Thoughts on the Current Environment
Fourth Quarter 2023
by Ralph Segall, CIO
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“The seven good cows stand for seven years, and so do the seven good heads of grain. The seven skinny, ugly cows that came up later also stand for seven years, as do the seven bad heads of grain that were scorched by the desert wind. The dreams mean there will be seven years when there won’t be enough grain.”
—Genesis 41:26-27, Contemporary American Bible, 2nd edition1
As 2023 began, we identified several themes that appeared to be consensus among most strategists, based on our decidedly unscientific survey of year-end strategy reports. These themes included the following: a recession in the U.S. was more likely than not in 2023, an economic resurgence in China would be the capstone to the resurgence of the global economy, and the Federal Reserve (Fed) would be cutting interest rates by the fall. As fall arrives in the Northern Hemisphere, those consensus forecasts appear to be “just a bit outside,” in the immortal words of baseball announcer Bob Uecker.
The Folly of Forecasting
The U.S. economy has not moved into a recession and is indeed chugging along, the Chinese economy is in disarray, and the Fed has shown no signs that interest rate cuts are imminent. The central bank has continued to raise interest rates through the first half of the year and advises that it will remain “data dependent” in terms of future actions, i.e., rates could continue to rise. It would be noteworthy, to say the least, if a strong economy caused the Fed to raise interest rates within 12 months of a national election. This is something the central bank is generally loath to do.
The experience of 2023 should remind us that accurate forecasts are hard to come by, and that’s why we largely keep them out of our investment process. The closest we came last year was to suggest that if a recession arrived, it would likely be less stressful on Main Street than on Wall Street. To date, this looks pretty accurate. What we were suggesting was that the real economy should be in good shape, given the normalization of COVID-induced supply chain issues and the continuing benefits from government stimulus programs. That has been pretty much borne out as employment conditions, while softening slightly of late, have been reasonably strong year-to-date. The labor participation rate has improved as more people return to the workforce. Wages have been rising as well, in many cases well in excess of inflation.
All Is Not As It Appears
Wall Street, on the other hand, has had its issues. The S&P 500® Index ended the third quarter with a decline of -3.3%.2 For the full year, the market is up 13.1%2, but this is a year in which appearances can be deceiving. Excluding the top ten mega-cap companies—which include technology stocks focused on the glamour and glitz of artificial intelligence (AI)—the rest of the stock market is up a meager 2.5%2 this year through the third quarter. Moreover, whatever gain the stock market has enjoyed has, on balance, been driven not by underlying gains in profits but on gains in the valuations accorded those profits. The decline in profits of companies in the S&P 500 Index was -9.6%2 on a net income basis and even less when measured on a per-share basis (-9.1%2), year-over-year through June 30. In other words, any advance of the stock markets cannot be due to underlying profit growth. Meanwhile, the other component of price, valuations on stocks (as measured by trailing 12-month profits), ended the third quarter at a historically high price-to-earnings ratio of 20.7x2. This suggests there is not much room for disappointment in the minds of investors about the likelihood for profits to resume solid growth in 2024.
For their part, fixed income markets have produced decent returns this year in the face of rising interest rates, in our opinion. Interest rate increases, after all, do have the virtue of being somewhat self-correcting. Higher interest rates, even if they cause a markdown in the value of existing bonds, provide the opportunity to buy new investments at more attractive levels. Such a statement should be qualified, however. In the case of U.S. interest rates, a more accurate description might be “merely less attractive.” While interest rates are much higher than they have been in the last 15 years, most of the yield curve is still not providing returns that exceed inflation. Securities with less than two-year maturities are the exception.
Can the Fed Stick the Soft Landing?
In sum, the most optimistic view of the economy as expressed by bullish forecasters is that of a “soft landing” with economic growth just slow enough to not stoke renewed inflation fears. Soft landing levels of growth do not likely allow for expansion of corporate profit margins, a characteristic of the economy over the last 20+ years. While this does not seem to faze the stock market at the moment, it’s unlikely it will go unnoticed indefinitely. In our view, if the economy grows at a sedate pace without inflationary pressures building, profits are not likely to grow sufficiently fast enough to generate earnings growth strong enough to support current valuations and leave upside into next year. Conversely, if economic growth is sufficiently high, interest rates are at risk of going higher, putting even more pressure on valuations.
The AI Buzz: Separating Hype from Reality
There is only one way such a circle can be squared: an improvement in productivity strong enough that it can permit robust growth to take place without increasing inflationary pressures. And here we have the fourth theme to broadly sweep the stock market in 2023: the virtues of artificial intelligence. AI, as its boosters will proclaim, may be such an incredible force that it will enhance business prospects in ways we can only imagine. It is so powerful it may need to be strictly regulated, lest it actually be harmful to mankind (think of James Cameron’s “The Terminator” movie series that began in the 1980s).
This may be a decidedly contrarian point of view on our part, but the AI buzz seems reminiscent of the dot.com bubble of the late 1990s. As you may recall, the early and mid-90s saw the introduction of Microsoft’s Windows software and the explosion of the Internet. As people began to consider how the Internet could alter the way people led their lives, the possibilities started to seem endless. As some winners began to appear, a strong belief developed that any venture connected to the new worldwide web was a sure-fire success, guaranteed to coin profits. Internet stocks became market darlings for which no valuation was too high. Some of us can recall analysts wanting to measure the progress of some companies by “clicks per eyeball”, or how many customers would go to a company’s website. Shares of any number of new companies were brought to the market and immediately went to large premiums, creating a buzz of excitement and a “can’t miss” belief.
The reality was nowhere near as gratifying. Most of the business models that looked so robust in the glow of a hot stock market were decidedly pale when the hubbub faded. Many of these companies went bankrupt. Many of those with some aspect of their business that made sense were absorbed by companies with stronger balance sheets and management. To be clear, the Internet has proven to be everything it was thought to be…and more. After all, iPhones were but a gleam in Steve Job’s eyes in 1999. That is the point to be made: we believe AI will be a big deal, probably a very big deal not just in the stock market but in our economy and in all aspects of life. But we believe it will achieve this degree of significance not in the short term, such as 2024 or 2025, but over time, in the next decade. Along the way, who will benefit from AI and who will falter—and what companies’ stocks will benefit the most—simply cannot be known, but history suggests the big winners will be far less numerous than the would-be’s.
The Current State of Affairs
If there is no magic bullet to drive the stock market higher, what are we to make of the current state of affairs? In short, the solution is time, and the remedy is patience. The global economy continues to suffer from two long-term issues. First, efforts by the global central banks to address the problems of the Great Financial Crisis of 2009—by cutting and holding interest rates at zero—did not lead to a strong recovery but it did leave behind huge levels of debt3. Zero interest rates also produced great excesses in valuation in the financial markets. Second, the COVID pandemic, among many things, exacerbated the fracturing of the carefully constructed logistical arrangements built when China re-entered the global economy in the late ‘90s. It will take time and effort for the new trading blocs that will emerge to shake down and function as efficiently as possible. In short, moderation in expectations may be the theme of the day in our stock and bond markets. Unless, of course, the power of AI is not merely real but highly fast-acting.
As of September 30, 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.
3Just before third quarter-end, the Institute of International Finance published a report showing that global debt (government and sovereign, corporate, and household) rose to a new record in the first half of 2023, reaching $307 trillion, which represents 336% of global GDP. These figures are all the more significant because the prior peaks were achieved in a period in which interest rates were still near zero (and even negative for European sovereign debt) and servicing costs were correspondingly less onerous than now. “Global debt pile hits record high of $307Tn,” www.ft.com, 9/20/23.
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