The markets have rejoiced at the prospects of lower interest rates. As the markets continued to shake off Q2’s expectations that rates would stay “higher for longer,” the mood in Q4 once again looked to the arrival of the Fed lowering interest rates and a loosening of monetary conditions. Investors drove up bond prices, sending yields lower. Equity investors embraced this hope, bidding stocks up in general, and the S&P 500 specifically by a staggering 15% since the end of Q3. On December 13th, the Federal Reserve added fuel to the fire, projecting three rate cuts (actually 0.75% in total) in 2024. Since that date, the S&P has rallied 5%, reaching all-time highs. As we have seen in the past, this euphoria is predicated on the Fed and the market delivering on lower interest rates and doing so soon. But as we have cautioned in the past, this celebration is potentially premature. With the markets pricing in economic gains from a more accommodative interest rate environment, valuations have once again swelled to nearly 19 times the forward 12 months’ expected earnings. Though that’s not near the peak, it is about 120% of the long-term norm. But if the markets don’t get the rate cuts that they are hoping for, they may throw a tantrum like they did in Q2 of last year. As one will see in our comments, we see plenty of reasons for potential disappointment ahead.
How the Markets Fared
As mentioned above, with the expectation that the Fed had ended its trend of raising rates and that declines in short-term lending rates were drawing near on the horizon, the intermediate and longer end of the bond market responded with big declines in yields. The 10-year Treasury saw yields decline from 4.57% at the end of Q3 down to 3.87% at the close of 2023. This decline was even more dramatic from the intra-quarter high of just under 5% reached in mid-October. These declines in yields across the curve helped drive gains of 2% to 3% in most ends of the global bond markets for the quarter, wiping out losses for 2023 for all but longer-dated maturities. The high yield bond market was the brightest spot for Q4 and for 2023 as a whole, with gains of over 9% for the year. High coupons and the decline in expectations for an upcoming recession helped this credit-sensitive end of the bond market post equity-like returns.
Stocks saw gains across most indices during Q4. Once again, returns were dominated by the surge in stock prices and related earnings multiples of a select few large cap growth stocks. This helped propel the large growth and broader S&P 500 indices far ahead of the broader market. This phenomenon deserves note, as the top 10 stocks in the S&P 500 gained an average of 62% in value in 2023, while the remaining 490 stocks averaged just an 8% return. The weight of these top ten stocks was a staggering 32% of the index while they provided 23% of the earnings. 23% from just ten stocks is impressive; but, compared to their returns and their weighting in the index, one can see there was still a disconnect of proportionality. Broader U.S. companies still managed modest single-digit returns for the quarter and for the calendar year 2023.
Internationally, the story was a bit reversed. Large-cap equities in developed international markets saw slightly stronger gains for the year in the more cyclically sensitive value indices than in growth stocks, though growth did outpace value in Q4. Smaller international companies lagged as they did here in the U.S. but still posted marginal gains for the quarter and the year. The same was true for emerging market equities (EM) in general. However, there was one stand-out in the EM, and that was Latin American stocks. Latin American equities outpaced the S&P 500 for the year and for the final quarter of 2023. Latin American equities’ performance was somewhat surprising, as the fortune of those stocks and their underlying economies oftentimes trade in relation to commodity prices due to their high reliance on natural resource exports. With commodities seeing modest declines for both Q4 and 2023 as a whole, one would not have expected this region to rally as hard as it did.
