As we reflect on the year that just passed and attempt to forecast what may be in store for this new year, we can’t help but wonder if 2023 was the grand finale of the many unique pandemic distortions that have kept us guessing for the past four years. From the Summer of spending on experiences at any cost, to the surprise acceleration in GDP growth following the Federal Reserve’s signaled final rate hike, 2023 was another year for the history books. Perhaps what made it even more remarkable was the fact that it turned out to be an economic year that was the opposite of what so many were initially projecting. Back in December of 2022, a Bloomberg monthly survey showed that most economists were placing a 70% chance of a recession in the year ahead. No one was anticipating a return of over 25% for the S&P 500. It is fair to say that economists collectively had egg on their faces in 2023, and it is also a great reminder that oftentimes the consensus view is not right. Fortunately, we remained skeptical of this prevailing view throughout the year and as a result our clients participated in the surprising stock market strength.
As we consider what this year may bring, we are seeing several signs that are pointing to—dare we say it—a year that may be more “normal”. Of course, that depends upon one’s interpretation of normal. In a world where there are constant things to worry about, there will be plenty of significant risks, from two active wars, many important elections worldwide—including the U.S. presidential election—and countless other events and circumstances that will surely challenge us. Nevertheless, we expect that the U.S. economy will begin to behave in a way that is more predictable.
One of the most unsettling developments of the post-pandemic world was the abrupt rise of inflation. No one was immune from its impact, and it left everyone wondering how, and when, prices might stabilize and hopefully come down. This anxiety was especially acute since most of the working-age people in the country these days were either not alive or weren’t adults during the severe inflation of the 1970s. Nonetheless, even though we were all troubled by this recent inflation “crisis”, wages actually grew for the first time in several decades, and social security payments were also adjusted higher. Plus, the job market remained historically strong, and housing and other asset prices stayed stable or increased. The overall result has been an environment where consumers have remained remarkably strong. Then—during the past year—a development that some have referred to as immaculate disinflation occurred, as inflation came down even though economic growth remained healthy. As of December, inflation was just over 3% and appears poised to continue to improve back to levels that many consider to be “normal.”
In our view, spending should also be more balanced following the binge on travel and “experiences” that was widespread last year, which contributed to prices rising within the services industry. Consumers seemed to be willing to spend on experiences at any cost and we don’t expect that this will be a sustainable mindset moving forward. It has also now been several years since the goods buying spree of 2020 and 2021, and we are projecting that consumers may return to spending on a more predictable mix of goods and services. This would certainly be a welcome development as both of these important sectors of the economy have gone from boom to bust at a record pace over the last few years and have each experienced recessions along the way.
Most corporate CEOs and management teams have had an incredibly challenging four years navigating this ever-changing, and highly uncertain, environment. Moreover, the past 18 months have been characterized by the pervasive and constant view that a recession was just six months away, and hence many companies engaged in cost-cutting measures as they prepared for such a downturn. As this mindset becomes less prevalent, we expect that corporate spending will resume—particularly if costs are moderating as inflation comes down. This should help support a year of more typical corporate earnings growth following the earnings recession that occurred during the first half of last year. In our view, the current projection for low double-digit earnings growth for the collective S&P 500 should support an environment where the stock market can appreciate in line with, or slightly below, this level.
Lastly, the Federal Reserve has changed course and is signaling three rate cuts this year. Most U.S. consumers have been relatively unaffected by the rise in interest rates since they have continued to benefit from the very low interest rate mortgages that were previously originated or refinanced when interest rates were near zero. However, more highly indebted companies, as well as the U.S. government, are beginning to feel the impact. As interest rates come down, this should ease some of the eventual pain that these entities would have otherwise felt. If rates follow the Federal Reserve’s projection and eventually settle around 2.5-3%, this would be a level that is much more in keeping with the “normal” that we all knew before the Great Financial Crisis in 2008. Indeed, the interest rate environment that we have been in for the better part of the last 15 years has been very abnormal with the Federal Funds Rate held at zero for nine of those years. We don’t expect that we will see zero interest rates again in the foreseeable future and this represents a big change. Many spending projects that made economic sense in a near zero interest rate environment may no longer pencil out; and this could result in a period of slower economic growth but isn’t likely to result in a recession, in our view. In many respects, it should produce a healthier environment where only viable businesses with a path to profitability are funded.
As you read this, you may conclude that returning to normal is only wishful thinking on our part. Admittedly, after navigating through the last four difficult years, there is certainly going to be some element of hopefulness for a return to an environment that is easier to predict. And we don’t expect that many other risks—including elevated geopolitical risk—will dissipate anytime soon, and we still spend a lot of time contemplating these issues. But we are highly encouraged by the current path of inflation, the prospect of more rational spending patterns, less fear of an impending recession, and (likely) declining interest rates. We continue to position portfolios in a way that we feel is appropriate given the underlying backdrop that we have described above, and that means holding a small overweight to capital appreciation assets while also favoring more bonds over alternative investments for the capital preservation part of the allocation.
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