Above the Noise: The case for optimism
I recently remarked to an audience of financial professionals that “the pessimists sound smart, but the optimists make money.” The pens came out instantaneously as the audience scribbled the meaningful phrase into their notepads. Even one of my fellow panelists admitted her plan to steal the line from me. She can have it. I stole it from someone else. It’s not a mystery to me why financial professionals would want to remember that line. Investors, in fact Americans in general, are just not feeling optimistic.? In a recent poll, 78% of respondents said the US is heading in the wrong direction(1) while roughly 80% say that the economy is “only fair” or “poor,” and “getting worse.”(2)
Far be it from me to sit in my sandy beige 6-foot by 9-foot office and question the mood of the American public. To update a phrase from the Bill Clinton era: It’s prices, stupid. I understand. If eggs had cost you $1.25/dozen on the eve of the pandemic and $2.06/dozen now, you’re probably feeling worse off, irrespective of the fact that egg prices have fallen by nearly 60% since earlier this year.(3) You may think that only egg-head strategists like me care about the year-over-year percent change or the three-month moving average of egg prices, but financial markets care as well. Markets generally don’t trade on whether conditions are good or bad (over $2/dozen for eggs!), but rather on whether they are getting better or worse (egg prices down from $4.82 in January!).
For much of 2023, conditions have gotten better as the rate of inflation has declined rapidly(4), and the economy has been resilient(5). The actual misery index (unemployment rate plus current inflation rate) stands at 7.1%, down from 12.2% just 15 months ago and below the 9.2% average dating back to 1947.(6)
Maybe it’s not as bad as people are feeling?
A ’keep it simple’ strategy
We start with three simple questions.
1.?Where are we in the cycle?
This cycle, like all cycles, will end — but maybe not as soon as once expected. US inflation is coming down rapidly(7) without deterioration in the labor market.(8) It’s a “soft landing,” at least for now.
2.?What’s the market telling us about the direction of the US economy?
Credit spreads tight.(9) Stocks outperforming bonds.(10) The market is suggesting that growth may be stronger between now and the first months of 2024.
3.?What will be the policy response?
The October Consumer Price Index reading may have officially ended the suspense.(11) Dare we say that the Federal Reserve’s tightening cycle is over?
Per our framework, we maintain a risk-on posture and expect it to persist into next year. Tactically we favor cyclical, smaller-cap, and value-oriented stocks.
It's that time already?
The 2024 election is 12 months away. Above the Noise will provide one fact each month between now and next November to hopefully ease concerns about the election and its (un)likely implications for the financial markets.
Here’s our first fact:
Neither party can claim superior economic or financial market performance. Market returns have been positive during most administrations since Dwight Eisenhower, with the notable exceptions of Richard Nixon and George W. Bush, both of whom had terms end during recessions. Each of the other presidents’ terms experienced annual returns of 9.5% or greater.(12)
It may be confirmation bias, but…
…the heavy concentration at the top of the S&P 500 Index suggests that the market-cap-weighted index is unlikely to continue its extended outperformance against other equity weighting methodologies like equal weight or investing styles like GARP (growth at a reasonable price) and value.
Currently, the S&P 500 Index’s top five holdings comprise a near-record 24.5% of the index while the valuation gap between the top five names and the rest of the index is as wide as it was in the late 1990s.(13) The emergence of such heavily concentrated markets has tended to be indicative of the latter stages of policy tightening and market cycles. Market participation tends to broaden as new monetary policy policies emerge and new market cycles commence.
Almost 25% of the S&P 500 Index is concentrated in its Top 5 holdings
Since you asked
Q: Why didn’t the US economy enter a much-anticipated recession?in 2023?
A: I’ll put forward three potential explanations.
1.?The traditional economic excesses that have tended to presage recessions were not evident this year. For example, consumers held excess savings(14), business inventories were lean(15), and housing supply was historically low.(16)
2. Most American homeowners were not impacted by the higher interest rates. It’s estimated that 80% of US home mortgages are fixed rate.(17)
3. While other parts of the economy have slowed, economists simply underestimated the pent-up demand of American consumers that emerged from the pandemic-era closures.
It was said (Part 1)
“I’m not sure the world is prepared for 7%.” – Jamie Dimon, CEO JPMorgan Chase
I’m not either! But I’m also not sure why the world would need to be prepared for 7% interest rates. Interest rates have tended to be highly correlated to nominal gross domestic product — which equals real economic activity plus the rate of inflation. And here’s where those components stand:
·?Inflation: Inflation expectations have been very contained. The 5-year, 5-year forward inflation breakeven, a measure of expected inflation (on average) over the five-year period that begins five years from today, is below 2.5%.(18) That’s well within the US Federal Reserve’s perceived “comfort zone.”
·?Real economic activity: ?The projected US potential growth rate, which is largely based on labor force growth expectations and productivity trends, is typically forecasted to be between 1.5% and 2.5% over the next decade.(19)
Simple math suggests that it’s reasonable to expect long-term interest rates to range between 3.5% to 4.0%. ?I’m not sure how you get to 7%.
