The End of an Era

December 13, 2023

Monthly View 

Harmen Overdijk

The easy money era that prevailed from 2009-2021 is now clearly over. We are unlikely to see another prolonged period of zero interest rate policy, nor the sustained use of quantitative easing as a monetary policy tool during the next economic slowdown. So, in that respect, the Fed’s “Higher for Longer” comment will likely hold true. However, that does not mean that the Fed will not cut rates if the U.S. economy slows down rapidly.

High interest rates are clearly having an effect on developed markets. At the same time, the U.S. and European economies are slowing. The employment market is back to a normal level of job openings and job seekers, which means that wage pressures are disappearing. This makes it even more likely that inflation pressure will continue to come down next year.

Currently, we believe that economic growth will slow to a below-trend pace in 2024. Unemployment may rise marginally, but real GDP is not expected to contract. A temporary contraction in corporate profits is possible but would not be meaningful. However, the FOMC will probably be compelled to ease monetary policy as inflation approaches the 2% target to prevent a sharp rise in short-term real interest rates. Consequently, the Fed could begin cutting rates around May or June.

Rate cuts are fine when there is slack in the economy, but at full employment, there is a risk that excessive monetary easing could reignite inflation. This suggests that the Fed will be reluctant to cut rates by a meaningful degree. The Fed will have to walk a fine line over the next year, but it is not improbable that they will succeed in creating an environment that will resemble a soft-landing. The US economy could suffer a contraction next year in line with previous mild recessions (the early 1990s and 2000s). This scenario could place even more downward pressure on inflation, which may fall below the Fed’s 2% target sometime in 2024. Thus, the Fed may slash short-term rates beginning in the second quarter of next year. The Fed funds rate will likely continue to fall towards 1.5% in 2025 before gradually returning to a neutral level.

The Strength of the U.S. Economy

The U.S. economy has stayed resilient this year, even though the Fed has pushed rates much higher than most anticipated at the start of the year and the bond market has sold off throughout most of this year.

Only in hindsight has it become clear that fiscal expansion has largely offset the impact of higher rates, allowing the economy, profits, and equities to advance, along with soaring bond yields.

In this vein, the weaker-than-expected payroll report for October was an important development in that it coincided with diminishing fiscal stimulus, suggesting the bout of economic strength driven by fiscal support may be ending. November’s “upside surprise” on payrolls from last week was not that surprising given it included the return of striking auto workers. Adjusted for one-time events, new payroll gains are clearly trending down. Meanwhile, the job quits rate has also returned to pre-pandemic levels. Importantly, the falling quits rate has coincided with falling wage growth, suggesting the labor market is regaining balance.

Had fiscal stimulus persisted, it would have forced the Fed to take a more hawkish stance, causing a renewed sell-off in bonds and stocks.

In this regard, the recent softening of the labor market is an important step toward supporting this view: with less fiscal stimulus, the natural tendency is for the economy to weaken. This is good news for asset prices because a softening economy eases the selling pressures in bonds, which in turn allows stocks to resume their advance. This is exactly what occurred in the past five weeks. We saw a sharp reversal of the rise in bond yields, which in turn ignited a rally in global equity markets.

What to Expect in 2024

The interplay among financial markets, the economy, and Fed policy is like walking on a tightrope, with recession risks on one side and undesirable economic strength on the other. The Fed’s maneuvering room has narrowed as rates have already become restrictive, but growth remains strong. The tapering wedge can lead the economy to a soft landing, but admittedly, it would be easy for the Fed and other central banks to make a policy mistake.

What is a “soft landing” anyway? In simple terms, it is non-recessionary growth deceleration, with core inflation falling toward 2%. In this outcome, the Fed can declare victory and ease, while economic expansion is largely maintained. A soft landing does not preclude GDP growth from dipping into negative territory for a quarter or two, but a sustained contraction may be avoided.

There are obvious risks to this “soft landing” outcome. The first is that the Fed has already over-tightened, which could push the economy into a recession next year. The risk that this happens is a real possibility, but we still think another outcome is more likely.

In a “soft-landing” scenario, we think there is more room for equity markets to rise both because of higher corporate earnings and expanding valuations.

Of course, all these calculations become problematic if the U.S. economy is hit by a recession where earnings collapse. However, our baseline outlook is for a “soft patch”, where a sustained economic contraction is avoided.

In this case, stocks may avert a bear phase. Although earnings will slow, bond yields will drop, probably precipitously, to offer protection for equities.

What should one expect in terms of equity market performance, if the Fed holds rates “higher for longer”? The only historical parallel we can think of is between 1995 and 2000 when the Fed held rates at 5.5 – 6%. During this period, many emerging market economies blew up, but the U.S. equity market kept rising.

Equity valuation multiples expanded from 1995 to 2000, even though the Fed held rates largely steady. Of course, there is no guarantee that a similar phenomenon will be repeated, but the fact that forward EPS is reaccelerating on high and rising interest rates lends some optimism that stocks will continue to advance even if rates are held at current levels for a longer period than anticipated.

Finally, if the Fed pivots its policy next year, either because of a soft patch in the economy or due to much lower-than-anticipated inflation, stocks could overshoot, led by technology on the back of the productivity gains aided by Artificial Intelligence (AI).

The mega-cap tech stocks, though trading at a premium price already, could continue to do well powered by the prospect of lower rates and an improving economy.

We can find another bullish sign in the bond market. There are signs that the relative performance of US inflation-linked bonds (TIPS) has peaked versus nominal Treasury bonds. The S&P 500 saw most of its gains in the past 20 years when TIPS were underperforming.

Time to Buy Luxury Goods Sector?

Over the last 30 years, technology stocks outperformed the general market by a large margin but there is another sector that has done the same and that is the luxury goods sector.

