The Investment Climate

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As winter weather envelops the homes of New England, our thoughts naturally turn to warmer days and maybe a beach house on Cape Cod.? Of course, if you intend to rent such a house for a week next summer, it’s pretty much a roll of the dice.? You could get lovely weather or it could rain every day.? However, if you plan to buy a beach house on Cape Cod, you really only need to understand the climate.? The sunny summer days will far outnumber the wet ones.

Long-term investing is like buying, rather than renting, a beach house.? The important thing is to understand the climate rather than to forecast the weather.? Every December, market strategists publish their forecasts for the S&P500 for the end of the following year.? Some are bullish and some are bearish.? However, if we are being honest, it’s an almost impossible task.? The logical construction of a year-end 2024 estimate would require an accurate short-term forecast of growth, inflation and the dollar, how these variables could impact profits and interest rates, how policy makers might respond to markets and other forces and, most importantly, how unforeseeable but inevitable shocks would impact investor sentiment and flows.? Getting this right over a one-year time horizon is next to impossible.

Projecting average long-term returns is a good deal easier.? If inflation overshoots in one year, it will tend to undershoot the next.? In the long run, economic growth is determined by the growth in labor force and productivity, fairly stable trends, rather than very volatile aggregate demand.? There are also long-term forces that determine the value of the dollar and the share of corporate profits in the economy.? In the long run, policy corrects from being overly hawkish to overly dovish or vice versa.? And, in the long run, shocks to markets and swings in investor sentiment begin to cancel out and thus fade in significance.?

This is one reason why, every year, we put so much emphasis on our Long-Term Capital Market Assumptions which project average returns and volatility for all major asset classes over the next 10 to 15 years.?

The other reason is that it is actually long-term returns, not short-term returns, that matter to long-term investors.? Despite the focus on 2024 year-end targets, the true investment horizon for the vast majority of institutional and individual investors is measured in decades rather than years.?

But if all of this is true, why bother to examine short-term data and events such as last week’s jobs report, this week’s CPI report or this Wednesday’s communications from the Federal Reserve?? One answer is that these data points and events can help confirm or challenge our ideas on the long-term evolution of the economy and policy and thus help fine-tune our long-term forecasts.

The Jobs Market – More Flexibility; Less Wage Pressure

Looked at from this perspective, there are some important messages in last Friday’s jobs report.?

The first is the continued ability of a strong labor market to attract workers from the sidelines.?The unemployment rate has now been below 4% since December 2021, a level that the Federal Reserve regards as akin to full employment.? However, despite slow growth in the working age population over the past two years, total employment has risen by 6.4 million workers, or 4.1%, aided by a surge in labor force participation among the population aged 18-64 to its highest rate seen in almost 15 years.? As we witnessed in the later stages of the last economic expansion, a full employment economy is surprisingly capable of drawing in new workers, supporting stronger-than-expected economic growth.? This was underscored by a further 532,000 increase in labor force last month.

A second important message is that this tight labor market still appears consistent with easing wage inflation.? Despite a slightly stronger-than-expected 0.4% monthly increase in average hourly earnings, the year-over-year gain fell to 3.96% in November, down from a peak of 5.92% in March 2022 and the lowest year-over-year gain seen since June of 2021.? Notwithstanding some high profile strikes this year, the reality is that businesses are succeeding in holding the line against strong wage gains.? Moreover, job openings fell by more than 600,000 in October and are on track to revert to their pre-pandemic peak by the spring of next year.? With the labor market normalizing and consumer inflation falling, it is likely that wage growth will continue to moderate going forward.??

Inflation Continuing to Fall

This week should provide further direct evidence of a moderation in inflation, with year-over-year CPI inflation expected to fall to 3.0% in November - its lowest reading since March 2021.? Falling gasoline prices should be a significant contributor to this decline, a trend that has continued into December.? However, there are many other signs of waning inflation, including declines in new and used vehicle prices, hotel rates and the ISM manufacturing vendor delivery index.?

