2nd Quarter, 2024
Markets have a poor record of pricing geopolitical risks.
THE MARKETS
Throughout the second quarter, the stock and bond markets reflected swings in sentiment as to the direction, magnitude and timing of the Federal Reserve’s next interest rate move. Of late, consensus has moved from “higher for longer” to expectations of a pre-emptive cut to avoid a hard landing in the economy. Although the stock market was calm on the surface, the bond market was more turbulent. The two-year Treasury rate rose to 5% in April before heading back down, finishing not far from where the quarter started. Importantly, market forces no longer seem fixated on reaching the Federal Reserve’s 2% inflation target.
Stocks continue to be fueled by the vision of an economy transformed through Artificial Intelligence (AI). Whereas companies without obvious involvement in AI have been punished severely if earnings fall short of expectations or forward guidance disappoints, those directly involved have been handsomely rewarded. This has created over-concentrated market conditions, notably in the US, Taiwan, and Korean markets, where the AI component hovers at 41%, 57%, and 36% of market capitalization respectively. Other developed markets are less concentrated and, as such, are not as vulnerable should AI fever cool.
The US fiscal 2024 deficit expansion is ongoing: it seems likely to exceed $2 trillion, or 6.5% of GDP, with the possibility it will be even higher in 2025. The Treasury has increased its issuance of short-term Treasury Bills to fund the deficit as market appetite for long-dated bonds has dwindled. This is partly a reflection of foreign buyers’ wariness of the deficit’s size. It also may reflect the US government’s hope that lower rates in the not-too-distant future will provide better opportunities for longer-dated funding.
The S&P 500 is currently trading at 22.3 times forward earnings estimates, having moved up meaningfully over the last 2 years. We regard this aggregate valuation level to be full. There is dispersion at the sector level, which ranges from a high of 32.8X (Information Technology) to a low of 12.7x (Energy). When overall levels are taken in the context of expected slower corporate earnings growth rates and the prospect of slowing economic growth, there is reason for caution. Should Federal Reserve policy follow current market expectations, growth would likely trend higher and the much hoped for soft landing might be achieved; however, in this more positive scenario inflation would likely remain well above the current target of 2%.
Overall, markets have been relatively unscathed by the uncertainty of electoral changes and broad geopolitical turbulence. These tensions remain largely unpriced.
THE ECONOMY
The US economy has begun to react to restrictive monetary policy.
The data suggests an economic slowdown, which could result in negative growth for the balance of 2024 if there is no pivot in monetary policy. Consumers have largely exhausted their COVID savings and households are feeling the sting of inflation in purchases of necessities. Prices have increased faster than wages, further exacerbating the pain. Consumers fear that prices will continue to rise. A deferment trend in consumer durable goods spending is now emerging. All of this is reflected in the recent declines in consumer sentiment indices.
The story is more positive at the corporate level. Recent conference board surveys of CEOs show that recessionary fears for the next 12 to 18 months have more than halved since the 4th quarter of 2023 (from 72% to 35%). The mood of business leaders appears cautiously optimistic; they do not expect conditions to worsen. About one third of them expect to add to their full-time workforce in the next four quarters. A vast majority, though, expect higher input costs, including 3% or greater wage growth.
We find ourselves in an economic environment where continued pursuit of the Fed’s inflation mandate is under serious challenge from market forces expecting a pivot leading to significant rate reductions in 2025. Meanwhile, domestic GDP growth is expected to be subpar (approximately 1%) leading to softer earnings growth for the next year.
Outside of the US, inflation has had a more rapid descent which has brought about earlier interest rate cuts. In the European Union, the growth trajectory has begun to diverge from the US, setting the stage for rising GDP due in part to more rapid monetary easing and alignment with fiscal policy, where deficits appear contained at 2.5% to 3% of GDP. European unemployment continues to improve and is now at the lowest level in several decades.
Housing is a large factor for European consumers, It is seeing significant relief from easier monetary policy because most mortgages are floating rate and interest only. However, housing rentals remain in demand as occupancy rates remain high and new supply is in arrears.
In our view, the issues of interest rate policy, the health of the US consumer, the quadrennial national election and rising geopolitical risks remain underpriced.
INVESTMENT STRATEGY
Domestic stocks are now in expensive valuation territory, driven by an insatiable appetite for any issue that can show it is participating in the AI frenzy. At mid-year 2022, the S&P 500 forward P/E stood at 16.5x, and now it trades at 22.3x, a 35% increase in valuation levels. Relative to bonds, the S&P 500 commands a bottom quartile equity risk premium versus 10-year treasuries, providing little cushion on the downside.
With the market at current levels and uncertainties swirling, we are cautious, with a view that in the near-term further upside gains are likely limited, and some recognition of recessionary risk is warranted as markets are vulnerable to a swing in sentiment. Now is a good time to estimate portfolio funded cash flow requirements for the next 12 months and harvest gains from positions that have significantly outperformed. Holding proceeds in T-bills at 5% until needed provides a real return in the interim.
As for fixed income, we have begun modestly lengthening maturities using US Treasuries in preparation for a rate reduction pivot. We have initiated new positions in corporate bonds sparingly, as the spread between corporates and Treasuries remains historically narrow. Going forward, we expect rates to remain positive - the zero-interest rate period appears to have joined the annals of history.
Our active search for new equity opportunities continues, with the goal of making opportunistic purchases for the longer-term. A good source of funds for new positions is capital gains harvested from outsized holdings priced at the higher end of what we consider to be a rational level.
RISKS THAT ARE ARISING
As always, investors confront an environment replete with risks including global geopolitical instability, cyber security, excessive sovereign debt issuance and uncoordinated monetary and fiscal policies.
There are two ongoing and seemingly intractable hot wars which continue to fester and could become game changers whose risks cannot be ignored. The Israeli Hamas conflict has recently expanded to include Hezbollah, the Iranian proxy. These hostilities could evolve into a direct conflict between Israel and Iran if the present regimes remain in control. Russia’s war with Ukraine, a proxy war with the West, continues to create devastation and human suffering in both countries with no clear path to cease fire. In addition to the humanitarian issues, the Russian-Ukrainian conflict has severely impacted the Euro zone’s energy and food supplies, slowing its post-COVID recovery.
China continues to ratchet up regional intimidation tactics against Taiwan and its US-backed allies: Japan, Philippines, and South Korea. The recent defense changes in China have tightened the command-and-control structure now in the iron grip of Xi Jinping, the paramount leader who has a publicly stated goal of reunification. The impact on the global economy of a Chinese invasion of the world’s leading producer of semiconductors would be dire. However, the Chinese Communist Party (CCP) knows it must promote growth of the Chinese economy to remain in power. This delicate balance should act as a brake on Chinese adventurism for the next several years.
Cyber risk has vaulted to the top of the list of business executive concerns. The frequency, intensity and cost of cyber maliciousness continues to rise faster than the forces of deterrence. The cyber battlefield is global and no public or private sector organization has immunity from a growing number of perpetrators.
The recent annual report of the Bank for International Settlements states that “rising public debt is the biggest threat to monetary and financial stability, markets could turn quickly on governments thought to have unsustainable debt levels. We know that things look sustainable until they no longer do. That is how the markets work.” Although concern about this risk continues to grow with some foreign governments showing a wariness of owning Treasury securities, US debt outstanding relative to total US GDP remains well below what is considered an unsustainable level.
In sum, there are many uncertainties facing investors. This has always been true and will continue to be true in the future. We acknowledge the uncertainties by concentrating our investments in real businesses (no digital assets or meme stocks!) that will produce real economic returns over the only time horizon that counts for serious investors, the long-term.