Happy Holidays, from WMS (and the Market)

“When a consensus of policymakers, commentators and investors is arrayed so overwhelmingly behind the narrative that the danger is over is often when it makes most sense to take out insurance.”

With the holidays comes gift-giving season. Capital markets fittingly ended the year in a giving mood. After about a half dozen head-fakes throughout 2022 and 2023, Fed chair Jerome Powell finally gave the market the gift it had so desperately coveted—an assurance that the Fed would reverse its current tight monetary policy to combat any signs of weakness in the economy and/or financial markets. This old-fashioned Greenspan-vintage “Fed put” was welcomed by both equity and bond markets as each reciprocated Powell’s generosity with strong returns to close out 2023. The 60-40 portfolio, so widely eulogized after last year’s massacre, appears resurrected, posting an 18%+ year-to-date return as of this writing.

Importantly, since the prospect of rate cuts became more tangible in November, these gifts have been more widely shared. The historic concentration of gains in just seven stocks, even while bonds, small-capitalization stocks and international stocks struggled for traction, had left many worrying about the dangers of such lack of breadth. Yet even this Matthew effect* has begun to recede. The S&P 600 Index of small-cap stocks is up over 25% since its low just before Halloween. A spooky October had left bond investors staring down the very real possibility of a third consecutive year of losses. Now, the Bloomberg Aggregate Index, a leading benchmark for the US bond market, is back in black for the year, the risk of a nasty interest rate surprise looks markedly reduced, and bond fund managers might actually have a shot at wooing back clients who have plowed nearly $6 trillion into money-market funds.

What caused this sudden outburst of beneficence? History books will probably write off 2023 as a year when the markets and the public began to digest the implications of generative AI and large language models (Chat-GPT was released to the world in November of 2022). To be sure, any stock perceived as a beneficiary of the AI tailwind has outperformed these past thirteen months. Our belief is that, while generative AI is a revolutionary, potentially paradigm-defining general purpose technology for the economy, its ultimate effect in reshaping the landscape of business—particularly the identities of the winners and losers—remains far from ordained. Experience teaches that it often takes decades and the wholesale reorganization of business processes before powerful technologies like electric power, digitalization, or the Internet, can begin to make their true power felt. Workflows need to be transformed, workers retrained or replaced, and shopfloor structures adapted. This is not a prediction, but the 2023’s darling Nvidia could look, twenty years hence, the way that 1999’s sweetheart stock Cisco Systems looks today.

There may be a better technological metaphor for 2023 and its apparent feelgood ending. Though first approved two years ago, 2023 marked the moment when investors began to appreciate and embrace a new class of wonder drugs, semaglutides or GLP-1 agonists. Marketed to diabetes sufferers alongside Beverly Hills socialites under brand-names such as Ozempic and Wegovy, semaglutide injections appear to have powerful salutary effects not just on the management of blood sugar, but on obesity generally, and even on impulse control. There is, for example, increasing evidence that these medicines are somehow linked to reductions in desire for alcohol or gambling. Snack merchants are already reporting a noticeable impact on margins. Truly magic pills indeed. It would not be the first time that the pharmaceutical industry stumbled into a “general purpose” recipe that proves fruitful (and profitable) for numerous unintended indications—aspirin, Viagra, statins, SSRIs just to name a few examples. Though there are always side effects, sometimes the drug industry cooks up a win-win-win. Payors are certainly considering such a possibility.

Underpinning the long-anticipated Fed pivot to lowering interest rates, the U.S. economy appears to be on its own version of magic pills. Twelve months ago, most market commentators (us included) would have rated the likelihood of an economy simultaneously seeing inflation in quiescent free-fall, jobs plentiful but labor frictions significantly cooling, and growing at a 5% annualized pace as wildly improbable. This is not a soft landing scenario; this is a “no landing,” or, more accurately, something approaching an “immaculate disinflation.” As core inflation has cooled to only 0.1% month-over-month, we seem to be witnessing the synchronized reversal of supply chain snarls, overheated labor markets, anemic productivity growth, and mortgage rates that all but box out a generation of would-be homeowners. To be sure, there are still some warning lights blinking. Consumer sentiment remains terrible and persistently grouchy attitudes on the economy have birthed a neologism: the “vibes-cession.” Global indicators of factory output have been sluggish, notably in China. Banking stress that emerged in the spring has been quelled but not permanently dispelled: commercial real estate loan portfolios will at best constrain lending for years. Perhaps this will signify the start of a “golden age” for alternate forms of credit.

