Our analysis for 2023 centered on preserving capital and enhancing portfolio robustness against inflation-driven challenges. We emphasized short-term income and tangible assets over equities, as we discerned the S&P500 to be moving within a consolidation range (3,800 to 4,200) due to factors including compressed relative valuations (S&P earnings yield of 5.17% vs 2-year bond yields at 4.25%), escalating capital costs, yet cushioned by the ongoing support from expansive fiscal and monetary policies initiated during the COVID era.
Year to date, the S&P500 has surged by 14.59%, while the S&P493 stocks (excluding dividends) have risen by a modest 4.3%, failing to outpace the risk-free US Treasury Bill, which currently returns an annualized yield of 5.43%. Notably, only 20% of stocks have outperformed their respective indices, showcasing a narrow performance in equity markets. Presently, S&P500 earnings yields rests at 4.66%. This renders equity risk a challenge for investors to embrace when returns are akin to the risk-free rate.
The Federal Reserve’s sequence of rate hikes has lifted short-term rates from 4.25% to 5.43%, in line with our projected pause of around 5%. Long-term bond yields have also gone higher, now residing at 4.30% compared to 3.88% at the onset of 2023. After touching highs of 9% last year, inflation has tapered to 4%, in line with our outlook. Going forward, we believe the moderation in core inflation will likely remain sticky at these levels.
In hindsight, there are two things that have impressed us this year. First, corporate America’s ability to pass on price increases with little consumer pushback and secondly, the rapid pace of the advancement in AI. The latter of which has played a pivotal role in the success of the “magnificent seven” stocks.
Navigating the Economic Lags and Cost of Capital
Economic resilience likely to diminish in 2024
The US stimulus fueled economy is still on solid footing. The tailwinds of the enormous monetary and fiscal policy responses are still playing out in the real economy as shown by the growth in the labor market, manufacturing construction, onshoring of global supply chains, and higher inflationary run rate. The lagged effect of the stimulus along with its multiplier effect explains in good part why the strength in the consumer and the private sector has remained relatively immune to rate hikes. This shift has led to a departure from recession forecasts by many leading economists, including Goldman Sachs coining it “recession capitulation”.
Although stimulative measures persist, they have been waning. The accumulated excess savings of U.S. households during the pandemic, now at $190 billion, are projected to diminish by the end of Q3 according to the San Francisco Federal Reserve. Analysts at JP Morgan believe excess savings have already been depleted when adjusted for inflation. The savings rate is hovering around a mere 2.4%. Consumers are now facing the task of replenishment. With U.S. T-bills yielding 5%, provides an opportune time for consumers to rebuild some cushion.
Amid concerns about inflation and the new debt limit, the Federal Reserve and U.S. Treasury are shifting their focus to reducing debt vulnerabilities and rebuilding fiscal reserve buffers as a paramount priority. The impact of policy stimulus on GDP is set to normalize in 2024. Consequently, higher rates will become a more potent tool for curbing inflation, albeit at the cost of growth.
Bond Bear Market – Prolonged Elevated Rates and Persistent Inflation: The New Norm
Investors must bear in mind that we are currently navigating a bond bear market. Phase two of this bear market, characterized by a steepening of the yield curve, is now underway. This trend has substantial implications for high-risk assets, as their performance is intimately linked to capital costs and term premiums.
The resounding drumbeat of fresh treasury issuances is underway. Barclays projects a net rise in coupon-bearing debt to be $0.6 trillion for the remainder of 2023 and another $1.7 trillion in 2024.Their estimates align with the Treasury Borrowing Advisory Committee’s (“TBAC”) recommendation that government target 15-20% for short-term T-bills with the remainder in longer term issuance. The considerable influx of long-duration issuance will be difficult for the market to digest as investors will demand extra compensation for holding long-duration bonds. To summarize, we believe the new normal will be higher for longer with persistent inflation.
Charting the Course for 10-Year Treasuries
Bill Dudley, the former Chief Economist of Goldman Sachs, former NY Fed Chair, and current Bloomberg Columnist, succinctly encapsulates the situation, stating, “Suppose the Fed’s short-term interest-rate target, adjusted for inflation, averages about 1% over the next decade. Inflation averages 2.5%, and the bond risk premium is one percentage point. In sum, this suggests a 10-year Treasury note yield of 4.5%. And that’s a conservative estimate: Given historical neutral short-term rates, the recent persistence of inflation, and the troubling US fiscal trajectory, all three elements could easily go higher.”
If this is correct, the high cost of capital and sub-trend growth could be with us through 2024.
2025 and Beyond: The AI Paradigm shift has begun
“A new computing era has begun. Companies worldwide are transitioning from general-purpose to accelerated computing and generative AI,” said Jensen Huang, founder and CEO of NVIDIA.
Generative AI could not come at a better time to shore up waning growth. As the positive effects of the fiscal policy boost to GDP wear off and the long-term AI productivity gains kick in, building portfolios incorporating these elements for the long-term is compelling.
Conclusion – Shifting Landscape
We remain in a bond bear market. A persistent inflationary and “higher for longer” rate environment, which threatens risky asset valuations, requires a steadfast commitment to preserving the purchasing power of portfolios and maintaining their resilience as we move into 2024.
As we stand on the cusp of the “Era of Accelerated Computing”, the future investing landscape assures transformational change in the years ahead. Companies that embrace genAI, particularly companies that embrace it at the enterprise level, will likely become new leaders in their industry, while companies that don’t are likely to be left behind. With this type of innovation lying ahead, a compelling case can be made for a pendulum shift away from passive (benchmark) strategies to high quality active managers, particularly those who embrace this wave of diversified innovation at the company level into their portfolios.
The road ahead demands a balance of safeguarding portfolios against the current market environment and capitalizing on the winds of change steered by the “Era of Accelerated Computing”.
Andrew Marsh
