This inflation cycle has played out much differently than past cycles.
The primary challenge in tackling stubborn inflation today is that the ultra-low rates of the past several years allowed companies to assume long-term debt very cheaply. The Fed’s Open Market Committee (FOMC) can only change the shortest-term interest rates, primarily impacting revolving and floating debt like credit cards and bank loans. The anticipated increase in corporate demand for financing at higher rates never materialized and delinquencies have been well-managed. So, the financial system has remained resilient and provided consumers with the confidence needed to continue spending.
Entering this cycle, consumers were also flush with spending power due to government stimulus, low fixed-rate mortgages, and lower-than-average debt service costs. So, Fed rate hikes haven’t impacted consumer behavior as much as in past cycles. Equally important, companies took advantage of robust demand by raising prices – further feeding inflation – and allowing them to protect or even increase profit margins while retaining their workforce. This self-reinforcing loop has allowed the economy to avoid recession and the stock market to recover faster than virtually every economic indicator – and our own fears – otherwise suggested.
Today we are in a momentum-led rally with the market assuming interest rate cuts later this year and a renaissance of capital spending on Artificial Intelligence over the next many years.
Momentum can carry a market a long way and we have enjoyed a period of market stability without suffering any meaningful pullback. This is rather surprising with 3 of the “Magnificent 7” having underperformed YTD, the Fed lowering projected rate cuts by half, and the past two months of inflation coming in higher than projected. The stock market has defied all but the rosiest of scenarios, with equity issuance (including IPO’s) at the highest level since 2021. This too shall change, but when it does it shouldn’t derail the bull market we are in. Volatility will return to test the conviction of investors. There will be some rougher sledding for us all at some point (it could be sooner rather than later).
Integras Partners strategies allow our clients’ stock exposure to be insulated by time. We don’t take meaningful market risk with money that our clients need soon. We don’t want them to change their spending decisions due to financial markets. Our objective has always been for our clients to enjoy life and leave the worrying to us.
2024 started with concern over stock prices, focused on the widening gulf between the price moves of the “Magnificent Seven” tech stocks and the rest of the market. Expectations for this gulf to close were rooted in the Fed’s actions – when they would begin cutting interest rates and how many cuts would occur in 2024.
At the end of 2023, the bond market had priced in nearly a 100% chance that rate cuts would begin in March.
Our expectation has been that cuts were not likely to begin until this summer. Given the most recent inflation data, and conceivably similar readings to come, it would now not be surprising to see no cuts until even deeper into the year, if at all.
The 1st quarter saw the S&P 500 rally 10% while almost totally discounting Fed rate cuts this year. This could be the market seeing lower rates and slowing inflation ahead, however, inflation is proving to be more difficult to tame towards the Fed’s 2% target. Sticky inflation may prove to be the Achilles heel of the current advance.
We also wrote in our Q4 2023 commentary that the focus of the market would soon turn from interest rates to the market fundamentals of earnings and valuation. This has started coming to fruition, but complicating this calculus is the momentum of any company involved with artificial intelligence, and market expectations for revenues and earnings of all companies due to AI’s influence. While in early days, “AI” has overtaken the narrative of the Fed needing to lower interest rates, and the speculative nature of investors has re-emerged. Today we are in a momentum-led rally with the market assuming rate cuts later this year and a renaissance of capital spending on AI over the next many years.
While the advance has its roots firmly embedded in the AI excitement, other green shoots are becoming visible as well.
Valuations are very attractive in small caps and international stocks, and mutual fund flows are reflecting an increased appetite for value vs. momentum. These are signs of a healthy market – ones that should be embraced, although they will likely be tested.
While not our base case, there is a chance that with financial conditions having eased so much already, a renewed upswing in inflationary forces are taking root. Should the economy remain strong, coupled with government stimulus funds (JOBS Act, Infrastructure, Inflation Reduction Act, etc.) flowing into the economy and consumers continuing to spend, inflation may not recede to the Fed’s 2% goal. Perhaps worse, the Fed may start easing only to have to pivot and raise rates again. These are risks we are mindful of and recognize that regardless of how rosy a set of projections may look now, there are several catalysts that could change investor sentiment in a meaningful way.