But, on the whole, the economy’s resilience to its first dose of tough monetary medicine since 2005 has surprised nearly everyone. As with the new semaglutide drugs, which appear to pack a smorgasbord of benefits into one narrow mechanism, the economy took its injection of rate hikes and is now getting a stocking full of goodies all at once. We entered 2023 with a prescription for higher interest rates and we hoped not much else would “break.” Instead we seem to be getting a panacea: an easing future path of interest rates, an incipient (AI-driven?) productivity explosion, strong but not-too-strong wage gains, and the list goes on. Even holiday shoppers defied weak expectations and continued to splurge.

Markets are ending the year feeling jolly. How long can this festive spirit last?

Without shouting “humbug” at a cascade of legitimately optimistic economic news, we would point to reasons why the patient’s chart requires a slightly more balanced reading than December’s jubilant mood would allow. Among the many positive surprises in 2023 was the additional assist provided by a significant decline in energy prices. This was, for most strategists, a stunning outcome given the wars in fossil fuel-producing parts of the world that continued to rage throughout 2023. Lower prices for primary economic inputs like energy, minerals, and food helped take inflation off the boil in 2023, but supply-side risks have not evaporated. Likewise, if the prospect of lower interest rates, loosening financial conditions, and stronger real incomes perversely conspire to lift demand and cause inflation to re-accelerate in 2024, the Fed and markets may both need to reevaluate their posture. Jay Powell’s speech of December 13^th could turn out to be a self-defeating prophecy.

When markets rally on the expectation of a Fed pivot, actual (not simply jawboned) rate cuts become priced in. Investors are effectively cheering for central banks to lower rates aggressively to keep the party going. An uncomfortable reality is that any surprise of faster easing is likely associated with, at best, an economy with momentum conspicuously slowing from the third quarter’s rapid pace (and all that would portend for corporate earnings and employment). Either that cheerless proposition, or something much worse indeed: a regional banking crisis? A U.S. sovereign default? This is to say, when every economic dial is turned to “Goldilocks,” it doesn’t take a lot for the market to be disappointed.

In recent years, we have witnessed heightened volatility in the U.S. Treasury market, the largest and most important market in the world. Doubtless the extravagant borrowing needs of the federal government, the changing constitution of Treasury demand, Congressional games of chicken, and ongoing concerns about liquidity and intermediation all contribute to nervousness in the market for U.S. debt. One further culprit has been the Fed’s messaging around the path of policy rates or the size of its balance sheet. Into this mix, Fed speakers’ new charm offensive sits uneasily. This scenario has played out many times before. The Fed believes it has sent a direct message to the markets, the markets misinterpret it, and consensus trades unwind in ugly fashion.

We do believe the Fed made a policy mistake by not hiking quickly enough. The last thing it should do is compound that error by declaring inflation dead and raising the “Mission Accomplished” banner. The Fed does not have an officially defined financial stability or macroprudential mandate, but occasionally— outside of emergencies and crises—it does attempt to influence financial conditions through the “signaling” channel. As long-term investors whose preferred philosophy is to focus on cash flows, we often wish the Fed desist and just shut up. Our interpretation of the sudden turnabout is that the Fed remains data-dependent and flexible regarding future policy decisions. Equity and fixed income markets seem to be reading a different message.

Futures markets have already energetically front-run a path of multiple rate cuts, and history shows that all such forecasts are poor at anticipating cyclical turning points. A bout of easier money may well be in the cards for 2024, but policymakers may nevertheless need to confront a trilemma in the near future: geopolitical or macro surprises will raise calls for intervention at the same time that fiscal authorities are running historic debts and deficits and some supply-driven element of inflation is proving sticky. Certainly, inflation base effects will be less flattering to the CPI next year than they have been recently, making the road to 2% harder. And yet, recently, several media outlets have begun to crow that this so-called “last mile” should be less tricky than initially presumed. When a consensus of policymakers, commentators and investors is arrayed so overwhelmingly behind the narrative that the danger is over is often when it makes most sense to take out insurance.

An approximately correct forecast of inflation will be critical to investment returns in 2024 and beyond. This self-evident (but too often ignored) fact was demonstrated for a decade when low inflation and low volatility inflated an “everything bubble” in, well, everything. It was further reinforced last year when an inflation surprise wiped almost 20% off the S&P 500 and precipitated the worst annual bond rout in history. We believe that inflation will remain relatively cool in the coming years, but we also see confirming evidence for our previously stated view that the floor will likely be higher than in the post-GFC years for multiple structural and geopolitical reasons. This blend of constructive facts and nagging worry leads us today to be cautious bulls on cyclical assets, quizzical of certain valuations that seem to imply some sort of gravity-defying, AI-driven productivity miracle, and, above all, mindful of the possibility of a sudden, nasty downside shock. Equities and bonds have been taking magic pills for a few months. Next year, their effects could wear off.

* From the Parable of the Talents in the biblical Gospel of Matthew: "The rich get richer and the poor get poorer."

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