Getting to Work
Let’s get right to it. The Fed isn’t getting what it’s looking for out of the labor market. Despite the Fed catapulting short-term interest rates from near zero to over 5% in just 15 months, the U.S. labor market remains as tight as a drum. The unemployment rate for January stayed parked at 3.7%, still well into over-employment conditions. Non-farm payrolls grew at an average of 289,000 for the trailing three months, showing no signs of slowing down. Importantly, unfilled jobs in America swelled back above nine million, according to the latest JOLTS report from the Bureau of Labor Statistics. Despite being well off the high of nearly 12 million, these unfilled jobs are still 20% higher than the pre-COVID highs, and tight labor conditions are creating upward pressure on wages that shows no signs of abating. Average hourly earnings for January rose 4.5% over the last year versus 4.3% for the 12 months ending in December. Like the JOLTS report, these numbers are getting worse from the Fed’s perspective, not better. The Fed wants to see these numbers growing at a pace that is less than half the current rate. Until unfilled jobs in the JOLTS report come down below five to six million, we just don’t see that happening.
Building Buildings
Prices for existing homes continued to increase, up 4.4% year-over-year. Though the pace of sales is still down six percent year-over- year, low inventory continues to provide support for prices despite high borrowing costs. The inventory of available homes remains extremely low at just a 3.2-month supply, even after factoring in the currently muted sales pace. Supply sank to a six-month low and remains at about half the typical inventory during a normal, balanced market (about six months’ supply). Though still hampered by mortgage rates that are double what they were two years ago, the market likely has benefited a bit recently from borrowing costs declining over one full percentage point from their peaks just six months ago.
What Goes Up, Must… Might Come Down
Consumer prices continue to edge closer to the Fed’s stated target rate of 2% inflation but still have a long way to go. Core CPI (consumer inflation less food and energy costs) was up 3.9% year-over-year versus 4.0% in November. That’s still double the Fed’s target. Total CPI in December (including food and energy) was closer to the 2% Fed target at 3.4% year-over-year but headed in the wrong direction, re-accelerating from November’s reading of 3.1%.
Besides the wage inflation discussed earlier, the other major factor keeping inflation higher than desired is the increasing cost of housing. The shelter index component of CPI was up 0.5% month-over-month for December and 6.2% year-over-year. Ironically, the higher interest rates engineered by the Fed to fight inflation have delayed the pace and driven up the cost of new construction, exacerbating the housing shortage and thus contributing to shelter inflation (the exact opposite impact desired by the Fed).
Inflation at the wholesale level, considered one leading indicator for future consumer costs, has been benign for nearly a year. Year- over-year, the PPI index was up just 1.0%, and the PPI index for final demand less volatile food and energy inputs was up just under 1.8%. However, these wholesale costs have not yet worked their way into consumer prices. One reason may be that the important Services component of PPI is still showing support for higher consumer prices. In fact, they may be re-accelerating as well. The December PPI Services index was up 3.4% year-over-year, accelerating from 3.0% in November. Obviously, services are significantly impacted by a tight labor market and its related rising wages, so this trend is understandable. Nonetheless, it represents an impediment to overall inflation continuing to decline to the Fed’s 2% target overall.
Consume Boom?
The Consumer Confidence Index from the Conference Board jumped to 114.8 in January from 108.0 in December. This was led by a massive spike in the Present Situation Index, rising from 147.2 in December to 161.3 in January. Similarly, the University of Michigan Consumers Sentiment Index popped up to 79.0 in January from 69.7 for December. In the latter report, respondents’ feelings about their present situations as well as future expectations both jumped about 10 points in the survey. This is likely bolstered by the continued strength in the jobs market, moderating inflation, and the recent stock market rally.
What is interesting is that the survey respondents of the University of Michigan report said that they expect inflation for the coming year as well as the next five years to moderate to just 2.9%. However, the Conference Board data showed that consumers in its survey still expect inflation for the coming 12 months to increase by 5.2%. If the latter survey results prove to be right, this is one area ripe for disappointment for both consumers and investors alike.
This rather robust consumer sentiment is supported by actual spending behavior. Retail sales for December ended up with an upside surprise from earlier expectations, jumping 0.6% for the holiday-themed month. That was good for a strong 5.6% year-over-year gain. This is likely spurred on by a 4.2% year-over-year increase in real disposable personal income. Many have speculated that this spending was due to households overextending on credit. Though credit use has increased off of the stimulus-influenced lows over the last two years, most households are still in very good shape fiscally with debt service ratios still below pre-COVID lows. This is remarkable, as it factors in the impact of much higher debt financing rates than we saw in the years prior to the pandemic.
