Thoughts on the Current Environment
First Quarter 2024
by Ralph Segall, CIO
“Excessive credit expansion … is commonly driven by a sense of market enthusiasm … or the widespread belief that the old rules no longer apply. … U.S. and non-U.S. governments alike have at best posted a mixed record of anticipating, preventing, or correcting financial crises.”
—”Manias, Panics and Crashes: A History of Financial Crises,” 8th Edition 2023, Robert Z. Aliber, et al; prologue by Henry Kaufman, pp. vi-vii.
I recently had a question posed to me by one of our thoughtful clients that became the basis for this quarter’s essay. The client was curious as to why we discuss macroeconomic issues when we have clearly stated over time that broad macro concepts do not largely impact our selection of individual stocks and bonds. It is true that our fundamental research on stocks and bonds does not require us to have a specific view on the U.S. or global economy. Rather, our research focuses on the investment opportunities and challenges presented at the company level.1 Having said that, it is also true that we try to stay keenly aware of two critical components of the global macro picture: interest rates and profits.
Our Foundation for Valuing Assets
Why these two elements? Because we believe they are the basis for the valuation of assets. Not just financial assets, but all assets—from homes to solar panel farms to office buildings to farmland. First, interest rates. Interest rates, as we know, are the basis for setting the cost of capital. Higher interest rates mean that the value of a dollar to be received in the future is worth less today than in the same world with lower interest rates. That’s because if interest rates are low, there is less to be earned holding a dollar compared to investing it in a venture that will take time to generate cash flows back to its owners. Having a view of what could influence the level of interest rates helps us assess how much the global financial markets are pricing the potential for growth and/or how much risk the markets attach to future opportunities for growth.
Second, profits. We know that corporate profits are the result of economic activity, and typically provide the wherewithal for a company, an industry, or a country to invest more to continue or accelerate growth. A company may reinvest in its business to fund growth. That growth generally attracts additional investors who buy shares of that company to participate in the anticipated future growth. Our work shows that companies whose business models are oriented on finding, developing, and maintaining profit growth can generate above-average returns on invested capital (ROIC) over time. Strong or growing ROIC companies are the focus of our equity strategies; we seek companies we believe will generate above-average returns for their shareholders over time2. To be very clear, none of the foregoing is meant to be a definitive roadmap to successful investing. But this focus does allow us to spend more time on what we believe to be important and less time on the extraneous.
With this as a backdrop, let us offer some comments on both factors, interest rates and profits.
Global interest rates, we believe, are in the process of finding equilibrium after two material external shocks over the last 15 years. The first was the Great Financial Crisis of 2008, brought about by the collapse of the residential housing market in the U.S. That was followed, 12 years later, by the COVID-19 pandemic. In both crises, the Federal Reserve’s (Fed) policy response was to drive interest rates to zero (and in Europe and Japan, to negative levels) and to flood the economy with liquidity. While this combined response averted market collapse, this liquidity contributed to the return of inflation. As 2023 came to a close, interest rates in the U.S. for Treasuries were 4.25% for the 2-Year and 3.88% for the 10-Year.3 We think it is significant that not enough time elapsed between these two crises to permit the paydown of some of the debt that was issued by the government to fund relief spending to avert serious financial crises in the economy. The cupboard was virtually bare when COVID hit. Interest rates were already near zero and the only useful tool was a fiscal policy that used direct payments to the public (funded by borrowing) in addition to keeping interest rates at zero.
It wasn’t until inflationary forces appeared and were more than transitory that the Fed determined it had to end its quantitative easing (printing a lot of money) and allow interest rates to rise. While the key rate the Fed controls rose dramatically over the last two years, it is hard to argue that interest rates across the yield curve are excessively high compared to the range of the last interest rate cycle, which ran 40 years to 2022 (see Nominal Yield Curve chart, below). Adjusting for the effects of inflation, which purports to be the objective the Fed is measuring in this tightening effort, real interest rates are generally still below the median level of the last interest rate cycle (see Real Yield Curve chart below).
Nominal Yield Curve
Source: FactSet. Data as of 12/31/23. Past performance cannot predict future results.
Real Yield Curve
Source: FactSet. Current yield curve as of 12/31/23. Past performance cannot predict future results.
Most interest rate forecasts we have seen for 2024 suggest that the central banks will cut short-term rates in 2024, a reprise of last year’s forecast that called for the same. Our view is unchanged: we have no strong feeling about the direction of short-term rates other than to observe that this may be one of those situations in which one shouldn’t wish too hard for something for fear the wish might come true. If policymakers are focused largely on the trend in the inflation rate to decide if or when to cut rates, a significant number of rate cuts could imply that inflation was continuing to decline but at a much more rapid pace than expected. We note that much of the decline in inflation in 2023 was the result of supply chains being repaired and the dollar remaining strong, both of which have contributed to the prices of goods coming down. From this point on, continued improvement in inflation readings will likely turn on trends in services, primarily wages, and in housing and rents. More weakness than expected in these series could suggest greater underlying economic weakness, which could affect the second factor on which we focus: profits.