We continue monitoring all these factors, watching developments, and adjusting our strategies and client portfolios as necessary. Where there is disruption and change, there is often opportunity.
Laser-focus on inflation was the key driver of both interest rates and market performance over the past two years.
Inflation continues retreating towards the targeted 2% range, which should largely be achieved around mid-year. We expect the Fed will begin lowering rates during the summer. While the bond market has priced-in 6 rate cuts for the year, beginning as early as March, we believe it will be a more modest and later cutting cycle. From there, the narrative should shift from inflation and interest rates back to the fundamentals of economic growth and earnings. There is still a risk that the economy could pick up steam and inflation return to haunt us once again, a la 1980. Nor are we out of the woods of potential economic weakness. But we see light at the end of the tunnel.
We remain optimistic about the long-awaited resurgence of small-cap, value, and international stocks closing the performance gap versus U.S. large-cap growth over the ensuing economic cycle.
The old maxim of ‘no tree grows to the sky’ will ultimately prevail. We find it unlikely that valuations of the “Magnificent 7” can continue to rise unabated. Valuation is a fundamental driver of long-term performance, and small caps and international markets remain undervalued relative to history.
As we expect a return to economic fundamentals over 2024, much depends on the economic growth and labor productivity needed for earnings to meet or exceed expectations. Should the economy slow, stock markets will have a hard time producing meaningful gains. While not our base case, we will remain mindful of the many economic indicators still flashing red.
We understand it is an election year. As November approaches, we typically see markets stagnate or slightly decline as the uncertainty and anticipation mounts. However, history tells us that regardless of who wins, there is negligible impact on financial markets in aggregate. In the end, regardless of whether your favored party wins or loses, there is no advantage in changing investment policy.
The normalization of interest rates is an uncertain path and forecasting economic growth is even more difficult. As investment themes change throughout the year, we will be looking for areas where valuation and earnings potential appear strongest – a disciplined approach that has served us well long-term.
What remains paramount is our desire to always take care of our clients’ current investment needs, while working towards achieving long-term investment goals.
With our time horizon investment process, we have successfully sheltered near-term spending needs from market disruptions, giving the longer-term assets the time needed to allow these disruptions to play out. Our long-held mantra of “go live life, we’ve got your back” has worked throughout this period of upheaval and we will be making sure that continues.
So, enjoy today and tomorrow, and let us do the worrying!
While the S&P 500 rose 26% at the headline level, it was almost entirely due to just seven “magnificent” tech stocks. The remaining 493 names contributed very little – on average up just 4%. This concentrated market condition continued through October when we finally enjoyed broadening market participation. Small cap stocks began a long-awaited turn-around with a two-month advance of 16%. The broad International Index rose 18%. Both are areas we overweighted in 2023 due to their relative valuations. While we think these sectors will continue to waffle back and forth for several months (as January has already shown), we expect a further broadening of market performance once we get some assurance on timing of Federal Reserve rate cuts.
Interest rates have been the story since early 2022 and October showed what happens when our uncontrolled fiscal deficit intersects with decreasing foreign demand for Treasuries. The 10-year Bond went from a yield of 3.3% in May to 5% in October as auctions witnessed a pullback in foreign investors. This will become a larger theme in the future should our deficit growth continue unabated. Nevertheless, as inflation readings continued to decrease during the Fall and the market began anticipating rate cuts, the yield on the 10-year treasury ended 2023 at 3.9%.
We wrote last quarter that we were cautiously optimistic.
But the year ended better than, even we, anticipated. Surprising employment strength and increasing home prices have remained dominant forces keeping the U.S. from entering recession. As consumers spend down COVID savings, they remain heartened by job stability, so overall spending has remained quite strong. Strong home values have also buoyed consumer confidence. This is very different from the historical pattern (although welcome and needed). In a normal economic contraction, people lose jobs and must sell homes, increasing housing inventories which bring prices down. In this rate cycle over 90% of existing homes carried mortgages under 4%. People were not forced to sell and have no desire to trade a 3% mortgage for a 7% mortgage. Inventory remains tight while demand stays solid, so prices have risen. The banking system remains resilient, financial conditions have eased, and financial market performance followed.
Heading into 2024, we see light at the end of the tunnel, while recognizing the risks that are still present.
