1st Quarter, 2024
Don’t underestimate the sustained resilience of the economy.
THE MARKETS
2024 scored the best first quarter equity returns since 2019. The year began with a continuation of the surge in Artificial Intelligence (AI) related companies and gradually broadened into a global advance that lifted sectors that were laggards in last year’s market.
Expectations that the Federal Reserve will reverse course and embark on a rate-cutting program have bolstered the equity market’s strength. However, there is a tug-of-war in the bond market centered on the magnitude and timing of the Fed’s cuts. This has led to meaningful volatility in bond prices but has not yet dampened equity investors’ enthusiasm. The economy’s resilience is a critical ingredient, and indications are that it remains intact.
That being said, there are abundant risks facing global markets, not the least of which is the long-tail risk of 15 years of negative real interest rates. There remain many enterprises whose business models were built when money was practically free that will struggle to survive in a world of more normalized, positive real rates. Highly leveraged private equity deals and cash burning venture-backed start-ups are near the top of the list, but there are companies in public markets that may fall victim to the new rate regime as well. Geopolitical risks continue to fester and become more intractable. Although the direct financial impact is yet to be clarified, the backdrop of instability is not constructive as corporations make strategic decisions affecting future growth.
It is worth noting that presidential election years on average are positive for equities. In our view, the dance of Wall Street is welcome, but requires care to have a seat when the music stops.
THE ECONOMY
Domestic GDP growth remained robust in the first quarter of 2024, driven by strength in labor force productivity, government spending, and consumer expenditures, which were largely fueled by debt. Consumer sentiment has remained consistent during the first quarter, reflecting general views that overall conditions are less stressful now than they were a year ago. The University of Michigan index of consumer sentiment has risen to 76.9, a 15% increase over the past year. At this point, consumer sentiment is about halfway back to pre-pandemic norms of 100 from the nadir of 50 at the heights of the inflationary pressures experienced in mid-2022.
For the remainder of 2024, continued economic growth is reliant on sources of consumer liquidity and business investment remaining intact, which may not be a given as capitol allocators evaluate the outlook for post-election opportunities.
As the general election draws near, we can expect a constant barrage of political posturing by candidates and parties each taking credit for the resilience of the US economy. Ultimately, the economy will march to the beat of its own drum and consumer sentiment will follow.
Despite the Fed’s late start in applying its interest rate tool kit to contain inflation, the Fed appears to have achieved its target of restricting unbridled growth and dampening inflationary pressures at home. However, the remaining pressures are more global in nature and beyond the response of a single central bank. Therein lies the challenge of getting 3% down to 2%. The most likely course for success is in better coordination of fiscal and monetary objectives by G-20 nations that caps deficits and leads to neutral rates that favor real economic growth.
In the US, fiscal and monetary policy are at odds with one another. The federal deficit continues at 6.3% to 6.8% of GDP for the third year running. In fiscal year 2023, the deficit was $1.7 trillion, which added $68 billion per year in interest costs at 4%. Chronic deficits, which are funded by the Treasury, create inflation which needs to be contained by the Fed. Neither funding nor inflation reduction is easy.
This suggests that the last mile is going to be the longest. The lack of fiscal discipline at home suggests that 3% may replace the sought after 2% norm. The downside to this scenario is that there will be significant recalibration of long-term interest rate expectations for bonds, which ultimately leads to discounted equity valuations.
Continued resilience in the US economy and a return to 3.5% to 4.0% GDP growth requires a modicum of fiscal discipline. The likelihood of that fiscal discipline becoming a reality is low.
INVESTMENT STRATEGY
The goal of our investment process is to produce growth of capital and income that exceeds the rate of inflation, i.e. preserves the real value of your portfolio. One of our core tenets is that equities produce higher rates of return than fixed income assets over full market cycles, increasingly so as investment time horizons lengthen.
This is not to say that fixed income assets have no role in our strategy whether the time horizon is short or long. Equity returns, while higher over time, come at the “cost” of much higher variability or risk. It is the rare investor whose risk tolerance is at peace with a 100% equity exposure, particularly during inevitable market corrections. A thoughtful blend of fixed income and equity assets can still accomplish the objective of preservation of real value while “smoothing the ride” to better conform to risk appetites. This is why portfolios hold bonds.
The Federal Reserve’s currently restrictive monetary policy has restored fixed income assets other useful attribute, the production of current income returns in excess of inflation. We believe that this relationship is the norm, not the artificially low interest rates of the post financial crisis and COVID eras, which vitiated market mechanisms of proper capital allocation.
We do not believe in market timing, i.e. trying to shift in and out of equities and bonds to enhance returns. There are too many known and unknown variables to consider to consistently outwit capital markets. We invest in companies where business models and management skill prevail over time. When asked what mankind’s greatest invention was, Albert Einstein responded “compound interest.” We agree.
RISKS THAT ARE ARISING
Private Equity
Buyout entities that were funded during the 15-year era of cheap money are facing a “long tail risk”. Many PE deals were predicated on financial engineering that stripped out the cash and then highly leveraged the company. With refinancing looming at higher real rates, some of these entities will no longer be as profitable or possibly even economically viable.
2. Regulatory Inflation Impact
Federal and state agencies have and are continuing to deliver an extraordinary spate of new regulations covering a broad spectrum of the economy. The impact of these regulations is proving costly to small businesses, in particular. These added costs inflict further inflationary pressures on the overall economy.
3. The Chinese Economy is Likely Weaker Than Previously Thought
President Xi Jinping is personally wooing American business leaders to invest in China. This is totally out of character and suggests the Chinese economy is in more dire straits than previously thought.