Vigilare Wealth Management 2023 Q4 Commentary
By Jason@vigilarewealth.com on January 7, 2024 in Investor Lounge
The markets closed out the year with a strong 4th quarter rally. The catalyst was better-than-expected inflation easing, along with U.S. long term government bonds peaking and declining from the elevated 5% levels. The peak in inflation/rates shifted expectations regarding the Federal Reserve (The Fed) having to raise rates further. We anticipated the possibility of a Q4 rally and wrote about it in our last quarterly commentary.
Even with all this gloominess there is the potential for a strong 4th quarter year-end rally. There is a seasonal tendency for the market to finish the year strong. Even in the depths of the financial crisis (right after Lehman Brothers failure) the market staged a 20% rally to end the 2008 year. We would not be surprised to see a tailwind of seasonality and have stock markets finish strong and even possibly surpass all-time highs. A Fed pause and a short-term rebound in earnings could be the catalyst. (Remember markets like Fed pauses but fear Fed pivots). This would not change the longer-term outlook of a slowdown, just simply part of the ebbs and flows of stock markets.
This volatility has created some favorable rebalancing opportunities both in stocks and bonds, but a larger question still looms… Where’s the Recession? Or is it a Soft Landing? Our upcoming market outlook for 2024 is titled, ‘New Bull Market or Double Top?’ It’s easy to forget that despite a strong showing in the equity markets in 2023, markets are still slightly lower over the last two years.
The U.S. economy and markets have proven more resilient than most anticipated. The massive government fiscal spending has been winning the economic tug-of-war against the aggressive monetary tightening by the Fed. This large fiscal spending will continue into 2024. As of the last U.S. Government debt report, the Federal deficit was $510 billion in Q4 of 2023. That would be over $2 trillion, if extrapolated over four quarters, which is even higher than the $1.7 trillion deficit in 2023. Total Federal debt now stands at $34 trillion as of the end of 2023. It is unusual for the deficit spending to be so high in a non-recession environment. This level of aggressive spending (and lower tax revenue) is usually observed in the “response” to an existing recession and not before one. Our view is that this large Federal spending has been the main recent contributor to our resilient economy.
This large government spending along with the anticipation of a Fed pause and pivot in rates has most market pundits predicting a soft-landing scenario (no recession) in 2024. This is a possibility given the level of government spending, however history points to the soft-landing as the exception and not the usual outcome following such a large rate hike cycle. In fact, the last bona fide soft-landing was in 1994/1995 and that rate hike cycle was much gentler. We are open to the possibility of a repeat of 1994/1995 and have scrutinized the types of investments that would benefit from a soft-landing.
Although most strategists are anticipating no recession in 2024, we feel the risks are still elevated. This is despite markets within a whisper of all-time highs. Most leading indicators still point to recession risks that were present throughout 2023. It’s important to remember that before every recession we are technically in a soft-landing, until we aren’t. Looking at post-WWII recessions, markets are usually at or close to highs in the month leading up to a recession (unemployment is usually at lows and GDP positive). We have to be mindful of this because the shifts can be quick. Also the implication to markets is dramatically different than in a soft-landing scenario. Historically in a recession, markets almost always find a bottom during (not before or after) the recession. Clearly the investment playbook is different in this environment, and we also have to be prepared for this outcome.
Expectations are also a very important determinant of future market volatility and returns. A large risk going into 2024 is that market expectations are now for the Fed to cut rates 6 times in the year. To put it another way, if the Fed kept rates where they are today, that would be equivalent to 6 implicit rate hikes. If inflation ends up being more stubborn than anticipated, the Fed would be more reluctant to lower rates, thereby putting unexpected pressure on the financial markets and economy. The Fed needs a “Goldilocks balance” of lowering rates to stimulate the economy, but at the same time not lower rates too much where inflation starts to pick up again. That latter case happened in the 1970s and the track record of market returns and volatility were horrible when there has been inflation flareups and Fed flipflopping.
Adding to our concerns is that S&P valuations are near all-time highs. This means that the market is priced for a very favorable outcome, all things equal. Again, this is possible but any change in expectations means that markets will adjust to the new reality. P/E ratios are not a good market timing tool over the short term, because markets can go from expensive to very expensive from month to month or even from year to year. If you look however, at returns over 5-10 years, the P/E ratio is very predictable of future returns. A “buy and hold” strategy with a 10-year horizon yields radically different results when the starting P/E is 15x versus 20x where it is today (we will post the data that supports this in our 2024 Outlook and Strategy). So, mathematically and historically speaking, this is one of the worst times to have a passive buy and hold strategy over next 5-10-year period, making risk management extremely important today.
In summary, despite this recent economic resilience, we still see significant risks ahead in the U.S. economy. Our base case is a Recession in the not-so-distant future. However, forecasting in this post-pandemic economic environment is a futile endeavor. Most important is to plan and prepare for a multitude of possible outcomes and take the appropriate action to manage risk and seek opportunities.
Thank you for your trust.
The Vigilare Wealth Management Team
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