There’s No Business Like Slow Business
As seen above, the major inputs affecting consumers, who are responsible for over two-thirds of U.S. GDP, have generally all been positive. Real GDP increased at an annual rate of 3.3% in the fourth quarter. This was driven by personal consumption expenditure growth of 2.8% in Q4 after increasing 3.1% in the third quarter. This contributed 1.9% to Q4’s 3.3% increase in GDP.
But the other third of the U.S. economy is driven by business-to-business activity. Despite the stock market forecasting record earnings for the coming year, business sentiment surveys paint a different picture for U.S. businesses than we see for consumers. The Institute of Supply Management® report on business (the ISM ROB®) for the manufacturing side of the economy rose to 49.1% in January, up from 47.1% in December, but is still below the key 50% mark that indicates expansion. The increase to its highest level in nearly two years was driven by a jump in the New Orders Index to 52.5% from 47.0% last month, a positive future indicator. However, we saw the exact opposite action in the ISM Non-Manufacturing Index® covering the service sectors that represent nearly two-thirds of U.S. business input to GDP. The services survey declined to 50.6% from 52.7% in November due to a pullback in new orders. When looked at together, the ISM data suggests an anemic economy from a business-to-business standpoint for the coming year.
PIERing Ahead
Yes, it’s an election year. And yes, it is very likely that the Fed is going to lower interest rates at some point. However, we remind you that the Fed was incredibly slow to lift rates off from zero two years ago despite a strong economy and skyrocketing inflation. Even once the Fed began telegraphing the move in January of 2022, it was timid in starting, and when it eventually did in March of that year, it only raised rates by a quarter of a point. This is the same Fed. Unless there are clear signs that inflation, and specifically wage inflation, has been ultimately tamed, there is a very real chance that the Fed will act slower and with less conviction than the street is forecasting.
The headline from its official December 13th statement was that the Fed was going to cut three times in 2024. But that soundbite was deduced from the median of the 19 Fed Governors and Reserve Bank Presidents’ projections at that time. However, if one looks at the data that this headline was taken from (see chart right), one will see that the median was for a 75 basis point cut, yet there were eight of the 19 participants (42%) that projected less than 75 basis points, and only five projected more, with just six suggesting that 75 basis points would be the right number. In fact, three governors estimated no or just one 25 basis point cut! The 75 basis points in cuts (which the headlines from the press turned into three, assumed to be 25 basis point decreases) were only two votes of the 19 away from being a “two cuts” (or 50 basis points) headline instead of three. Hardly a certainty to base a 15% stock market rally on.
Cracks in this often repeated “three cuts” conjecture have already appeared. In the Fed’s recent comments after its latest FOMC meeting (where it held the discount rate at 5.25%-5.5%), it was stated that the “committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2%.” That could very well be interpreted to mean that the data needs to move further in the direction of lower inflation. But as we mentioned earlier, wage growth and the Services component of PPI show that those key measures of inflation are actually accelerating! Further eroding the three-cuts myth were comments from Fed Chairman Powell following the recent Fed decision, where he said:
“[I]nflation is still too high; ongoing progress in bringing it down is not assured, and the path forward is uncertain.”
– Federal Reserve Chairman Jerome Powell, January 31, 2024*
One might wonder where Mr. Powell’s personal estimate fell in that December 13th poll of expectations. Was he in the “three cuts” or more camp? Or perhaps he was more hawkish than the oft-echoed headlines suggested?