So, enjoy today and tomorrow, and let us do the worrying!
Barring a major unforeseen event, we expect stocks to rally later this year as the corporate earnings and consumer strength picture becomes clearer, and markets “look through” to next year. We discuss some of our reasoning here.
Which parts of the market are best positioned for growth? While impossible to say, there are parts of the investment universe that have long underperformed the tech heavy S&P 500 Indexâ and the NASDAQ. We continue to see the huge disparity built up between U.S. and foreign markets over the past 10-15 years, and between the largest stocks vs. the smallest. These are areas where we look to become more heavily invested (and in the past couple of months we have done just that for our clients). We are already seeing the disparity close, with foreign markets outpacing U.S. markets over the first quarter. Investors in smaller companies will need to look through to next year before they start closing that gap, but the stage is set for this also.
Opportunities arise during periods of fear. While one could sit in cash and let the storm pass, by the time confidence returns the largest gains have already occurred. If you believe that any recession is likely to be shallow and short-lived, as we do, your longest time horizon capital can withstand short-term drawdowns while positioned for greater returns. At Integras Partners, we segment your investments by time horizon, with money you need sooner invested conservatively, and money you don’t need for a long time invested for growth. Our Growth Strategy is positioned to capture the disparities mentioned above.
Fear is always the enemy of good decisions, and it won’t evaporate. But as the year plays out, many current points of concern will fade, and confidence will start to return. As it does, we expect to capture gains that others miss. So, expect mixed signals and more volatility along the way, but recognize that no condition lasts forever, and the longer any condition does last, the closer we are to the end of it. We are close to the end of interest rate hikes. We need to know how deep and long earnings may contract, and that rests with a relatively healthy U.S. consumer. Overall, we may be closer to the end than we realize, and suspect that by the Fall markets will be looking forward and see much sunnier skies than it does today.
Enjoy today and tomorrow, and let us do the worrying!
Financial markets have no clear direction, trapped in No-Man’s Land until at least the next Federal Reserve meeting on May 3rd. Depending on the economic data points of the day, stocks are gyrating up and down within a narrow band without clear direction or conviction. Such is a time when opinions and predictions bounce markets until enough data exists to prove one right or wrong. There are several directions for future economic and market performance that need to clear up.
The First Compass is monetary policy – driven by the Fed moving interest rates and the supply of money. It is expected that rates will be raised another ¼ percent in May, and then a pause announced as the toll previous increases are having on the economy becomes clearer in the data. This includes inflationary pressures receding, employment growth cooling, and the availability of credit shrinking. Tighter financial conditions weigh on small businesses, who employ 2/3 of all workers. The possibility of recession has increased, and slower corporate earnings – the primary basis for stock valuations – are expected.
Secondly, virtually every recession indicator is flashing red, from manufacturing data, commodity prices, and a very inverted yield curve. But consumers will determine if a recession occurs and how severe it might be. Will consumers keep spending while bank credit is reduced, the economy slows down, confidence is eroded, and a true recession occurs? No one knows. So, today we are stuck in No Man’s Land.
There are clear signs that once the corner does turn, the recovery in stock prices could be fairly swift. While this all sounds ominous, the reality is that a possible recession should be shallow and short. Despite potentially slower short-term earnings, corporate and household balance sheets remain quite strong. Assuming this persists, any damage due to recession may not foster further reduction in stock prices. Earnings also historically prove stronger than pessimists fear. Finally, investor sentiment and positioning is downright despondent. Troughs in sentiment tend to precede strong equity returns. We are currently in the 16th consecutive month of negative market sentiment. The Great Financial Crisis had a span of 18 months. With the second longest period of negative sentiment in place, and cash accounts flush with $3-$4 trillion to invest, there will likely be great demand for equities when sentiment turns.
Barring a major unforeseen event, we expect a turnaround later this year as markets “look through” to next year. In the ten prior periods when markets were up in the first quarter after a negative year, the year finished higher in all of them. Further, 15 out of the last 16 periods produced positive annual returns in years when the market was up greater than 5% in the first quarter. We believe the stage is set for the market to accelerate into year-end once earnings and consumer strength pictures clear up.
So, what parts of the market are best positioned for growth?
Enjoy today and tomorrow, and let us do the worrying!
