Highlights:
· The much-predicted recession of 2023 never materialized. Stocks rallied in the fourth quarter on the expectation that the Fed would cut interest rates in 2024.
· The challenge for the Fed in 2024 will be to continue to rein in inflation without crashing the job market. This will go a long way toward determining if the recession has been delayed or the subscription has been outright cancelled.
· The Bank of England and European Central Bank appear set to diverge from the Fed and hold interest rates at historically high levels.
· China continues to be plagued by economic malaise, while news coming out of Japan is better, but not good enough to convince the Bank of Japan to raise interest rates from negative levels.
· Geopolitical instability is breaking out seemingly everywhere, but the global economy remains in seemingly reasonable shape. It is extremely difficult to predict the direction of the economy and almost impossible to predict short-term stock equity market movements.
Commentary:
“Behavioral finance is finance for normal people like you and me. Normal people are not irrational. Indeed, we are mostly intelligent and usually “normal-smart”. We do not go out of our way to be ignorant and we do not go out of our way to commit cognitive and emotional errors. Sometimes, however, we are “normal-foolish” misled by cognitive errors such as hindsight and overconfidence, and emotional errors such as exaggerated fear and unrealistic hope.”
-Meir Statman, “Finance for Normal People: How Investors and Markets Behave”
2023 was the year of all that could have gone wrong, but did not. It is hard to believe that a year ago, inflation was still at a pace above 6%, the Federal Reserve (Fed) was hiking interest rates hard with no sign of stopping, and almost everyone expected a recession. In March, we seemed on the verge of another banking crisis following the failure of Silicon Valley Bank.
Yet by the end of the year, the much-predicted recession had not yet materialized, the fallout from the Silicon Valley Bank failure seemed to be contained, pandemic-disrupted supply chains had continued to right, GDP was growing at its fastest pace in nearly two years, manufacturing-related construction was booming, inflation was back near normal levels, employment and wages remained robust, and the Fed looked poised to cut interest rates in the year ahead.
Expectations that the Fed will cut interest rates this year while the economy avoids a recession sparked a vigorous fourth quarter rally in the equity markets. One of the key issues for 2024 is likely to be whether inflation continues to retreat so that the Fed is able to cut rates at the pace the market expects and pull off the elusive soft landing without crashing the job market. Regardless of the outcome, the economy seems to be in the midst of a transition from demand-driven shocks to a macro environment dominated by supply constraints and ongoing inflationary pressures.
Despite signs that the job market is finally starting to slow down, unemployment has remained below 4% for a two-year period for the first time since the late 1960s. This despite the fact that of its two mandates – inflation and unemployment – the Fed has focused almost exclusively on inflation for the last two years. Put another way, the Fed was prepared to accept a mild recession to win the battle against inflation. With inflation coming down faster than anticipated, and the economy more resilient than forecasted, the Fed is now able to focus on trying to prevent a recession and beat inflation. Jerome Powell said as much following the central bank’s December meeting. “You’re getting now back to the point where both mandates are important. We’ll be very much keeping that in mind as we make policy going forward.”
While the Fed all but declared its rate hiking cycle over and signaled cuts would be ahead in 2024, central banks in Europe and the U.K. pushed back on expectations that interest rates would be lowered anytime soon. Having moved in lockstep over much of the last two years to swiftly raise rates as inflation soared, 2024 is shaping up to see Europe and the U.K. deviate from the U.S.
The Bank of England and the European Central Bank both indicated beliefs that rates need to hold at current levels to battle persistent inflation, despite signs that prices are finally falling. “We’ve come a long way this year, but we still have some way to go,” said Andrew Bailey, the head of the Bank of England. Along the same lines, European Central Bank President Christine Lagarde said, “We don’t want to lower our guard; we believe there is work still to be done. That can very much take the form of holding (rates steady)...We did not discuss rate cuts at all. No discussion, no debate.” The euro area and U.K. economies have faltered in recent months, which has raised fears that holding rates too high for too long could lead to further economic damage as inflation falls.
After showing signs of picking up steam in the third quarter, economic data coming out of China in the fourth quarter showed that recent supportive measures have not yet translated into near-term economic growth. Business investment and consumer spending slowed more than expected during the quarter, a prolonged property downturn showed no signs of abating, imports are slumping, manufacturing activity is shrinking, services activity is slowing, and deflation is deepening.
To address this economic malaise, the People’s Bank of China injected approximately $112 billion into the financial system during the quarter via one-year loans to banks. This was the largest amount of these types of loans on record. This follows other stimulus measures that were enacted earlier this year, including interest-rate cuts, extended tax breaks for companies, and lowered mortgage costs for homebuyers. Still, most economists believe these measures are insufficient and that a major stimulus package or cash handout to households is needed to keep China’s post-Covid recovery on more solid footing to complement economic bright spots, which include rising factory production and export volumes.
