4th Quarter, 2023
Geopolitical disruption adds to economic uncertainty.
THE MARKETS
During the 4th quarter, financial markets experienced a powerful “risk on” rally. The rally was fueled by expectations that the restrictive phase of the Federal Reserve’s inflation-fighting rate hiking cycle had concluded, implying significantly looser monetary policy as early as the second quarter of 2024. In that scenario, the odds of the US economy achieving a soft landing would be higher.
In the last eight weeks of 2023, the 2- and 10-year US Treasury yields declined from 5% to 4.25% and 3.87%, respectively, a sharp reversal of the rapid increase experienced in the August to October period. This resembled a duel between the Federal Reserve (Fed) and bond market participants. Chairman Powell’s abrupt shift in tone in mid-December suggested that easing could become a reality earlier than previously stated, which in turn, raised earnest questions about the Fed’s commitment to achieving the 2% per annum inflation target - the well-broadcast goal of many G20 central banks. Additionally, the new neutral rate, which is critical to the goalposts for both private and public credit, remains unclear.
Lack of clarity about the end destination did not hinder the strong “risk on” sentiment across global markets. Strength in equity markets was particularly significant in the quarter. The Dow Jones Industrials moved close to their all-time high and the forward price earnings multiple on the S&P 500 increased from 19.7 to 22.1.
Fixed income markets were also strong, with exceedingly small spreads between government and corporate credits, indicating shallow concerns about credit quality. Meanwhile, overnight repurchase obligations and other funding sources are showing signs of increased stress and volatility.
Notwithstanding the volatility in the Treasury market, the 10-year benchmark bond ended the year where it began at 3.87%. The unprecedented swings in rates were primarily driven by changes in inflation sentiment, expected Fed policy moves, and increased leverage funding of basis point trading strategies.
Markets have also clearly been influenced by the move to digital fund transfers, which played a significant role in the Silicon Valley Bank insolvency. This factor is likely to continue to change the landscape of transactional banking.
Stock markets have risen in the most obvious exhibition of the shift to “risk on” fervor. As a result, the multiple compression witnessed in late 2022 and early 2023 has evaporated. Our concern now is that markets have fixated on the early reversal of the rate hiking cycle that was undertaken to contain COVID driven inflation and are ignoring many of the global challenges and structural changes. In short, we are in a new era with new risks, some of which are not well understood.
The 15-year era of cheap money and negative interest rates has ended. The next growth cycle will have a real cost of capital that will have a geopolitical component reflecting the risks of a world in turmoil. As such, we remain cautious in the present bout of euphoria, but remain steadfast in our view that investment in well-managed companies will continue to bring attractive real returns over time.
THE ECONOMY
As we enter 2024, the global economy is poised to face challenges as the aggregate of restrictive monetary policy actions begins to take hold. We expect headwinds to economic growth in the G20 as national structural differences react to the higher for longer rate cycle that continues to target a return to 2% inflation.
The most challenged Eurozone country is Sweden, where the Riksbank was early in starting its hiking cycle largely as an antidote to a runaway housing boom. The Swedish boom featured dramatically rising housing values in a market in which 90% of mortgages are floating-rate and interest-only. Sweden is expected to post flat to plus 0.2% Gross Domestic Product (GDP) growth in 2024. Spain, which had its property bust several years ago, is expected to be among the best performing economies. It is expected to grow 1.7% in 2024, down from 2.4% in 2023. The UK is likely in recession now, however the Bank of England, along with the European Central Bank (ECB), are not ready to pivot on rates as inflation containment remains paramount.
In the US, third quarter GDP growth of 4.9%, while resilient, is unsustainable. The debate over a soft or hard landing continues with much evidence tilting towards at least a shallow recession, which will likely end by the 3rd quarter of 2024. GDP growth is likely to fall into a range of 1.5% to 2.0%.
The Fed’s shift in phrasing from higher for longer to earlier and faster in mid-December took both markets and central bankers by surprise and has now subjected other central banks to unwanted and intense pressure to follow suit. The immediate fallout has been a sharp decline in the dollar against the Euro, UK Pound, Japanese Yen and Swiss Franc. The steep dollar drop only adds to inflationary pressures as the cost of imports rises.
Now, market prognosticators are busy forecasting the pace and extent of the Fed’s downward rate spiral. The Fed pivot has added a significant risk of propellant to markets at home and abroad. The markets do not need increased volatility in the present period of geopolitical stress and recession.
INVESTMENT STRATEGY
Geopolitical disruption adds to economic uncertainty. In the last year, a layer of remarkably open-ended and unpredictable geopolitical risks has been added, leaving markets open to surprise, reprisal, and the wrath of unintended consequences.
Based on a reasonable assumption of 2024 GDP growth of 1.5% and a yet undetermined new neutral rate of interest, equity markets appear fully priced. A shift of funds from money markets to equities and equity related instruments has likely added to current market risk.
The major short-term market risk stems from supply chain disruption triggered by an aggressive downdraft in interest rates unleashing pent up demand in sectors where physical supply is inelastic. Case in point, the housing and materials sectors, where commodity speculation has recently become evident.
Another concern is disruption in the bond markets due to potential crowding out as federal deficit funding collides with corporate borrowing. This could lead to a reversal in the sharp fall in yields. Any such move would likely create more volatility across markets. Due to this potential reversal in rates, we continue to advocate for a shorter duration posture in bond allocations.
Overall, we believe investors should be mindful of their long-term asset allocation targets and should consider taking gains to reallocate where years of excellent stock market performance have led to an over-allocation to risk assets.
RISKS THAT ARE ARISING
As we enter 2024, we need to seek out risks that have the potential to disrupt or significantly alter current economic thinking.
There are numerous areas where current thinking is ripe for change due to new norms in the post COVID world, the beginning of a new credit cycle reflecting positive real rates of interest, and new risks associated with the rise in global geopolitical turmoil.
We have identified four areas of interest which have begun to move from latent to real risks and which lack broad understanding by market participants, creating an environment for mispricing risk.
Increasing Pace of Structural Change
Much has been written about the importance of data driven decisions and dot plots and their use in forecasting future economic and market trends. Economic forecasts have always been driven by a mix of hard data and subjective tweaks at the margin. There is a risk that some of the forces driving the economy have changed and that forecasts based on historical relationships are no longer well founded. This trend has its origins in the post-COVID world and a lack of comprehension of new norms. Thus, structural changes have evolved faster than the ability to quantify and understand them.
2. Technological Shift in Banking
Digital banking, which came of age with a bang during the regional banking crisis in the Spring of 2023 that caught the Fed with blinders on as digital transfers of billions of dollars were moved at warp speed to other financial intermediaries creating the world's first digital banking run. Thus, the well-structured technology that was right in front of us was ignored by regulators who are now struggling with new thoughts on increased capital buffers and the creation of sovereign digital currencies.
3. Supply Chains Disruptions and Imbalance
Future supply chain disruption could quickly arise as a major concern. Shipping challenges and production lags in the last 4 years have been a material driver of price increases and could lead to the reignition of inflation faster than most other levers. The Fed’s dovish impulses could become reality and inadvertently reignite inflation.
4. Global Commodity Supply and Demand
We live in a world where material demand exceeds supply. Long-term demand exceeds current supply capacity for many of the crucial inputs to the global economy. The root cause in most cases is twofold: a prolonged period of underinvestment in new production and secondly, the absence of an acceptable risk adjusted return on capital based on rising geopolitical risk and the escalating cost of environmental risk. The reality of the marginal cost for additional supply is not currently well understood by the market.