilocks, of course, finds Papa Bear’s porridge too hot and Mama Bear’s too cold, before settling on Baby Bear’s as juuuuust right. As for porridge, so for the economy. We don’t want it running too hot (too much inflation) or too cold (recession). The Goldilocks Economy so beloved of financial news anchors is in that happy medium of growth that is moderate, but still positive. In another metaphor overused by the chattering class, it is the soft landing pulled off by the Fed as it tries to thread the needle of a monetary tightening without driving the economy into the ground.

Approaching the Runway

The Fed has not yet stuck the landing, but the numbers are looking pretty good as the plane approaches. This week saw an upward revision of third quarter GDP real growth to 5.2 percent, while the latest inflation data in the form of the PCE report validated the continuing downward trend in consumer prices seen in the most recent Consumer Price Index release a couple weeks ago. Meanwhile the labor market is still growing, with a more moderate pace of monthly nonfarm payroll growth, and consumer confidence levels are reasonably stable from month to month. All this would seem to be about as Goldilocks as it gets.

Investors have taken notice. The S&P 500 closed out November with a gain of nearly nine percent, its best monthly performance since summer of 2022. The Nasdaq Composite did even better, coming in at 10.7 percent for the month on the back of yet another rally in the Magnificent Seven and its posse of tech / growth stock darlings. The Fed eased up on its hawkish-leading commentary from earlier in the fall, producing another outsize run-up in bond prices as yields plummeted. This sets the stage for (wait for it) yet another metaphor that Wall Street will never get tired of: a Santa Claus rally in December. Though maybe not starting today, if S&P futures are any indication of how the first day of the new month will play out (always subject to change throughout the day).

Some Caveats

We think overall conditions seem fairy supportive for a positive end to the year. As always, though, there are plenty of ways for things to turn pear shaped. Let’s start with the bond market, which is never too far away center stage in our analysis. The pattern of volatility that has been a constant theme of this year is still with us. In the most recent rally, the 10-year Treasury yield fell from five percent on October 19 to 4.27 percent earlier this week, a percentage change of 17 percent. This is the third big rally for bonds this year, following the misplaced enthusiasm about inflation at the beginning of the year and then the mini-crisis in the banking sector in March. It’s worth noting that on both previous occasions yields snapped back after the initial exuberance. Bond traders are once again pricing in rate cuts that the Fed insists are not up for discussion any time soon, so the happy vibes of the moment could face a reality check.

Then there is the persisting fact of the narrowness of gains in the equity market this year, dominated (as we discussed in some detail last week) by the small number of names able to tap into the general enthusiasm for artificial intelligence. That theme will get more scrutiny next year, leaving an open question as to where the big growth drivers will come from.

As for the economy, it mostly comes down to the US consumer. Strength in consumer spending has been the most important factor keeping the economy performing ahead of expectations this year, even in the face of all those interest rate hikes making credit more expensive. Will that strength carry into next year? Assuming that inflation continues its downward trend and the Fed really is done with its tightening, one could make a fairly good argument for yes. But it’s not a given. Nothing lasts forever, not even the prodigious might of the world’s consumer of last resort.

It’s hard to believe that we are already here, a day away from Thanksgiving and thus the onset of the holiday season. Amid the frantic shopping and general merrymaking, this is the time when we look back on the big stories that collectively defined the year gone by. For those of us in the investment profession – and quite possibly for humanity as a whole – there is arguably no bigger story to define calendar year 2023 of the Common Era than that of artificial intelligence.

Off To The Races

The year opened with the realization that generative AI – applications that generate highly advanced written or visual content from just a few easy prompts – was now available to anyone with a standard-issue computer, phone or other smart device. In late 2022 a company called OpenAI had released a program called ChatGPT that bedazzled its early adopters with its ability to do, well, just about whatever a user asked it to do (and sometimes much more, as some journalists discovered somewhat uneasily in their encounters with the system).

Then OpenAI announced a partnership with Microsoft to build out commercial applications on top of generative AI capabilities. It wasn’t too long before the market figured out which companies had a good story to tell involving AI. Seven of them – Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Nvidia and Tesla – became the single biggest force driving US equities throughout the year.

