We always arrive at work on an Inflation Day with a certain amount of uncertainty hovering over us. When the CPI or the PCE report – the two main indicators of US consumer price trends – comes out at 8:30 a.m. it has the potential to sharply shift market sentiment away from whatever direction it was moving in. When the numbers come in hotter than expected, that sentiment can turn sour very quickly. Not so for the hot numbers that came out this week. The Consumer Price Index report for February came out on Tuesday and showed inflation advancing faster than economists had expected. The core CPI number (i.e., excluding the volatile categories of food and energy prices) in particular looked worrisome. The month-on-month increase of 0.4 percent was above estimates and roughly double our own metric for a “good” monthly number being a gain of 0.2 percent or less. That monthly number translates to a year-on-year consumer price gain of 3.8 percent, still stubbornly ahead of the 2.0 percent target the Fed has been trying to engineer with its rate policy.

Supercore is the New Core

So, what could be in store for markets once Tuesday trading got underway? Stocks down and bond yields up? Haha, no, that would be far too rational! Au contraire, stocks had themselves a nice little gain of more than one percent, while the 10-year Treasury did move up a bit but stayed within recent trading ranges without much drama. The dynamic seemed to be more of what we talked about in our commentary last week, with the glass half full crowd winning the day more often than not.

The positive theme investors latched onto on Tuesday was “supercore.” This is yet another way of dissecting inflation down to its supposedly least volatile categories, this time by stripping housing costs out of the calculation for services prices. In January this “supercore” number was a very hot 0.87 percent, but in February it slowed to 0.47 percent. Still higher than we would like to see, but what the collective wisdom of the market decided it saw was the trend moving in the right direction. This week saw a record flow of funds into the US equity market — $56 billion, eclipsing the previous weekly record of $53 billion set in March of 2021.

Flowing Into What?

Where is all that new money going? Well, this week saw a big move into the old theme of tech stocks, with the usual suspects atop the Big Tech pile getting a midweek boost. But there is a decided lack of consensus about overall directional moves these days. Over the past month or so the mega-caps have lost some ground to out of favor sectors. The S&P 500 Equal Weight Index, a measure that takes away the distorting effect of contribution to the index from companies with outsize market capitalizations, has outperformed the benchmark (market cap-weighted) S&P 500 for the past month, reversing a longstanding period of underperformance (for the last twelve months, the equal weight index has lagged the benchmark by some sixteen percent).

That may or may not be indicative of anything sustainable – we have seen plenty of false dawns for value stocks and other overlooked sectors of the market in the recent past. But it’s worth paying attention to. While all of this has been going on in the equity market, bond traders have been quietly lowering their (previously outlandish) expectations for Fed rate cuts. All else being equal, higher rates tend to have a more punishing effect on the growthier sections of the stock market. Next week, all eyes will be on the Fed and the March FOMC meeting, which will include an updated set of Summary Economic Projections and thus the latest thinking by the Committee members themselves about where the Fed funds rater is likely to be by year-end. We’ll see what they have to say. Lots to process, and no easy answers.

The US equity market has been at one of those junctures recently that could go one of two ways. Glass half empty, or glass half full? Happily for those of us who like to see the stock prices trending in the upward direction, the glass half full crowd seems to be winning the day. The central point of contention has been thus: can Mr. Market overcome his bitter disappointment at once again being wrong, so very wrong, about how many interest rate cuts are in store for 2024, and learn to love the idea of a strong economy?

Well, the market is up this week on a string of upbeat numbers for the economy: a Purchasing Managers Index (PMI) report on Tuesday showing a healthy and better than expected composite expansion, followed by a final revision of Q1 productivity growth that was well ahead of economists’ estimates, and finally today’s jobs report from the Bureau of Labor Statistics clocking in with nonfarm payroll gains of 275,000 versus a forecast of 200,000 (the unemployment rate did tick up to 3.9 percent, though, and the blockbuster January payroll numbers were revised down to 229,000). At least for the time being, good news for the economy does seem to be good news for the market. But will it last?

The Fed’s Tough Love

The standard mantra for market pundits singularly focused on the direction of interest rates is “good news is bad news” – because when the economy is running strong, the Fed has less urgent need to start swinging the axe and cutting rates. At the beginning of this year, for reasons we continue to not understand at all, the market had priced in six interest rate cuts for 2024. This, despite the Fed’s own summary projections of just three cuts in the December FOMC materials, this despite the apparent lack of a brewing recession and this despite the fact that cutting rates six times in a presidential election year would drag a politics-abhorring Fed into the toxic mess of electoral finger pointing.

This week the Fed was all over the airwaves reminding everyone that, no, not six nor five nor perhaps even three rate cuts were in store. Regional Fed chiefs from Atlanta and Minneapolis opined that two, maybe one would be sufficient, sometime later in the year. Fed chair Powell, who had the very unenviable task of spending the better part of two days briefing members of Congress about matters financial, reiterated what he had said at the FOMC press conference a few weeks ago: don’t expect a rate cut in March, and don’t get out over your skis about what might be coming later (as if the bond market, especially, could restrain itself).

