In January of 2023 an economic recession seemed all-but inevitable. Both stocks and bonds had been pummeled as the FED battled rampant inflation–raising interest rates at the fastest pace on record. The era of quantitative-easing (QE) and artificially low interest rates abruptly ended. Surely a consumer and credit-driven economy accustomed to ultra-loose monetary policy would experience sudden and severe withdrawals, right? Well, not quite.
Many companies and consumers took advantage of record-low rates during the pandemic by securing fixed-rate debt. According to Federal Reserve Economic Data over 83% of US corporate debt is fixed-rate. Fixed-rate mortgages account for nearly 70% of cumulative household debt in the United States and over 82% of households with a mortgage pay less than 5% interest. To pre-existing, low fixed-rate debtors, the FED’s aggressive rate-hike campaign had no direct economic impact. Individuals and companies with cash-rich balance sheets enjoyed a net benefit as higher rates produced more interest income.
Business models and economic activities relying on cheap credit were not as fortunate. Existing home sales hit 13-year lows as mortgage rates flirted with 8% over the summer. Silicon Valley and Signature Bank failed as their bond portfolios hemorrhaged losses. Struggling retailers, real estate developers, and transportation companies filed for bankruptcy protection. Even the United States Government saw their credit rating downgraded. Pressure mounted on the FED to crush inflation before high interest rates crushed the economy.
Thankfully inflation statistics provided an encouraging backdrop throughout the year. Headline CPI fell from 6.1% in January to 3.1% in November. Core CPI dropped from 5.7% to 4%. Services inflation declined from 7.6% to 5.1%. Even with inflation above the FED’s 2% target for 33+ months, the mighty US consumer kept consuming! As the year advanced without the widely-anticipated recession, confidence grew in the FED’s ability to tame inflation and orchestrate the elusive “soft landing.”
Investors cheered, driving the S&P up 23%. But the gains were not evenly distributed. The equal-weighted S&P 500 index rose 11%. The small-cap index rose 14%. Emerging markets up 4%. Remarkably, through November nearly 80% of the S&P 500’s gain came from just seven companies. To that point the cumulative return generated by the other 493 stocks underperformed cash! By and large, our clients outperformed on a risk-adjusted basis thanks to long-term positions in many of 2023’s leaders and exposure to early artificial-intelligence beneficiaries.
With the Fed Funds rate comfortably above inflation, the FED is unlikely to raise rates further. In fact, if inflation’s benign decline continues the FED could cut rates in order to avert undue pressure on the economy. This inclination is supportive of equities and multiple expansion. However, if inflation persists above 2% in 2024, further rate hikes could become necessary. As always, the ability to stay nimble and adapt to new information is paramount.
Looking forward, we are cautiously optimistic about the path for the economy and markets. Artificial-intelligence (AI) has emerged as a core part of the long-term opportunity set. Goldman Sachs estimates that AI could boost productivity growth in developed nations by 1½-2% over the next decade–lifting GDP while alleviating demographic challenges. Similar to the early days of the internet, AI’s potential reach and disruption is beyond comprehension. But the proliferation and application of AI will be swift and powerfully deflationary–enabling professionals, developers, and consumers to do more with less. You are already benefiting from AI by means of equity ownership in the earliest AI winners. Still, we are vigilant to study, identify and invest in the next-generation of disruptive beneficiaries.
While the odds of an economic “soft landing” have improved in recent months, prudence is still merited–especially if you are in or near retirement. Leading economic indicators have been negative for 19 months in a row. Yield curves remain inverted. Bankruptcies are rising. Geopolitical storms are brewing. Money supply is declining. Quantitative tightening (QT) continues via the FED’s shrinking balance sheet. Yet despite all of this, the S&P trades at approximately 24 times earnings–above the historic median of 17.8x. At least in the short-run, valuations and investor sentiment have become frothy.
Shrinking money supply (M2) is a rare occurrence in modern times and usually associated with recessions. After all, a growing economy requires extra capital to facilitate transactions. But added context paints a clearer picture. Since October 2019 the net supply of US dollars has increased 37%! This explosion of currency in circulation coupled with out-of-sync supply chains sparked the inflation we are battling today. This is why it is important to convert fiat currency into hard assets–like real estate, common stocks, precious metals, etc. Over the long haul, you want to own assets that are in limited supply and/or have pricing power to account for the inevitable devaluation of fiat currencies.
The absurdity of the US Government’s fiscal situation is getting harder to ignore ($34 trillion in debt and counting). Between March 2020 and June 2022 our Government added $7 trillion in new debt. It initially took 215 years for US debt to surpass $7 trillion. In just the last twelve months we’ve added another $2.6 trillion. The problem becomes clear as interest rates rise. At 4% average interest expense, the cost to carry $34 trillion in debt is $1.36 trillion per year. Meanwhile, in fiscal 2023 the Federal Government collected $4.44 trillion in taxes. Playing this scenario out, it would take 30% of gross tax revenue just topay interest on the debt. Hide your wallet.
Today, a six-month US Treasury Bill pays 5.3% (annualized). Patience has a rewarding yield. For the first time in decades, risk-averse investors are being compensated to hold cash and short-term bonds. Banks are still paying significantly lower interest on deposits in savings accounts, and most bank’s CD offerings have substantial early-withdrawal penalties. You can capture materially higher risk-free yields by depositing excess savings into your investment account. Plus, adding capital now engenders an opportunity to accumulate quality assets on sale.
Putting it all together, our strategy is to stay balanced and selective–concentrating on high-quality businesses with durable competitive advantages and fortress balance sheets. With the cost of capital near its highest level in decades, we anticipate continued market dispersion across and within sectors. Companies flexing strong balance sheets ought to weather the coming debt-refinancing cycle better than unprofitable or over-leveraged names. Outside of AI we have identified compelling opportunities for growth in areas like the reshoring of critical supply chains, automation, and increased investment in national security.
Thank you for your continued trust and confidence. We remain steadfast in our commitment to guide you through any market environment. We wish you a blessed and prosperous 2024 and beyond. If your financial situation or life circumstances have changed materially, please let us know. If you would like to discuss your portfolio(s), we welcome an opportunity to speak with you individually.