For much of the year, in fact, these seven companies were the only thing driving the market – had it not been for their existence, the S&P 500 would have been underwater for much of the first half of the year. The pace has shifted a bit since then, but the Magnificent Seven, as they inevitably came to be known, still account for just under 30 percent of the entire market capitalization of that index of 500-ish stocks.

The Good, The Bad…

As is often the case, observers continue to argue about whether the AI story is based on something substantial, or yet another in a never-ending parade of effervescent bubbles. Is generative AI the key to enhanced productivity, the one thing that has been missing from the economy in recent decades? Will it be something that helps more people do more things more effectively, or will it put people out of work as AI applications take over everything from the most mundane forms of labor to the rarefied reaches of elite white-collar professions? Does Artificial General Intelligence – the holy grail of AI in which machines can perform anything humans can, only much more effectively and without having to take lunch breaks or sick days – imply something even more dire for civilization than mere widespread unemployment?

These questions haven’t necessarily been at the forefront of investors’ minds as they bid up the likes of Microsoft and Nvidia – but boy howdy, have they been hotly debated in the halls of OpenAI, and this week we were treated to a full-on spectacle of how this has been playing out.

…And The Ugly

It would be hard to overstate just how many palms of the hand slapped how many foreheads last Friday evening, when the news surfaced that OpenAI’s board of directors had fired the company’s CEO, Sam Altman. Altman was, for all intents and purposes, the official public face of AI and thus the single human being on the planet to whom all turned for insights about the year’s number one story. The story played out like a soap opera, and anyone who follows the daily doings of the denizens of Silicon Valley would already be familiar with the many characters who rushed in to be a part of the story – big-name VCs, other tech titans, journalists and others who ply their trade in the silicon sandbox.

By the end of the weekend Altman announced he was taking his talents to Redmond to team up with OpenAI’s partner Microsoft. Then practically the entire staff of OpenAI threatened to quit and follow their leader up north – including (not making this up) the board member who led the original move to fire Altman. Now it appears that Altman will be returning to OpenAI. Maybe! Who knows anything, other than that this story has more chapters to be written.

The soap opera aspect, unsurprisingly, is what has dominated the news this week. But there is a very serious set of circumstances behind it, reflected in the peculiar organizational and governance structure of OpenAI that was a deliberate feature of its original blueprint. Should an organization in possession of intellectual property with so many far-reaching and as-yet unknown potential implications be dedicated to putting prudence ahead of profits? Or should it be yet another tech behemoth (the organization already had an imputed valuation of around $90 billion before the events of last Friday) focused only on scaling up, moving fast and breaking things? Sam Altman was moving in one direction. Other board members found that direction concerning. A public spectacle ensued, and while order may well be restored in the short run, the questions will go on. Whether AI will continue to be the front and center story in equity markets is unclear. What is quite clear is that it will not be exiting the stage any time soon as far as the economy, and society in general, are concerned.

As we get ready for the holidays, we want to wish each and every one of you a happy Thanksgiving, full of joy, love and laughter shared with your friends and loved ones. We are truly fortunate to be a part of your lives.

The Japanese stock market is having itself a hot minute. The Nikkei 225 index, a benchmark for Japanese equities, is up nearly 30 percent so far this year, a standout performance among global markets and a sharp contrast to Asia’s other large economy, China, where stocks have been limping along in negative territory and getting little in the way of love from foreign investors. Long a byword for chronic economic sluggishness, Japan is back on the radar screen. Is there a strategic case to make here? A word or two of caution is in order, we believe.

33 Years And Counting

Those of us with a sufficiently long institutional memory know that Japan is the asterisk tacked onto the mantra that stocks go up in the long term. The Nikkei 225 reached an all-time peak of 38,915 on the last trading day of the year in 1989. Yes – the year that saw the fall of the Berlin Wall, Czechoslovakia’s Velvet Revolution and the birth of Taylor Swift, among other seismic world events, was also the last time the phrase “Japanese stocks closed at a record high” was ever uttered.

The Nikkei 225 today sits at 33,585. That is still around 14 percent below the 1989 record high, but it’s tantalizingly close, considering where the index has been for much of the intervening period, as the above chart shows. Foreign investors have been a big source of the market’s upward trend this year. Last week, in the wake of a broad global rally on the back of positive sentiment about the Fed and interest rates, Japanese stocks attracted some $7.4 billion from international buyers. Last month the Wall Street Journal called Japan “the most exciting equity market in the world.” Warren Buffett has been a fan of late. Is there enough juice left for a final surge to bridge the 14 percent deficit and set a new record high?