All That’s Left Is Growth

So there will be no rate cut pony out back. We will admit to being pleasantly surprised at how calmly the market is adjusting to this new reality (new, that is, for the six rate cut crowd – but an old reality for anyone who was not partaking of the market’s rate cut Kool-Aid last December). All that’s left to do is to be cheerful about the good growth numbers. Today’s jobs report marks the 39^th straight month of job gains, and also the longest stretch for a sub-four percent unemployment rate in decades. Productivity – the only plausible source of long-term economic growth – is higher than it has been anytime since the turn of the century. The Fed appears to have engineered a dramatic increase in interest rates without sending the economy into recession. So yes – sometimes good news really can be good news.

If you are a long-term reader of our weekly commentaries and our annual outlooks you are no doubt familiar with our thoughts about cryptocurrencies. If you are new to our writings, then here is a short summary: at this point in the 16-odd year of this asset class, it exists essentially as speculation for speculation’s sake, with a real-world use case limited to underworld transactions on the dark web. Oh, and as a way for El Salvador’s autocratic president to style himself as the “world’s coolest dictator.” All of which is to say, we do not consider bitcoin and its ilk as suitable additions to the portfolios we construct around the long-term financial goals and attendant risk considerations of our clients.

Plus Ça Change

That’s not to say that we don’t get asked about crypto – we do, quite often, especially in times like the present when the speculative spirits are once again running high and bidding up prices to close in on record high levels. Here’s a picture of bitcoin, the granddaddy of crypto, from the last wave of euphoria in 2021 to the despairing pits of 2022 and back again.

That’s a whole lot of movement, suggesting that some fundamental changes must have happened with the asset – right? Anyone? Bueller? In fact, nothing much in a fundamental sense has changed at all. Other than the people who attend those over the top conferences where the high priests of crypto gather to spread their gospels, nobody really has a use for blockchain currencies in their daily lives. Thanks to other digital technologies like contactless payment systems, paying for things has never been easier. Tap, swipe, hover, whatever – but none of that involves cryptocurrencies, which are in fact quite clunky when one tries to apply them in a typical transactional setting.

Nor do they have any real function as a store of value, because there is no tangible basis for the value. Bitcoin afficionados will prattle on endlessly about its “scarcity value,” deriving from the fact that only a limited amount of that particular currency will ever get produced, but that ignores the existence of literally thousands of other blockchain “currencies” that, in a world where they actually mattered, would be fungible with each other. The difference between bitcoin and Ethereum and dogecoin and all the rest is hardly the same thing as the difference between gold, silver, platinum, copper and natural gas – commodities that actually have uses in the real world.

Number Go Up

So what explains those seismic shifts, and especially the apparent stampeding of the bulls that is going on now in crypto markets? Last year, author Zeke Faux coined a phrase that became the title of his book, a bestseller among the crop of 2023 business reads: “Number Go Up.” That phrase pretty much explains it: how a bunch of digital ones and zeros with no demonstrable value suddenly turned into trillions of actual dollars. A group of people – not so much large in number as outsize in tech-world influence – simply wanted the number to go up and hyped the living daylight out of things until it did. Remember those Super Bowl ads in 2022 with A-list celebrities pumping up cryptocurrencies and their misbegotten stepchildren of the cultural milieu, non-fungible transactions (NFTs)? But then interest rates went up, and the pumpers did what pumpers normally do and dumped, and the crypto crash was on.

The subtitle of Zeke Faux’s book was “Inside Crypto’s Wild Rise and Staggering Fall.” Now, of course, he will have to update that subtitle to “…and Wild Reincarnation From the Ashes.” Although, as we noted above, nothing fundamental has changed in regard to the properties of blockchain currencies, a recent SEC regulation permitting bitcoin ETFs has made it easier for the average Dick and Jane to trade them (i.e., take a punt on them). The FOMO-meter, the only thing that truly matters in driving the price for crypto, is back in fifth gear. Now it’s just a question of waiting for whatever comes along that will send the animal spirits into reverse again.

So what do we say when the question comes up about whether we will ever change our views about the appropriateness of cryptocurrencies as an asset class for long-term portfolios? We approach any asset with an open mind, we will say, and if something ever comes along to convince us otherwise, we will be happy to change our tune. There’s no ideological animosity here, just an unbiased accounting of pros and cons. Until that compelling case comes along, though, we will leave bitcoin and its ilk to those who enjoy speculation for its own sake.

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.

One year ago, we along with the vast majority of mainstream economists were predicting that the US economy would experience a cyclical recession. Not a deep one, not a cataclysm like 2008 or a manufactured one like 2020, but a regular old end-of-the-business-cycle recession. After all, interest rates had gone up by more than at any time since the draconian “Volcker shocks” of the late 1970s and early 1980s. Household savings were dwindling down to their lowest levels in decades as those extra cushions from pandemic-era stimulus payments wore off. Corporate management teams were warning of trouble ahead: “uncertain macro conditions” was one of the most frequently-heard phrases in quarterly earnings calls. Credit conditions would tighten on already-indebted households.

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.