Investment Insights 

 — Steve Orr 

Mid-month

Winter finally makes its way to the Lone Star State this week. U.S. stocks stayed warm last week, rising anywhere from one-quarter to 1.5%. Foreign burses did not fare as well, pressured by shipping war fears. Through last Friday, however, only the S&P 500 sat in positive territory for the year. A lousy start to the year? Well, yes, and we should expect a correction after strong double-digit runs since Halloween. Corrections can happen in price, time and sometimes both. We usually request time corrections from Mr. Market but are rarely rewarded. In a time correction, a stock or index will drift sideways in a narrow range, frustrating traders and investors alike. Price corrections are downtrends and make almost everyone unhappy.

The S&P 500 made another run at a new all-time high last Friday, failing for the third time since Christmas. Failures approaching a breakout to new highs do not concern us if market internals are strong. Multiple failures are common as the bulls build strength for an eventual push. Short-term, internals such as breadth and price momentum are lower than two weeks ago, but not concerning. A reminder: Our handy Stock Trader’s Almanac points out that since 1948, the S&P 500 has not finished in the red when a sitting president is up for reelection. More on election years in a moment. 

Changes

Fed members and markets got another reminder last week that the inflation war is not over. December’s Consumer Price Index reported prices rising at a 3.4% annual clip. CPI bottomed last June at 3% and had peaked at 9% in June 2022. December’s reading marks the seventh month of 3% or more readings. Despite lower gas prices, food, cars and services, prices continue to drift higher. A brief sample of prices over the past three years — CPI indices for new cars: 19.6%, food away from home: 20.8%, electricity: 25.8%, wages: only 14.5% (union and minimum wage impacts). You get the idea; those are statistics. We would wager that what we see at the supermarket and restaurants are even higher. Remember inflation at 3.4% means prices are continuing to rise, just at a slower pace than two years ago.

The Fed says it remains committed to bringing inflation down. There have only been a handful of times in history when the Fed has cut interest rates when CPI inflation has been above the unemployment rate. Core and “super core” (basically just services) are still above the Household Unemployment rate of 3.7%. Those times were either major wars or the stagflation period of the 1970s. FOMC members seem to think they have inflation on the run. Their median forecast is for short-term rates to end 2024 three-quarters of a percent below today’s range of 5.25% to 5.5%.

The Fed does watch a number of indicators and surveys. Supposedly this cycle, they are watching rents and housing costs closely. CPI “Owners Equivalent Rent” is the (say it fast five times) main series for these prices. The government surveys apartment and housing prices on a rolling six-month cycle, so this series is one of the least responsive or lagging data points in the CPI. Key here is that this series’ rate of change peaked in May of last year and is falling month-over-month. We admit that on a year-over-year basis, inflation could dip below 3% this year. If inflation were to stay below 3%, we believe the economy would be slipping into recession. A bounce higher would most likely come from overseas events, a la OPEC in the 1970s or a new version of the 1980s Tanker War in the Red Sea. One item to note: Hafnia, Torm and Stena Bulk confirmed that they halted traffic toward the Red Sea last week. They are some of the largest petroleum tanker operators.

Outlook

As a general rule, we confine our forecasts to sporting event scores. Forecasting requires hair, a suit and a weather map. We have suits. We do spend a good deal of time worrying over the roadmap for economies, markets and geopolitical events. Public and private markets require earnings and rule of law. Earnings are necessary to justify prices being paid for an asset. The rule of law supports ownership and control of assets.

Economic growth drives company earnings. Nominal growth (which includes inflation) peaked three years ago at 11%. 2022’s growth stepped down to 9%, and 2023 will likely finish around 6%. Growth of 5% this year would be a surprise; subtracting 3% inflation means real growth — the number that gets the headlines — would finish 2024 at 2%. Given rolling recessions in housing, manufacturing and now consumer goods, we think 1.5% is more achievable, which puts nominal growth closer to 4.5%. 

Fed again

Wall Street continues to demand five or six rate cuts this year, depending on the day. Of course, they have demanded fewer raises and more cuts since this current rate cycle began. We take the Fed at their word, that several quarter-point reductions will come this year. Wall Street is all over the calendar in timing. Some say March; some say end of the year.

Shifting from raises to cuts is a policy change. History suggests that the Fed rarely, if ever, makes a policy change before an election. If they are going to cut in March or May, there needs to be compelling evidence of further slowing in the economy in our view. In a “real” or nominal interest rate sense, there is no need to cut at the moment. After the election would follow historical precedent. Base case is a Fed Funds rate of 4.5% to 4.75% at the end of the year. The Fed cuts aggressively when recessions or events turn ugly. Think 2020’s pandemic shutdowns. We place a low probability on a 4% level by year-end. A reignition in temporary inflation pressures could also come from overseas; for example, the Red Sea mentioned above. Again, we would place a low probability on Fed Funds approaching 6% — that would be an exciting red-hot economy growing above 3%. 

Rates

Longer term rates are near, well, their very long-term averages. The 10-year Treasury, at about 4% today, is within half a percent of its 200-year average. Two-year Treasury Notes still yield slightly more than their 10-year brethren, making the yield curve inverted. The current inversion is nearing its one-year birthday, an uncommon feat. Our base case is that the curve takes most of 2024 to uninvert, with the two-year Treasury falling while the 10-year Treasury stays close to its current level.

Last year’s run to 5% by the 10-year was driven in part by Secretary Yellen’s reliance on notes and bonds to fund the deficit. In 2024, the Treasury will need to refinance roughly a quarter of the $27 trillion public debt. All of that debt will be refinanced at substantially higher rates than when it was issued in prior years. Net new borrowing is projected to be $1.9 trillion. Someone will need to buy that debt. We think by the middle of this year, the Fed will slow or stop its Quantitative Tightening program. This is the tool where over the past year it has purchased fewer Treasury bonds each month than were maturing from its portfolio. The net result is a consistent run off its Treasury holdings.

Since the program began, the Fed’s balance sheet has fallen from $8.8 trillion to approximately $7.6 trillion. The amount of money in circulation used to be a rough guide for the size of the balance sheet. At around $4.5 trillion, this suggests the Fed has about $3 trillion left to reduce. By buying more Treasury debt later this year, the Fed will “help out” Treasury in its efforts to fund Congressional spending habits. 

Election thoughts

According to the Financial Times, this year, seven of the 10 most populous countries will have national elections. In total, some 40% of the world will have elections. A good portion of these voters are used to Cold War global trade and relative safety. At the beginning of 2023, we counted three major wars. Today we are on the verge of seven: cyber, space, Ukraine, Africa coups, Iran-Israel and possibly Kosovo and Nogorno-Karabakh. We put a pretty low probability on the saber rattling of Venezuela against Guyana.

Here at home, Biden is the candidate for the Democrats and Trump looks to have enough delegates after Super Tuesday in March for the GOP nomination. We usually start paying attention after the conventions. In politics, 11 months is a century. One interesting note we saw suggests that independents continue to be the largest voting bloc in the U.S. In 2023, independents constituted about 43% of U.S. adults.

Our election is important for earnings for two reasons: 1) deficit spending since shutdowns has driven a large part of economic growth. Deficit spending is approaching 7% of GDP, a war-time level when we are not at war. 2) in 2025, a number of Trump-era tax rules expire. Also, tariffs need to be addressed. We note there is a tax “fix” bill floating around D.C. at the moment, but nothing has passed either house at this writing.