Going Its Own Way

We are not going to make bets on short-term prospects for the Nikkei – that’s not what we do. But when we consider the strategic case for a long-term position in Japanese equities, we do not see much evidence to support such a move. It is true that, after many years in which the economy flirted with chronic deflation, consumer prices have risen in the past couple years. The national consumer price index currently sits around 2.7 percent – low in comparison to recent inflation levels in Europe and North America, but much higher than the levels of the previous decade when it struggled to stay above zero.

But at the same time that inflation is above trend – and above the Bank of Japan’s target of two percent – the economy is stagnating. Real GDP growth for the third quarter fell by 2.1 percent, a larger decline than expected. Consumer spending is weak, as average domestic wages have not kept up with higher inflation. Capital investment by businesses was also negative. The outlook for improvement in key areas like consumer spending is fairly muted. Japan risks transitioning from one kind of malady – deflation – to another – that old 1970s-era ball and chain of stagflation.

The government recently announced a proposed fiscal stimulus program that could potentially run to about three percent of the country’s total GDP. That might or might not work – stimulus efforts in the past have had decidedly mixed results. But it comes at a very awkward time, because monetary policy has been delicately trying to go in the other direction – tightening (i.e., anti-stimulus) after years and years of one of the most aggressive monetary easing programs ever pursued by a central bank. In addition to being the sole remaining country with negative benchmark interest rates, the Bank of Japan exerts pressure on long-term maturities through a policy of yield curve control. It is trying to loosen this control, though the BoJ’s opaque pronouncements on the subject have tended to leave investors more confused than enlightened. Fiscal stimulus and a stagnating economy make the BoJ’s job even harder than it already was.

Japan has arguably done a more or less respectable job with its economic policies, going back to the “Abenomics” era of the early 2010s, in fighting against some deep-seated long-term problems, not the least of which is the demographic challenge of a declining working-age population (along with the intractable cultural resistance to increased immigration to offset demographic decline). But the problems are not going away any time soon. At some point, we imagine the Japanese stock market will claw its way back to that 1989 high point. But for long-term portfolio allocation, we remain unconvinced.

Attached are the retirement plan limits for 2024.

Europe is stuck in an economic rut. Don’t take our word for it. Take it from Mr. Whatever It Takes himself, former ECB chief and ex-Italian prime minister Mario Draghi, who said this week and we quote (as reported in the Financial Times from an FT Global Boardroom Conference): “It is almost sure that we are going to have a recession by year-end.” The numbers bear out Draghi’s downbeat take on things in his part of the world. Real GDP growth was minus one percent for the third quarter, while the Purchasing Manager’s Composite Index, a measure of economic health, has been in contractionary territory since the middle of this summer (a PMI reading below 50 indicates contraction, while 50 or more means expansion).

Left Behind

Draghi’s concerns about the Eurozone’s economic prospects center on the fear that the region is falling further behind both the US and China in terms of global competitiveness. The European model for much of the past decade or so could be summed up as a tripartite dependence syndrome: on the US for defense, China for trade and Russia for energy. In fairness, Europe has done a great deal to change the third part of that dependence, demonstrating since the outset of Russia’s invasion of Ukraine in February 2022 that it was capable of weaning itself off Russian energy flows, particularly natural gas. On the trade front, though, China’s ongoing struggles with its own economy arguably are the key reason for that recent string of underwhelming EU GDP numbers. Europe is a major manufacturer of high-value goods, and China is an all-important customer. Germany, in particular, has felt the pain of diminishing demand for its China-bound exports.

The sense of falling behind is perhaps most acutely felt in comparison to the improved fortunes of the US economy. The gap between economic output between the US and the EU is growing; in 2013, EU GDP was roughly 91 percent of the US. Ten years later, that ratio is 65 percent, and even more pronounced on a per capita basis. A look at the composition of US and European stock market indexes offers a clue as to why. About 40 percent of the MSCI EU stock index is made up of companies in the industrial, financial services and energy sectors. Information technology, where much of the growth in the last decade or more has taken place, accounts for just ten percent of the index. That is a marked difference from US indexes like the S&P 500, where tech dominates not just in the formally designated information technology sector itself, but elsewhere like consumer discretionary (Amazon, Tesla) and communication services (Alphabet (Google), Meta (Facebook), Netflix).