The Stratification of the Market
Corporate earnings in 2023 were somewhat stronger than we anticipated, and the returns in the stock market, at least on the face of it, suggest the market responded accordingly. Such a conclusion is factually accurate but misses the thrust of the market entirely. The domestic stock market of 2023 was as stratified a market as we can recall. The stocks of seven companies, all of them mega-cap companies that had been down significantly the year before, rebounded with gusto. As a group, these seven companies rose 75.7% in 2023. Because of their significant weight in the broad market indices, such a large increase produced overall market results that were, to put it mildly, distorted. The Russell 3000® Index4 was up 25.95% in 2023 on a capitalization-weighted basis, meaning the largest stocks have the largest impact on returns. Calculating the returns on an equal-weighted basis, where the return of each company in the index is accounted for by an overall average, produced a gain of only 14.76%. Going one step further, there were more than 900 companies in the Russell 3000 reporting losses for the last 12 months.5 The return of that subset of stocks was 24.64%—in stark contrast. In other words, investors embraced risk and generally accepted over-concentration. It is, alas, the tendency of Wall Street to conclude that if a little of something is good, more of it is better. As we know from watching Wile E. Coyote, a really good thing can last for longer than we think…until it doesn’t.
Rates & Profits in 2024: What We’re Watching
In short, the profile of the stock market in 2023 suggested that investors generally dismissed several crosscurrents that haven’t gone away but remain for investors to contend with in assessing growth potential for 2024. Our intention here is not to be overly negative, but there are issues—in no particular order—that we believe pose serious concerns that could affect interest rates and profits as we head into the new year:
Geopolitical issues: The number of material armed conflicts has been rising. Beyond the loss of life and the destruction—to say nothing of the daunting costs to rebuild—investors should consider whether conflicts will broaden or spread.
Domestic politics: It will offend no one’s political sensibilities to observe that the electorate in the U.S. is as divided on many issues as it has ever been, outside of the decade before the Civil War and the decades during the Great Depression and World War II. Reaching solutions requires a willingness to compromise, a characteristic that seems to still be in short supply.
The challenges of global climate change: The process of moving from fossil fuel as a source of power towards electrification generated primarily from renewable sources appears to have reached a tipping point, and the train is leaving the station. The time, effort, and cost to bring this transformation about are as yet undeterminable, other than to say, “a whole lot.” How will it be funded? How long will it take? Unanswerable now.
The substantial increase in the U.S. government’s deficit: Borrowing by the U.S. government has brought levels of debt to GDP to unprecedentedly high levels. Beyond what level the financial markets will tolerate is another unanswerable question.
Migration: Massive shifts of populations are occurring—from South America to North America and from Africa and the Middle East towards Europe. The ability to absorb the movement of so many people is increasing political and social strains on many countries.
The state of the Chinese economy: China is the second-largest economy in the world. It has been undergoing the unwinding of a massive real-estate-driven borrowing boom for the last couple of years that we believe will culminate in 2024. Some observers think this will clear the way for a significant rebound. But as we saw in the West in the aftermath of the Great Financial Crisis during 2009 and later, recovery from a burst bubble in long-lived assets like real estate and manufacturing facilities can take years to work through. As all actors in an economy—workers, households, banks and financial intermediaries, exporters, and even governments—come to grips with the fact that the assets they hold are not worth the debt they support, they often change their behavior in ways that undermine growth. Couple that with the government’s stated focus of the Chinese economy—to aid and support the government and the revolution rather than to grow the economy—and we can see the makings of a long-term drag on global growth.6
On the positive side, the emergence of artificial intelligence (AI) as a commercially viable product holds considerable promise for making (especially developed) global economies more productive. Its possibilities have only begun to be considered.
In the realm of medical technology, the development of the GLP1 group of drugs will allow them to expand their range of approved uses (e.g., beyond diabetes to obesity). This could potentially improve the health of and quality of life for many people and reduce health care costs by averting costly treatments.
So once again we end up discussing macro issues. But the focus of this consideration remains on how interest rates and profits will be impacted. Many pundits are forecasting an economic “soft landing” next year, meaning inflation is tamed and the economy continues its modest growth. We, however, remain cautious at best. Landings, after all, cannot be classified as soft until the wheels have actually—and “softly”—touched the ground.
It’s a good thing that macro issues do not factor into our work, he said sheepishly. Our macro work is designed solely to help us better understand the potential impact on individual asset valuations. It is, after all, not a stock market, but a market of stocks. In the best of times, there are stocks to be sold for reasons unique to them. Conversely, in the worst of markets, there are always opportunities to be found. We are always on the hunt for them.
January 2023 to December 2023
Source: FactSet. Past performance cannot guarantee future results. All investments involve risks, including the potential loss of capital. One cannot invest directly in an index.
Research assistance from Tom Dzien and Michael Chilla in the preparation of this essay is gratefully acknowledged.
1Full-time careers can be built on the study of all kinds of economic factors that heavily influence interest rates and profits. We are just making the point that the “bottom line” of all that work is what matters to us.
2Based on FactSet/Russell data from 1984-2022, the top two ROIC quartiles of the Russell 3000 Index outperformed the bottom three quartiles on a cumulative performance basis. Past performance cannot guarantee future results.
3FactSet data as of 12/31/23.
4The Russell 3000 Index is a capitalization-weighted stock market index maintained by FTSE Russell that seeks to be a benchmark of the entire U.S. stock market.
5FactSet data as of 12/31/23.
6See “China’s debt isn’t the problem,” Michael Pettis, The Financial Times, Dec. 19, 2023, China’s debt isn’t the problem (ft.com).
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