Good morning. I hope everyone enjoyed an extended Christmas weekend. The few investors who resumed trading yesterday were generally in a good mood and pushed stocks once again to record highs.
2023 has been a surprisingly good year for stocks. I say surprisingly because if you turned the clocks back a year and looked into the crystal ball at that time, you would have seen harbingers of recession and steadily climbing interest rates. While short-term rates did continue to climb into mid-summer, the economy continued to grow at a pace not dissimilar to historic norms, somewhere close to 2% in real terms. Unemployment stayed well below 4% all year while long-term inflation expectations remained anchored a bit north of 2%. As a result, the yield on long-term bonds finished the year about where it started, near 3.9% according to 10-year Treasuries. What was unseen in that crystal ball was a consumer still willing to spend without fear of recession and a seemingly insatiable appetite to enjoy services deprived during the pandemic. Covid fears were already receding a year ago. Today, they are almost non-existent except for the elderly and those with co-morbidity conditions.
We enter 2024 next week. No one really cares this week. The only news of economic note is that Christmas season was OK, not great, but certainly not one that presaged a recession. In the minds of investors today, the risk of recession in 2024 remains, but the odds are a bit more diminished than they were just a few weeks ago.
But next week 2024 will matter. For hedge funds, next week starts the calendar all over. They will be quick to adjust or alter bets in anticipation of where they expect markets to be a year from now. The rally that began at the start of November has ignited investor aggressiveness. The rally has been sustained by some fearing being left out. It also has been sustained by deferred tax selling by individuals who want to defer realized gains into the 2024 tax year, and by corporations actively buying back their own stock. Corporate buybacks are now effectively shut down until after 2023 earnings are reported.
Looking ahead, here are some points to focus on.
1. The Fed is finished raising rates. The question is when will it start cutting? Whether it be March or June, short-term rates will be meaningfully lower by the end of 2024 but still above historic norms, recession or no recession.
2. Long-term rates will reflect a combination of inflation and growth expectations. It’s virtually certain that inflation expectations will continue declining, save from some extraordinary event such as an oil embargo that meaningfully affects the economic course. At the same time, growth in 2024 is likely to moderate from a surprisingly robust 2023. That doesn’t mean recession. But slower growth and less inflation probably means 10-year Treasury yields work lower before any move higher. With that said, I wouldn’t be surprised if the 10-year Treasury ended 2024 near where it is today. Any early year pessimism should be replaced by rising economic optimism next year.
3. Profits will be the key determinant of stock prices. On the plus side, AI will start to become more reality than hype. Simply said, AI is a game changer. It will enhance both productivity and the consumer experience. With that said, the hype is overdone. It always is when new transformative technology emerges. Think back to the advent of the PC. Thousands of companies dove into the fray. Most quickly drowned. But the PC was clearly transformative and fed an exciting economic era from 1980 until the Internet bubble (more hype) burst in 2000. AI will create clear winners. But it also will be expensive, requiring huge amounts of both computing power and electricity to flourish. Away from AI, however, declining growth rates and slower inflation mean corporate top line growth will moderate putting pressure on profit margins.
4. Employment is a lagging economic indication. The aforementioned pressure on profit margins will lead to a large increase in hiring freezes and, yes, some layoffs. A softening labor market will increase consumer restraint. Whether that leads to a modest recession or not is unclear. But it doesn’t change the fact that companies will have to work harder to maintain their 2023 revenue growth pace.
5. Of course, 2024 is an election year. What we know is that, at least at the moment, a rematch of the Biden-Trump contest of 2024 is most likely. Politics can change quickly. What we can say is that both candidates are well known to voters. While both have the habit of saying the wrong thing at the wrong time, voters over the next 11 months are not likely to learn anything substantively new about either, barring changes in the health of either one. The election will be persistent front-page news but won’t impact the stock market until very close to election day when voters will be more focused on the makeup of Congress than who sits in the White House. For 2025 and beyond, gridlock is good for investors.
6. China is a mess. Centralized economic policy is trying to put a round peg into a square hole. It can’t override declining population, a slow exit of its elite class, and too much debt. Consumers are increasingly nervous and don’t want to spend. If there is a way out, it isn’t apparent. China is the world’s second largest economy. For the past decade it has grown at a high single digit rate. By the end of this decade, it may not be growing at all.
7. Back home, it is unlikely that our politics will fix much of anything. It won’t be for a lack of trying. Biden will try to stop the pain association with the resumption of student loan repayments. His efforts to have everything made in the U.S. by union labor keeps running into obstacles. Nowhere is that more apparent than in the EV industry where his advertised tax credits are often illusions because cars can’t be made with 100% U.S. components, materials and labor, while the charging infrastructure lags far behind what is needed.
Add all the above together, and I see a year that probably doesn’t live up to the hype of the past two months. We might avoid recession but optimism about profit growth shouldn’t be supported until later in the year. If profits are to surge, that isn’t likely for several more months, not when both GDP and inflation are declining. Said another way, maybe the rally of the last eight weeks was too much too soon. That suggests the October lows will hold, but some correction in the first half of 2024 is likely.
Whatever the first half brings, the second half should bring clearer skies and more optimism. Whether you are a Trump or Biden fan, the first year of both their Presidential terms were positive in the stock market. Neither is likely to start a new term throwing a bucket of cold water on the economy. Thus, 2024 can see record highs but the second half of the year will likely be better than the first half.
2023 was clearly the year of the consumer, a year when consumer experiences dominated. Whether it was a Taylor Swift concert or a trip around the world, 2024 was a year to do what you couldn’t do during and shortly after the Covid pandemic. While another Taylor Swift world tour would surely sell out again, that vacation of a lifetime can be translated to mean been there, done that. Job security won’t be quite as strong next year. The campaign season will be an ugly one. Increasing acrimony could have unforeseen consequences. On both sides of the political aisle, those at the extremes overreach and make the most noise. Bitterness evolves and it evolves in unforeseen ways. Look to college campuses today for evidence.
The bottom line is not to expect a repeat performance of 2023 in 2024. It’s much easier to outperform when starting with a pessimistic bias. Right now, there is a clear and rising sense of optimism. Animal spirits have been ignited. Nowhere better to measure animal spirits than to look at the price of bitcoin which has more than doubled this year. I have no idea where bitcoin is headed. To me, its price is simply a measure of optimism or pessimism. While markets may be restrained in early 2024, that doesn’t mean all stocks must suffer. A flattish economy for all doesn’t mean flat prospects individually. Companies flourish in part because of an economic tailwind but more due to actions of their own managements. An investor’s task is to search for those who control their own destiny.
Today, actress Tovah Feldshuh turns 75.
James M. Meyer, CFA 610-260-2220