One crucial number from this week’s report will be the growth in auto insurance costs which have risen by an astonishing 1.9% in October and 19.2% over the past year, accounting for over 0.5% of the 3.2% year-over-year headline CPI inflation rate.? This series will have to decelerate soon given a decline in new vehicle transaction prices since the start of the year.? A second important issue will be shelter inflation which has been decelerating in recent months but which remains well above the actual inflation experienced over the past six months by renters signing new leases.

If these numbers moderate, as we expect them to over the next few months, the CPI inflation rate should fall to roughly 2.5% year-over-year by the spring of 2024, allowing the headline PCE deflator to fall very close to the Fed’s 2% target – well ahead of the Fed’s own schedule.? This inflation trend, if it continues, should convince both policy makers and investors that the inflation surge triggered by the pandemic and the invasion of Ukraine was, in fact, temporary and that the U.S. economy is likely to fully revert to the low, close-to-2% inflation path of the last decade.

Fed Communications

Both the labor market and inflation data can tell us something about the evolution of the long-term path of the U.S. economy.? Communications after the FOMC meeting on Wednesday should provide a fresh read on the extent to which the Federal Reserve appreciates this evolution.

First, the FOMC Statement is likely to see very few edits from the statement released after their last meeting on November 1st.? We don’t expect any change in the federal funds rate.? The Fed may acknowledge that recent indicators suggest that economic activity is now expanding at a “moderate” pace rather than the “strong” 5.2% gain seen in the third quarter.? However, they will also be highly aware that, since their last meeting, 10-year Treasury yields have fallen by 60 basis points and that the S&P500 has risen by almost 10%.? They will not want to encourage a further easing in financial conditions and so they are likely to retain language about inflation being elevated and their implied tightening bias.?

Second, the Summary of Economic Projections should see some significant changes from September in forecasts for this year although less change in the out years.?

• On real GDP, they will likely increase their estimate for year-over-year growth in 4Q2023 from 2.3% to 2.6%.? However, they will also likely continue to forecast a dip in growth to 1.5% next year before reverting to trend growth of 1.8% in 2025 and beyond.
• On unemployment, they will likely continue to forecast a slight increase in the unemployment rate from 3.8% in 4Q2023 to 4.1% in 4Q2024 and 4Q2025 before returning to 4.0% in the long run.
• On year-over-year PCE inflation, they may feel forced to cut their estimate for 4Q2023 to 3.0% from 3.3%.? Year-over-year PCE inflation was 3.0% in October and the November CPI reading, due out on Tuesday, should suggest something lower for November PCE.? However, we expect only a modest cut to inflation expectations for 2024 from 2.5% to 2.4%.
• Finally, on the dot plot, if they don’t increase rates this week, they will have to cut their estimate year-end projection for 2023 from 5.6% to 5.3%.? However, they may well leave their year-end 2024 target of 5.1% unchanged as they try to reiterate a message of “higher-for-longer”, at least for now.

Finally, in his Press Conference, Jay Powell will very likely try to double-down on a cautious approach to easing.? He will undoubtedly acknowledge progress on growth and inflation and may well characterize the runway for a soft landing as widening.? However, he will not want to trigger any further rally in the stock and bond markets towards the end of the year and, consequently, his remarks may express more confidence in the outlook for real economic growth and more doubt about the decline in inflation than he really feels or the data warrant.

However, again keeping a focus on the long run, the real message of all the Fed communications is that they feel a collective guilt for letting inflation get out of hand over the past few years and are bound and determined that it won’t happen again.? Personally, I don’t think they deserve too much blame for the surge in inflation or credit for its decline.? However, the determination of a central bank to achieve 2% inflation in the long run probably increases the likelihood of that target being achieved.

Recent economic data are positive on growth, profits, inflation and the labor market.? Valuations, although high, are not excessively so, provided inflation does return to a 2% or sub-2% pace.? That being said, there may be many potential economic, political and geopolitical storms for markets to confront in 2024, as well as shocks which are, by definition, unforecastable.? The S&P500 could easily rise or fall.? However, for long-term investors, the important issue is the investment climate, and, for all the turmoil of recent years, that climate today looks benign.

Disclaimers

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

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