Inflation in Japan, which has long struggled with flat or falling prices, has remained above the Bank of Japan’s 2% target for more than a year. Nevertheless, the bank continues to insist on further evidence of the sustainability of recent wage and price strength before committing to the increase of its key short-term interest rate from negative territory.
So much focus has been placed on the direction of interest rates and last quarter’s stock market rally, that it is easy to lose sight of the uncertainty of the path forward. To begin with, central banks to this point have been able to cool inflation without letting the job market collapse and driving the global economy into recession, but inflation still hasn’t made it all the way back down to 2%. In fact, inflation ticked up in December, with over half of the increase stemming from rising shelter costs. If the Fed were able to navigate a soft landing, it would be extremely rare. In the past 80 years, the Fed has never managed to bring inflation down substantially without sparking a recession. As former United States Secretary of the Treasury Larry Summers recently said, “second marriages and the soft landing of the economy have one thing in common: they represent the triumph of hope over experience.”
Manufacturing and housing, two leading segments of the economy, continue to show relatively anemic recoveries. Housing affordability has tumbled due to stubbornly high home prices and a spike in mortgage rates. Manufacturing fell into recessionary territory in 2022, and while it has started to show hints of bottoming out, it is too soon to say an uptrend has been achieved.
There is no end in sight for ongoing major wars in Ukraine and Gaza. The impact of these wars has generally been contained to regions where the fighting is taking place to this point, but the risk of a broadening conflict in the Middle East seem to increase by the day. In protest against Israel’s war in Gaza, which recently reached the 100 day mark, Iran-backed Houthi militants have launched more than two dozen attacks on vessels in the Red Sea since November, severely obstructing freedom in one of the world’s principal commercial shipping routes. In response, the U.S. and its allies have struck more than a dozen targets in Yemen controlled by the Houthis. Danish shipping behemoth Maersk and Chinese shipping giant Cosco recently announced plans to pause Red Sea transits until further notice due to the Houthi attacks. Lowered shipping capacity could put upward pressure on goods that are reliant on global trade, just as inflation is coming down, and cause a shortage of goods, just as retailers have finally recovered from the disruption to supply chains caused by the Covid-19 pandemic.
Countries making up over 60% of the world’s economic output and more than half of its population are holding elections in 2024. In the U.S., it is currently looking like a rematch between President Biden and Donald Trump that will have huge stakes for the country and the world. Taiwan just recently elected a president that Chinese leaders have referred to as a “troublemaker” and a dangerous “separatist.” Russia, Britain, India, Mexico, South Africa, and several European countries are also holding national elections this year. The results of these elections will likely be telling as to whether or not the world continues to depart from the post-Cold War era of globalization and geopolitical stability, and towards a world characterized by fragmentation, the construction of new economic blocs, and the realignment of supply chains.
The fourth quarter market rally stemmed from investors conviction that the economy is heading for a soft landing and lower interest rates, along with the promise of an Artificial Intelligence revolution to boost productivity, foster innovation, and drive economic growth. This may prove correct, but remember that the consensus heading into 2023 was that the Fed’s battle to tame inflation with rapid interest rate hikes would trigger high unemployment and a recession, as it had in the 1970s. These bearish predictions turned out wrong, as instead, the economy grew and the unemployment rate stayed low as the job market cooled, but remained strong.
We are not trying to imply that last quarter’s market rally is unsustainable. In fact, the stock market proved its incredible resilience in 2023, mostly due to corporations continuing to grow profit margins, the U.S. consumer continuing to spend, inflation seeming to be mostly transitory after all, and the economy showing it could apparently withstand higher interest rates. However, it is also true that, as the Fed has stated numerous times, it is premature to declare a victory against inflation, and geopolitical instability is breaking out seemingly everywhere. Yet stock valuations seem to imply that the inflation victory parade is already on the calendar for 2024 and investors do not seem to be impressed with current world events.
Just because 2023 ended on a high note, we have no idea what is going to happen with the economy or equity markets in 2024. Sometimes the stock market takes cues from the economy. Sometimes the stock market decides to do its own thing. We would not be surprised by continued economic growth nor a recession, by a continued rally for equities nor a pullback in the markets. Our investment policy accepts this uncertainty by only deploying funds to a diversified growth component that have been proven, via a comprehensive financial planning process, to be allowed to stay invested for at least 10 years. This long-term approach requires patience and is not overly exciting, but it does work over most long-term market cycles. To quote Morgan Housel, author of The Psychology of Money, “”Be more patient” in investing is the “sleep 8 hours” of health. It sounds too simple to take seriously but will probably make a bigger difference than anything else you do.”
Urban Financial Advisory Corporation – January 2024
Disclaimer:
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