It was said (Part 2)
“Social Security goes bankrupt in 10 years.” – Nikki Haley, Former Governor of South Carolina
No, it doesn’t! Social Security will never go bankrupt because workers will always be paying into it. We’ve covered this before, but I want to keep pushing back on it because it’s a large misnomer in the US.
The Social Security Trust Fund is expected to be depleted in 10 years.(20) That’s not bankruptcy. From that point forward, Social Security will pay out based on what is collected in tax revenue. The nation’s politicians can adjust the program (by raising the retirement age or increasing the taxable maximum, for example) to prevent retirees from receiving less than what they had expected.?
领英推荐
Phone a friend
China faces structural challenges. Why would investors consider allocating money to Chinese equities??I posed the question to Alessio de Longis, Head of Investments for the Invesco Investment Solutions Team.?His response:
“Be wary of narratives. Yes, China faces structural challenges, including worsening demographics and residential overcapacity.(21) It’s a far cry from 15 years ago when China was forecasted to be the strongest economy in the world. Those projections proved true(22), but paradoxically the Chinese financial markets didn’t deliver the results that investors had hoped. Perhaps the robust-growth narrative had already been priced in the market. The same could be said of today, but in the opposite way. Pessimistic growth expectations may prove true, but low valuations in the Chinese equity market suggest that the market may have already accounted for it.”
Automate my job?
Each month I pose a question to ChatGPT — the artificial intelligence-driven chatbot — and assess the response.?
Q: Do credit rating downgrades matter for US Treasuries?
A: Yes, credit rating downgrades can impact US Treasuries. While US Treasuries are generally considered low risk, a downgrade could still affect investor confidence and lead to changes in interest rates or demand for these securities. However, the direct impact is often less significant compared to other types of bonds.
Decent answer, ChatGPT, although I would have said that the direct impact has historically been nil. US Treasury rates, as mentioned above, are much more likely to reflect growth and inflation expectations than the opinion of the credit rating agencies. Case in point, on Friday, Nov. 11, Moody’s Investor Services cut its credit rating outlook?for US debt from stable to negative. US Treasuries subsequently staged a huge rally(23) on Monday, Nov. 14 when the inflation report was weaker than had been expected.(24)
On the road again
My travels took me to Minneapolis for the annual Financial Planning Association conference, where I joined fellow market strategists Linda Duessel and David Kelly to discuss The Great Economic Debate.? Last year, panelists David Kelly, Jim Paulsen, and I joked that we were concerned that each of us was optimistic about the US financial markets in 2023. Consensus, in that instance, wasn’t wrong. Not much changed this year as we continued to be optimistic about financial markets. So much for a great economic debate. I particularly liked Dr. Kelly’s light bulb analogy in answering the question about the potential timing of a recession. Will the bulb go out in three months? Probably not. A year? Not likely. Over the next couple of years? Sure. I may steal that one! I think the audience found it en-light-ening. #dadjoke
Here’s to a December that is the most wonderful time of the year for each of you!
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Investors should consult a financial professional before making any investment decisions. This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
All investing involves risk, including the risk of loss.
Past performance does not guarantee future results.
Investments cannot be made directly in an index.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Investments in companies located or operating in Greater China are subject to the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China’s dependency on the economies of other Asian countries, many of which are developing countries.?
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Tightening monetary policy includes actions by a central bank to curb inflation.
The United States Misery Index tracks the mood of the country by adding the unemployment rate to the inflation rate.
The US Consumer Price Index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices while headline CPI includes them.
The S&P 500? Index is a market-capitalization-weighted index of the 500 largest domestic US stocks. The S&P 500 Total Return Index assumes that all cash distributions are reinvested.
The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, and taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility, and financial issuers.
The Bloomberg US Aggregate Bond Index is a broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate pass-throughs), asset-backed securities and commercial mortgage-backed securities (agency and non-agency).?
A cyclical stock is an equity security whose price is affected by ups and downs in the overall economy.
Gross domestic product is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.
Option-adjusted spread (OAS) is the yield spread which must be added to a benchmark yield curve to discount a security’s payments to match its market price, using a dynamic pricing model that accounts for embedded options.
The opinions referenced above are those of the author as of Nov. 28, 2023. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
?? "Optimism is the faith that leads to achievement. Nothing can be done without hope and confidence." - Helen Keller. Your insight into the economic landscape is illuminating and echoes the power of a positive outlook. Let's keep fueling the conversation with hope and informed perspectives! ???? #EconomyOptimism
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12 个月Brian, I appreciate this newsletter as an optimist myself! The fact you shared is especially interesting. Looking forward to the next one!
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12 个月Optimism is a good virtue, it’s equally important to Understand your Business Environment and Industry alongside where and what you want in life, and where they go in Futures. Thanks for Publishing and sharing.