What is certain is that three cuts in 2024 is anything but certain. However, the stock market and, to a lesser extent, the bond market have fully priced these cuts in. If they don’t materialize in the magnitude or timeline that pundits and investors expect, what will happen to the recent market rally? What if inflation doesn’t abate, giving the Fed the “greater confidence” that it says it needs to begin lowering rates? Even worse, what if the tight labor markets and disruption to global shipping (discussed in our Fall 2023 commentary) worsen, reigniting inflation? Markets are completely ignoring these very real possibilities. Sure, the odds are that inflation will abate and that rates will eventually head lower. But those odds may be closer to the 11-of-18 ratio from the Fed survey than the near 100% that the press would have investors believe. Our pierspective on the situation is that we are far from being out of the woods and might be setting ourselves up for a major disappointment.
*Quote Source: Excerpt from actual Fed 12/13/23 statement (annotations added)
Winter 2023/2024 Market and Economic Commentary
The markets have rejoiced at the prospects of lower interest rates. As the markets continued to shake off Q2’s expectations that rates would stay “higher for longer,” the mood in Q4 once again looked to the arrival of the Fed lowering interest rates and a loosening of monetary conditions. Investors drove up bond prices, sending yields lower. Equity investors embraced this hope, bidding stocks up in general, and the S&P 500 specifically by a staggering 15% since the end of Q3. On December 13th, the Federal Reserve added fuel to the fire, projecting three rate cuts (actually 0.75% in total) in 2024. Since that date, the S&P has rallied 5%, reaching all-time highs. As we have seen in the past, this euphoria is predicated on the Fed and the market delivering on lower interest rates and doing so soon. But as we have cautioned in the past, this celebration is potentially premature. With the markets pricing in economic gains from a more accommodative interest rate environment, valuations have once again swelled to nearly 19 times the forward 12 months’ expected earnings. Though that’s not near the peak, it is about 120% of the long-term norm. But if the markets don’t get the rate cuts that they are hoping for, they may throw a tantrum like they did in Q2 of last year. As one will see in our comments, we see plenty of reasons for potential disappointment ahead.
How the Markets Fared
As mentioned above, with the expectation that the Fed had ended its trend of raising rates and that declines in short-term lending rates were drawing near on the horizon, the intermediate and longer end of the bond market responded with big declines in yields. The 10-year Treasury saw yields decline from 4.57% at the end of Q3 down to 3.87% at the close of 2023. This decline was even more dramatic from the intra-quarter high of just under 5% reached in mid-October. These declines in yields across the curve helped drive gains of 2% to 3% in most ends of the global bond markets for the quarter, wiping out losses for 2023 for all but longer-dated maturities. The high yield bond market was the brightest spot for Q4 and for 2023 as a whole, with gains of over 9% for the year. High coupons and the decline in expectations for an upcoming recession helped this credit-sensitive end of the bond market post equity-like returns.
Stocks saw gains across most indices during Q4. Once again, returns were dominated by the surge in stock prices and related earnings multiples of a select few large cap growth stocks. This helped propel the large growth and broader S&P 500 indices far ahead of the broader market. This phenomenon deserves note, as the top 10 stocks in the S&P 500 gained an average of 62% in value in 2023, while the remaining 490 stocks averaged just an 8% return. The weight of these top ten stocks was a staggering 32% of the index while they provided 23% of the earnings. 23% from just ten stocks is impressive; but, compared to their returns and their weighting in the index, one can see there was still a disconnect of proportionality. Broader U.S. companies still managed modest single-digit returns for the quarter and for the calendar year 2023.
Internationally, the story was a bit reversed. Large-cap equities in developed international markets saw slightly stronger gains for the year in the more cyclically sensitive value indices than in growth stocks, though growth did outpace value in Q4. Smaller international companies lagged as they did here in the U.S. but still posted marginal gains for the quarter and the year. The same was true for emerging market equities (EM) in general. However, there was one stand-out in the EM, and that was Latin American stocks. Latin American equities outpaced the S&P 500 for the year and for the final quarter of 2023. Latin American equities’ performance was somewhat surprising, as the fortune of those stocks and their underlying economies oftentimes trade in relation to commodity prices due to their high reliance on natural resource exports. With commodities seeing modest declines for both Q4 and 2023 as a whole, one would not have expected this region to rally as hard as it did.