Chronic Underperformer

And how have those EU stock indexes been faring this year? Let’s take a quick trip back to January, when “buy Europe” was one of the big themes among the financial chattering classes (that is, when they weren’t imploring you to buy 10-year Treasuries because you were never going to see yields as high as 3.5 percent ever again…oops).

Indeed, that looked like a pretty good trade for a while, as the above chart shows. But when we take into account the picture for the full year to date, we get a good lesson in why tactical investing is usually a bad idea. What sell discipline would have convinced you to start unloading your MSCI EU shares in May, when they started going the other way and eventually did what they have done so often in the past thirty years, i.e. fall behind the US?

And it’s not like there was some compelling structural case to make as to why Europe might suddenly look attractive, back in January. In fact – and this tends to be true more often than not – the main catalyst for the three distinct upward moves in the EU index – in January, March and July – all coincided with a concurrent rise in the value of the euro relative to the dollar.

For a US investor with a dollar-denominated portfolio, gains or losses from overseas investments derive from the organic performance of the asset in question along with the translation value of that asset’s home currency back into dollars. As for the euro, it has gone up and down this year against the dollar but is currently sitting not too far off from where it started the year. Much ado about nothing.

As most of you know, our investment philosophy is centered on the belief that long-term discipline, based on a strategic assessment of the relative risk-return qualities of different assets, is the key to success. Trying to time effervescent short-term opportunities through tactics is more often than not bound to turn out poorly. This explains the persistence of underweight allocations to non-US international equities in our portfolios for many years now. For Europe in particular, we defer again to Draghi and his take on things at the FT conference: “The geopolitical model upon which Europe rested since the end of the second world war, is gone.” Indeed, and while we will pay close attention to how the region addresses the challenges to its global competitiveness, we do not foresee a sea change in the immediate future.

Jobs Friday is here again. The first Friday of every month brings us the widely-anticipated report by the Bureau of Labor Statistics on the health of the US labor market. It’s a useful set of data for showing us what sectors of the economy are adding more jobs, how many people with part-time work are actively looking for full-time jobs, the extent to which hourly wages are keeping up with inflation (pretty well these days, actually) and so on.

What the jobs report does not do, no matter how many talking heads on the financial news shows may tell you otherwise, is say anything about where the economy is headed. The predictive power of the BLS and other labor market reports, for all their usefulness otherwise, is roughly zero.

Looking Backward

The chart below shows the US unemployment rate going all the way back to 1950. The gray columns represent recessionary periods.

Each of these recessions had its own unique set of features – to paraphrase Tolstoy, every unhappy economy is unhappy in its own special way. But one thing is common to each of them: the unemployment rate didn’t start to shoot up until after the recession had begun – and then it soared. Which makes complete sense – companies don’t start laying off people in droves until business is already bad. If it’s bad across the whole economy, those layoffs will come quickly and in large numbers. The unemployment rate can double in just a couple months or so, as the chart shows. In the parlance of economists, unemployment is a lagging indicator. It tells us where we’ve been, not where we’re going.

Cooling Off

Looking backwards has its own uses, though. Here below we show the unemployment rate combined with the change in nonfarm payrolls for the past three years.

What this chart tells us is that the labor market is cooling off, relative to where it was a year or two years ago. Again – this says nothing about whether we are heading into a recession or whether the economy will turn up again. It says that payrolls are growing at a slower rate than they were (with obvious exceptions like last month’s barnstormer of nearly 300,000 adds), and the unemployment rate is ever so slowly rising off its recent lows (though the current rate of 3.9 percent is still quite low by historical standards, as the earlier chart illustrates.

This picture actually looks pretty good for the Fed, which is probably why stocks started rising and bond yields fell when the BLS report came out this morning. For the Fed, a cooler jobs market suggests a higher likelihood of inflation continuing to moderate, meaning it can stop raising interest rates (which is how the market is reading it today). Once again – nothing here is telling the Fed or anyone else what the economy will look like one month or six months from now. No predictive intelligence here. But if a moderately cooling economy is where we are today, that’s good enough for now.