The strength of the luxury sector is led by the differentiation in economics from other goods and services in three important ways.

First, unlike other goods and services, luxuries have a price elasticity of demand that is greater than one. This means that, while for most goods and services, a higher price reduces demand, for luxuries it is the opposite. The higher the price of the luxury, the greater its cachet, exclusivity, and ultimately demand. This explains luxuries’ massive and sustained pricing power.

Second, because of this massive and sustained pricing power, the luxury sector is much less reliant on sales volume growth. Yes, luxury brands want to penetrate new markets such as China, but the unrestricted sales growth of luxury within a market would diminish its key quality – exclusivity.

Third, the luxury sector has a massive barrier to entry. This is because it takes decades to build the trusted quality, and exclusivity required in a luxury brand. Thereby, the leading luxury brands have built a massive moat around their profitability. Therefore, we believe that the luxury goods sector is also well-positioned to outperform in the current economic climate.

Bonds are Great Again

In the past month, long-dated bond yields came down significantly, with the U.S. 10-Year Treasury yield moving from 5% in October to 4.2% now. This created a massive rally in bond prices. However, this was after the recent sell-off. So, overall, bond markets are only slightly positive for the year. After 2022, which was the worst year for global bonds ever, 2023 has been a mediocre year for fixed income.

Looking forward, the landscape is very different. Given that we expect softer economic conditions next year, we think it is more likely that bonds yields will continue to fall going forward. Therefore, we now like to be strategically long duration in bond portfolios.

The Fed is still not convinced that inflation is returning to the 2% target. This may be due to the tight labor market, but various indicators are pointing to looser labor market conditions ahead. This should force the Fed to capitulate in a dovish direction. Stay overweight Treasuries and duration.

Credit spreads, falling year to date, have narrowed rapidly since the start of November. The current level of spreads implies a slight decline in the corporate default rate over the next 12 months. That is plausible in a soft-landing scenario, but not one in which the US economy succumbs to a recession. Given that corporate spreads are tight, we currently favor Government bonds over high quality corporate bonds. The extra risk is not sufficiently compensated for by higher yields at this time, but we would be buyers on any spread widening.

Bank of Japan’s Change in Strategy

Comments by BoJ Governor Ueda and Deputy Governor Himino have raised speculation that the central bank is getting closer to ending yield curve control (YCC) and its negative interest rate policy (NIRP). These unconventional policies are no longer necessary given that Japanese inflation is at a 40-year high.

As the BoJ normalizes monetary policy, there should be some upward pressure on JGB yields, but we do not expect a major sell-off. The Japanese private sector is awash with excess savings, which are more than sufficient to fund the government’s budget deficits. This is reflected in Japan’s current account surplus which is near a record high.

As the BoJ is getting closer to ending YCC and NIRP, we think the Yen can strengthen significantly in the coming year.

Is Gold Making a Comeback?

This year gold is one of the best-performing commodities. What is interesting is that while last year we saw high inflation and the outbreak of the Ukraine war, the price of gold fell. So, there must be other forces driving up the gold price this year.

Several central banks will take their cue from Russia by divesting out of U.S. Treasuries and into a neutral monetary asset such as gold. The last point is a particular point of concern for China, and for good reason. It still holds some $800 billion in U.S. Treasuries, even after reducing its holdings from a high of $1.3 trillion. It holds another $2.5 trillion in liquid FX reserves that could also fall under sanction risk.

Consider that the total value of mined gold is $13 trillion, of which roughly $2.8 trillion is held by private investors. If China were to raise its share of gold holdings in its reserves only modestly to 10%, it would imply a marginal demand injection into the gold market of $200 billion, or about 7% of the pool of tradeable stock. This shows that the gold market would struggle to absorb substantial purchases from China, leading to higher prices.

Of course, other developing countries will also be seeking to convert some of their sovereign wealth into gold. This includes the rest of the BRICS, Turkey, and the Arabian Gulf countries. The gold in their vaults has grown by 50% since 2017, a trend that is bound to persist.

What about Bitcoin?

In recent months we have seen a very strong rally in crypto currencies, and especially in Bitcoin and Ethereum. In fact, crypto is by far the best performing asset class this year.

The fact that financial regulators around the world have cracked down on crypto and introduced much stricter anti-money laundering regulations (AML) is inevitability positive for the whole crypto sector.

What is interesting to note is that crypto’s correlation to other asset classes seems to be going down again. Before 2020, bitcoin traded at a close to 0 correlation to global equity markets, which means it did not trade in line with stocks and was thus a good diversifier for portfolios. This changed after COVID as the correlation with S&P 500 rose and both cryptocurrencies and stocks did poorly in 2022. So far this year, however, the correlation has trended down to its long-term average, implying that holding a small crypto allocation in your portfolio can help improve diversification and potentially long-term returns.

DISCLOSURES

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred.  Returns do not include reinvested dividends.

The Standard & Poor’s 500 (S&P 500) Index is a free-float weighted index that tracks the 500 most widely held stocks on the NYSE or NASDAQ and is representative of the stock market in general.  It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Cryptocurrency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Cryptocurrencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not generally backed or supported by any government or central bank. Their value is completely derived by market forces of supply and demand, and they are more volatile than traditional currencies. Cryptocurrencies are not covered by either FDIC or SIPC insurance. Legislative and regulatory changes or actions at the state, federal, or international level may adversely affect the use, transfer, exchange, and value of cryptocurrency.

Purchasing cryptocurrencies comes with a number of risks, including volatile market price swings or flash crashes, market manipulation, and cybersecurity risks. In addition, cryptocurrency markets and exchanges are not regulated with the same controls or customer protections available in equity, option, futures, or foreign exchange investing.

Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market.  They are methods used to help manage investment risk.

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