Getting to Work
Let’s get right to it. The Fed isn’t getting what it’s looking for out of the labor market. Despite the Fed catapulting short-term interest rates from near zero to over 5% in just 15 months, the U.S. labor market remains as tight as a drum. The unemployment rate for January stayed parked at 3.7%, still well into over-employment conditions. Non-farm payrolls grew at an average of 289,000 for the trailing three months, showing no signs of slowing down. Importantly, unfilled jobs in America swelled back above nine million, according to the latest JOLTS report from the Bureau of Labor Statistics. Despite being well off the high of nearly 12 million, these unfilled jobs are still 20% higher than the pre-COVID highs, and tight labor conditions are creating upward pressure on wages that shows no signs of abating. Average hourly earnings for January rose 4.5% over the last year versus 4.3% for the 12 months ending in December. Like the JOLTS report, these numbers are getting worse from the Fed’s perspective, not better. The Fed wants to see these numbers growing at a pace that is less than half the current rate. Until unfilled jobs in the JOLTS report come down below five to six million, we just don’t see that happening.
Building Buildings
Prices for existing homes continued to increase, up 4.4% year-over-year. Though the pace of sales is still down six percent year-over- year, low inventory continues to provide support for prices despite high borrowing costs. The inventory of available homes remains extremely low at just a 3.2-month supply, even after factoring in the currently muted sales pace. Supply sank to a six-month low and remains at about half the typical inventory during a normal, balanced market (about six months’ supply). Though still hampered by mortgage rates that are double what they were two years ago, the market likely has benefited a bit recently from borrowing costs declining over one full percentage point from their peaks just six months ago.
What Goes Up, Must… Might Come Down
Consumer prices continue to edge closer to the Fed’s stated target rate of 2% inflation but still have a long way to go. Core CPI (consumer inflation less food and energy costs) was up 3.9% year-over-year versus 4.0% in November. That’s still double the Fed’s target. Total CPI in December (including food and energy) was closer to the 2% Fed target at 3.4% year-over-year but headed in the wrong direction, re-accelerating from November’s reading of 3.1%.
Besides the wage inflation discussed earlier, the other major factor keeping inflation higher than desired is the increasing cost of housing. The shelter index component of CPI was up 0.5% month-over-month for December and 6.2% year-over-year. Ironically, the higher interest rates engineered by the Fed to fight inflation have delayed the pace and driven up the cost of new construction, exacerbating the housing shortage and thus contributing to shelter inflation (the exact opposite impact desired by the Fed).
Consume Boom?
The Consumer Confidence Index from the Conference Board jumped to 114.8 in January from 108.0 in December. This was led by a massive spike in the Present Situation Index, rising from 147.2 in December to 161.3 in January. Similarly, the University of Michigan Consumers Sentiment Index popped up to 79.0 in January from 69.7 for December. In the latter report, respondents’ feelings about their present situations as well as future expectations both jumped about 10 points in the survey. This is likely bolstered by the continued strength in the jobs market, moderating inflation, and the recent stock market rally.
What is interesting is that the survey respondents of the University of Michigan report said that they expect inflation for the coming year as well as the next five years to moderate to just 2.9%. However, the Conference Board data showed that consumers in its survey still expect inflation for the coming 12 months to increase by 5.2%. If the latter survey results prove to be right, this is one area ripe for disappointment for both consumers and investors alike.
