Written by: Matt Lloyd | Advisor Asset Management
As we embark on 2024, we are reminded of Shakespeare’s quote from The Tempest: “What’s past is prologue.” While 2023 influences the current trajectory, there is an opportunity to experience a broader number of outcomes that need to have investments made for various contingencies. We filter down the broad economic landscape as the Harry Potter Economy in that the ultimate conflict between the protagonist (solid economic growth) and the antagonist (anemic to negative economic growth) was painfully obvious from the first book. However, the ultimate resolution took seven books to ultimately be decided and thusly the time between the many contradictory economic measures will look to ultimately be resolved in 2024. The three scenarios of a soft landing, hard landing, or no landing look to be clearer in probabilities as we proceed through 2024. As of now, we see little probability of a soft landing as history has told us that this has been almost as rare as a unicorn spotting in that we really saw it in the 1996-time frame. Recall that this also saw a micro-managing of the Fed Funds Rate where the rate had risen from 3.00% to 6.00% but as 1996 began it had already been reduced 75bps (basis points). That 300 basis points rate hike cycle was a fraction of the average cycle seen over the last 60 years where the average cycle of interest rate hikes is right at 500 bps or 5%.
As far as the markets are concerned, it feels like it is the Confirmation Bias Market in that no matter what your opinion and what your investment bias is, you can find metrics to corroborate it. Whether this is based off historical context or immediate results, there is not only data that can affirm it but also data that can prove to be troubling for the investor. Cognitive dissonance is a psychological trait by which in most simplistic terms is our search to minimize inconsistencies in our lives and causes a binary choice when reality doesn’t match up with our belief system. Logically, one would think that when reality doesn’t match up with our belief system, we adjust our belief system. However, the exact opposite tends to happen, and we adjust our reality to match our belief system. This, in a nutshell, is perhaps the biggest reason for inexplainable moves in markets as we have witnessed many times from tulips to the increased holdings and out of the world performance for such a narrowed number of companies as we currently are witnessing.
We enter the year with the dilemma of whether a true soft landing is possible and look to history for clues about this probability. From there we need to take the preponderance of current economic and market metrics to discern if this time is different…hint, it almost never is. Jurrien Timmer, the head of Global Macro at Fidelity offers a visual guidance of a soft landing and what has happened in fourteen previous scenarios.
Source: Fidelity
While he points out that three of the last fourteen cycles were technically a soft landing, the question arises as to how to define “soft?” The real EPS (earnings per share) rate growth mirrors a bit of the 1996 soft landing; however, the projections imbedded in risk assets may be a bit optimistic. Traditionally, we see a real negative growth and truly need to see other metrics corroborate this in the form of higher consumer sentiment and optimism to not only consume but have an increased level of disposable income to offset the cumulative impact of inflation. If you notice the scenarios where a soft landing did occur, and disregarding equity real returns, one sees it occurred during longer than average expansions.
We know how important the US consumption is to the domestic market as evidenced by the various domestic consumption rates below. However, the US consumption is over 17% of the global GDP number and makes countries that rely on manufacturing vulnerable to the sentiment of the US consumer.
Many have been pointing to the growth in retail sales as a bullish point, a key determinant in many GDP models. However, it presents a different picture when we take real (inflation adjusted) retail sales and sales volume. Bianco research gives this view in a very simple graph since 2015.
Below denotes the sales volume year over year from the OECD that in a way, reveals one of the murkier measures of inflated prices but very impactful, Shrink-flation. Recall Shrink-flation is the action of reducing the size of a good while maintaining the same price. Getting less for the same or more!
To justify a longer-term expansion, we need to see income increasing to justify the expansion from an earning standpoint. The labor market continues to be strong, but cracks have been emerging. Remember that employment, from an economic standpoint is a lagging indicator. Consider that when lending standards rise, as has been the case for some time, employment often sees a tougher environment in the next twelve months.
We also need to see more growth in the balance of manufacturing and services, which has not been the case.
When we look at what is going on with historically reliable indicators, the yield curve inversion has proven to be more accurate than many attribute to it. One vital point to remember is that the curve will steepen well before the recession is officially called. Thusly, many who only use the yield curve to promote a bullish scenario often get caught in a bear trap assuming all is clear for investing in the risk on pool of assets.
Source: Bianco Research, LLC
Now that we are getting to the finish line on the rate hike cycle, the ramifications of what it did to portfolios is substantial. Below is the measure of banks holdings and “paper” losses on the balance sheet due to the Fed Funds rate going up 550 basis points.
We will have far more on the investment themes in our firm’s investment outlook for 2024; however, the economic picture still requires a bit more time to play out. History has been a great teacher but is not above mistakes. As such we see below average growth for next year in the US and across the globe with a few outliers internationally. The prevailing bout of inflation will either continue to surprise on the upside or, if it should recede, would be on the premise of demand for goods declining into recession territory. The chances of a soft landing with a reversion to high fiscal stimulus and low monetary restrictions appears very remote and we would caution against the multitude of head fakes that occur within the journey to the conflict resolution. We continue to see a better reward potential for quality assets and a stress on cash flow and coupon for investments. We would caution against being married to an investment narrative as it often is easy to get divorced from reality.
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