Is it Really Time to Pivot?

2023 witnessed a notable drop in inflation as the lagged and variable effects of tighter monetary policy delivered the desired outcome. Despite elevated interest rates, consumers and government spending continued to power the economy along as unemployment remained low, wages grew, and fiscal deficits expanded. While still in its infancy, gains in Artificial Intelligence (AI) likely spurred productivity growth, which mitigated the headwind of a stubbornly low labor participation rate. Yet, as we step into 2024, cracks remain in the economic outlook. The cumulative hangover of prolonged inflation has diminished excess savings and disposable income, leading to declining corporate revenues and stagnant earnings. Notwithstanding, equity and bond markets have rallied, bolstered by the absence of a recession and Central Banks potentially nearing a triumph over inflation. However, geopolitical tensions remain near tipping points and nearly 40% of the world’s economy is preparing to vote to determine their political leadership, setting the stage for an eventful year ahead.

Are We Headed for a Soft Landing?

As inflation has cooled, the prospect of a soft landing has become mainstream. Although recession risks may be waning, historical patterns suggest they often follow seven quarters after the first Federal Reserve (Fed) rate hike, aligning precisely with our current timeline. Despite no recession yet, the possibility remains. The Leading Economic Indicators (LEI) Index approaches a historic landmark: 20 months in a row of recessionary levels. We have never seen levels this low for this long without a recession arriving.

The resiliency of the consumer has been remarkably strong even in the face of considerable headwinds. As we have noted previously in 2023, delinquencies on credit cards and auto loans have steadily risen since last year. More recently, since being reinstated in late 2023, delinquencies on student loans have begun to rise as well. Affordability is of concern for a broad swath of the economy. Home obtainability is the worst on record and core inflation still outpaces headline.  

A recession to this point has largely been avoided because the labor market has defied expectations. Throughout 2023, the Fed steadily dropped their forecast of the unemployment rate from 4.5% to 4.1%. Today, with unemployment at 3.7%, the economy has exceeded those forecasts. However, slight cooling signs are emerging, evidenced by the narrowing gap between job openings and available workers. The gap persists, in part, because labor participation has stalled below trend. While wage growth persists, stubbornly high inflation has suppressed real wages. Alongside this, excess savings and disposable income have diminished, aligning with depressed levels of Consumer Sentiment.  

 Is it a Fed Pivot or Capitulation?

It is though consumers, and market participants alike, are hoping for rate cuts to bail them out. In our view, hope is not a strategy. Markets are currently expecting a total of more than 1% in interest rate cuts during 2024.  History warns us that rapid easing could rekindle inflation. A soft landing is seemingly predicated on looser monetary policy moving forward. The challenge, in our view, is that historically, the avoidance of a recession after a prolonged tightening cycle has not been achieved when lending standards are also tightening.  

At present, banks, particularly regionals who are under tighter regulatory scrutiny following last year’s crisis, are steadily pulling back their willingness to lend. Soft landings (i.e., 1966, 1985, and 1995) unfolded after a Fed tightening cycle coincided with banks easing lending standards. However, after the first two soft landings, inflation reaccelerated, forcing a re-pivot to tightening cycles. This occurred, in large part, because unit labor costs (ULCs) were still too high. Only in the most recent soft landing were ULCs tame, keeping inflation cool, and preventing the Fed from re-tightening.

‍Why are Monetary and Fiscal Policy Out of Sync?

Fiscal policy, traditionally leveraged to stimulate growth during slowdowns, appears misaligned with monetary policy. In today’s era, there seems to be a lack of coordination between Congress and the Fed. As of now, Congressional projections indicate future financial constraints, with entitlement payments and debt interest consuming all Federal revenues by the early 2030s. Market pressures and rating agency downgrades are already prompting a need for substantial fiscal adjustments. To borrow the boiling frog analogy from J.P. Morgan’s 2024 outlook, we’ve become accustomed to deteriorating U.S. government finances with limited consequence for investors, and one day that may change with little notice before it’s too late.

Since the start of the pandemic, the annualized growth rate in the U.S. has been 1.8% and the 4th quarter 2023 growth rate is forecasted to be approximately 1%. The economic growth trajectory, coupled with inflation, higher interest rates, and rising debt, poses a contentious trade-off for Central Banks. If they want to stop inflation resurging, they will likely need to keep policy tighter for longer. We think policy rates are poised to settle well above pre-pandemic norms. Ultimately, we see central banks having to contend with higher inflation amid hefty government spending and debt loads. This sets the stage for a regime of slower growth, higher inflation, and as a result, higher interest rates with greater volatility.

How do Markets React to U.S. Election Years?

In 2024, 40% of the global economy (including the U.S.) is heading to the polls. Election years often see incumbent Presidents stimulating the economy to avoid downturns, historically benefiting stocks. Though it should be noted that historically there is a dip in market performance in the first 3 - 4 months of the election year. Elections introduce uncertainty, leading investors to favor quality and liquidity in their portfolios. However, market analysis reveals that, since 1933, markets have generally fared well under various political scenarios, and often best under divided governments, demonstrating resilience to political shifts. Given the amount of research surrounding financial markets in U.S. election years, we have dedicated a full report in a separate Insights piece.