This rather robust consumer sentiment is supported by actual spending behavior. Retail sales for December ended up with an upside surprise from earlier expectations, jumping 0.6% for the holiday-themed month. That was good for a strong 5.6% year-over-year gain. This is likely spurred on by a 4.2% year-over-year increase in real disposable personal income. Many have speculated that this spending was due to households overextending on credit. Though credit use has increased off of the stimulus-influenced lows over the last two years, most households are still in very good shape fiscally with debt service ratios still below pre-COVID lows. This is remarkable, as it factors in the impact of much higher debt financing rates than we saw in the years prior to the pandemic.
There’s No Business Like Slow Business
As seen above, the major inputs affecting consumers, who are responsible for over two-thirds of U.S. GDP, have generally all been positive. Real GDP increased at an annual rate of 3.3% in the fourth quarter. This was driven by personal consumption expenditure growth of 2.8% in Q4 after increasing 3.1% in the third quarter. This contributed 1.9% to Q4’s 3.3% increase in GDP.
But the other third of the U.S. economy is driven by business-to-business activity. Despite the stock market forecasting record earnings for the coming year, business sentiment surveys paint a different picture for U.S. businesses than we see for consumers. The Institute of Supply Management® report on business (the ISM ROB®) for the manufacturing side of the economy rose to 49.1% in January, up from 47.1% in December, but is still below the key 50% mark that indicates expansion. The increase to its highest level in nearly two years was driven by a jump in the New Orders Index to 52.5% from 47.0% last month, a positive future indicator. However, we saw the exact opposite action in the ISM Non-Manufacturing Index® covering the service sectors that represent nearly two-thirds of U.S. business input to GDP. The services survey declined to 50.6% from 52.7% in November due to a pullback in new orders. When looked at together, the ISM data suggests an anemic economy from a business-to-business standpoint for the coming year.
PIERing Ahead
Yes, it’s an election year. And yes, it is very likely that the Fed is going to lower interest rates at some point. However, we remind you that the Fed was incredibly slow to lift rates off from zero two years ago despite a strong economy and skyrocketing inflation. Even once the Fed began telegraphing the move in January of 2022, it was timid in starting, and when it eventually did in March of that year, it only raised rates by a quarter of a point. This is the same Fed. Unless there are clear signs that inflation, and specifically wage inflation, has been ultimately tamed, there is a very real chance that the Fed will act slower and with less conviction than the street is forecasting.
Cracks in this often repeated “three cuts” conjecture have already appeared. In the Fed’s recent comments after its latest FOMC meeting (where it held the discount rate at 5.25%-5.5%), it was stated that the “committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2%.” That could very well be interpreted to mean that the data needs to move further in the direction of lower inflation. But as we mentioned earlier, wage growth and the Services component of PPI show that those key measures of inflation are actually accelerating! Further eroding the three-cuts myth were comments from Fed Chairman Powell following the recent Fed decision, where he said:
“[I]nflation is still too high; ongoing progress in bringing it down is not assured, and the path forward is uncertain.”
– Federal Reserve Chairman Jerome Powell, January 31, 2024*
One might wonder where Mr. Powell’s personal estimate fell in that December 13th poll of expectations. Was he in the “three cuts” or more camp? Or perhaps he was more hawkish than the oft-echoed headlines suggested?
What is certain is that three cuts in 2024 is anything but certain. However, the stock market and, to a lesser extent, the bond market have fully priced these cuts in. If they don’t materialize in the magnitude or timeline that pundits and investors expect, what will happen to the recent market rally? What if inflation doesn’t abate, giving the Fed the “greater confidence” that it says it needs to begin lowering rates? Even worse, what if the tight labor markets and disruption to global shipping (discussed in our Fall 2023 commentary) worsen, reigniting inflation? Markets are completely ignoring these very real possibilities. Sure, the odds are that inflation will abate and that rates will eventually head lower. But those odds may be closer to the 11-of-18 ratio from the Fed survey than the near 100% that the press would have investors believe. Our pierspective on the situation is that we are far from being out of the woods and might be setting ourselves up for a major disappointment.
*Quote Source: Excerpt from actual Fed 12/13/23 statement (annotations added)
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