Why is the Semiconductor Cold War Heating-up?

The U.S.-China semiconductor competition has intensified, particularly following U.S. export controls on AI and semiconductor technologies to China in 2022. Semiconductors are crucial in modern-day warfare, powering a range of equipment including drones, radios, missiles, and armored vehicles. The U.S. Bureau of Industry and Security (BIS) announced the 2022 restrictions, saying that semiconductor chips are used to “produce advanced military systems including weapons of mass destruction.”  Taiwan has been able to distinguish itself as a leading microchip manufacturer and dominate the global marketplace due to its strong capabilities in OEM wafer manufacturing and a complete industry supply chain. Taiwan's prominence in semiconductor manufacturing places it at the center of this tension.

Diplomatic relations are crucial, especially during the Presidential cycle. While markets reacted favorably to Chinese President Xi’s visit to the U.S. late last year, Taiwan’s election on January 13^th will be a critical test of the U.S.-China ceasefire. U.S. policy developments and China's stance on technology imports further complicate the landscape. As for U.S. semiconductor policy, TSMC is building two new fabs in Arizona. The estimated $40 billion cost of TSMC’s U.S. fabs is multiple times higher than the same facilities in Taiwan. Additionally, the U.S. Commerce Secretary is saying more semiconductor and chip rules are forthcoming as China keeps discussing banning Apple products among government officials. National security is trumping economic efficiency. Needless to say, we are skeptical that the current ceasefire can hold in the long run.

Where are the Investment Opportunities in AI?  

‍Semiconductors are just the tip of the iceberg in terms of the role technology will play in influencing the economy. Advances in computing hardware and deep learning innovations have led to an inflection point for AI since late 2022. We may be just at the cusp of this AI revolution and the implications likely go beyond the near-term focus on productivity gains.  From here, improvements are likely to be exponential as innovation compounds. Yet tracking investment opportunities across geographies and sectors comes with high uncertainty. The "technology sandwich" model, comprising infrastructure, data, and applications, offers insights into potential investment areas. Early research suggests a positive correlation between AI advancements and broad earnings growth, indicating the tech sector's continued contribution to corporate profit growth. We see the resilience of the tech sector’s earnings persisting and expect it to be a big driver of overall U.S. corporate profit growth in 2024.

Asset valuations have had a nice run, where do they go from here?  

The challenge for investors heading into 2024: we’re contending with the markets that have already priced in a soft landing which led to a strong equity and bond rally in the latter half of last year. A further look at the fundamentals reveals that overall S&P 500 earnings were flat (they were up 33% for the “Magnificent 7” stocks and down 5% across the rest of the S&P 500). It comes as no surprise that, removing these 7 high-flying stocks reveals that multiples are more in line with long-term averages. Despite the overall run-up in valuations, we remain overweight U.S. equities relative to their international counterparts with a slight preference for smaller capitalization as they present better value.

Given their more cyclical nature, international markets present a significant discount, reflecting a more challenging economic environment outside of the U.S.  This may present an opportunity as Europe emerges from a recession. Going forward, falling inflation is a double-edged sword as nominal corporate revenues will fall in turn. Higher trend ULCs continue to hamper margins. The key to watch as this unfolds is unit volumes as companies try to balance declining revenues and profits.  At present, increasing inventory levels have us concerned.  

More broadly, markets will likely need to re-adjust to structurally higher inflation and policy rates. Markets are at a unique juncture: yields on equities, high grade bonds, T-bills and REITs have converged, which hasn’t happened in 20 years.  If this remains the case, in our opinion, holding some cash still looks like good value on a risk-adjusted basis. Our expectation of more yield volatility keeps us underweight long-term fixed income at the start of the year. As we navigate the complexities of 2024, market trends suggest a year shaped by early indicators, with January's performance potentially signaling the broader trajectory for the upcoming months. Added volatility brings about the importance of a programmatic approach to building a diversified allocation to Alternative Investments. Put together, these tactical allocation tilts intend to give the best posture for navigating a vast range of potential outcomes due to valuations, mixed economic indicators, geopolitical tension, and the uncertainty of lagged effects of monetary policy.  

Conclusion

As we move forward into 2024, the global economic landscape presents a tapestry of interconnected challenges and opportunities. The delicate balancing act of the Federal Reserve, the evolving dynamics of fiscal policies, and the geopolitical shifts all play crucial roles in shaping our economic future. Investors must therefore remain vigilant, adapting to the nuances of market changes while being mindful of longer-term trends. In this environment, informed decision-making becomes paramount, necessitating a keen understanding of the underlying economic drivers. Our commitment is to continue helping you navigate these complex waters with confidence and clarity. Together, we stand prepared to embrace the potential of 2024, turning challenges into opportunities and ready to pivot when the time is right.