MARKET PERFORMANCE-As Of April 12, 2024
Powell Pivot:
Federal Reserve Chair Jerome Powell announced a changed monetary policy direction on December 13 2023 that paves the way for interest rate cuts in 2024. Based on the March 20, 2024 Federal Open Market Committee announcement, rates were expected to decline 0.75% by year-end. Although the Fed was surprised by the speed that inflation accelerated after the pandemic, the Fed was also initially surprised how quickly inflation fell. Most recently, however, inflation is not moving down as desired and is proving to be more sticky. Consequently, the Fed is not expected to reduce rates as much as the market hoped. The Fed remains committed to pushing inflation down to the 2% target without causing a recession. Although a soft landing has been difficult to achieve in the past, the economy appears to remain positive.
Stocks Up and Bonds Down so far in 2024:
Most major stock indexes are positive so far in 2024 as corporate earnings are improving and the economy is proving to be quite resilient. Meanwhile, higher interest rates have pushed bond prices down, causing negative performance.
Positive Performance in 2023:
Equity markets were volatile but positive in 2023. U.S. large cap, and especially the so-called Magnificent 7, were particularly strong. Fixed income markets were negative earlier in the year, but rebounded strongly based on declining inflation and the prospect of future Fed rate cuts. The government debt default was averted as expected, fears related to a potential banking crisis appear manageable, inflation is trending downward, and there is growing optimism about avoiding a recession. Large financial institutions are well capitalized and appear to have reasonable risk control management, but mid-sized banks are more problematic. Silicon Valley Bank realized large losses when they were forced to sell underwater longer-term bond holdings to fund panicked investor withdrawals. Signature Bank troubles relate to a concentration of commercial real estate and crypto exposure. Credit Suisse has been a weak performer for years, and was not able to fund investor withdrawals. At this point, the “banking crisis” appears manageable and does not look to be a systemic threat. The recent advance report on 2023 Q4 GDP came in at a strong 3.3%. The Federal Reserve raised interest rates by 0.25% on July 26, to a range of 5.25% to 5.50%, a 22-year high. The Fed remains “data dependent” but is now on track to allow interest rates to move down in 2024.
2022 Performance Was Ugly:
The U.S. stock market and the bond market were both down sharply in 2022, with all major asset categories down on a year-to-date basis. The S&P 500 performance was down -18.1% 2022. The Bloomberg Aggregate Bond Index fell -13.1%, the worst decline ever. A diversified 60/40 equity/bond portfolio fell over -15%, the worst performance since 1937.
Breaking Things:
The Federal Reserve was too slow in recognizing inflation, and had to play catch up by ratcheting up interest rates much more quickly than past cycles. The Fed communicated the need to take strong medicine to avoid a lot more pain later and for much longer. The cost of doing too little on inflation outweighed the cost of doing too much. As a result, interest rates were raised at an unprecedented rapid rate, and there was fear that the Fed would break the economy and cause a “hard landing” recession. So far, the economy has proven to be remarkably resilient while inflation has declined. The current narrative is for a soft landing where inflation subsides without the pain of a deeper recession. Although the fear that the fed would break the economy has not yet materialized, it is difficult to know the longer-term impact from the higher interest rates, and either a recession or 1970s era stagflation is still possible.
Inverted Yield Curve:
The bond market has been in an inverted yield curve position since July 2022 as short-term Treasury interest rates moved above the longer-maturity U.S. 10-year Treasury Note interest rate. This inversion of the maturity timeline resulted from the Federal Reserve pushing up short-term interest rates to control inflation while the broader bond market, fearing a recession, pulled down long-term interest rates. (The yield curve typically has an upward slope with lower short-term rates than higher long rates as investors require a higher rate to compensate for the longer maturity commitment and unanticipated inflation.) This inverted yield curve has remained inverted, and an inverted yield curve preceded the last seven recessions. At this time, the economy has remained strong and there are no signs of an imminent recession.
GDP:
The U.S. economy advanced by 1.6% in 2024 Q1, helped by solid employment and consumer spending. The Federal Reserve GDP forecast for calendar year 2024 is currently at 2.1%.
Crypto Collapse and Recovery:
The crypto exchange FTX (previously one of the biggest crypto exchanges in the world) declared bankruptcy in late 2022. After revelations of risky, unethical business practices, there was a surge of customer withdrawals. Meanwhile, FTX had loaned out customer funds and then didn’t have sufficient funds to cover the customer withdrawals. Unfortunately, investors using the FTX exchange are facing a challenging legal battle in getting their crypto deposits back because the bankruptcy process typically treats their deposits as uncollateralized unsecured claims. FTX had been trading far above any fundamental value, so the precipitous decline was no surprise. Sam Bankman-Fried, former FTX CEO, has been convicted of fraud on all charges. Bitcoin, the largest blockchain-based digital asset traded on crypto exchanges, dropped from an all-time high of $68,991 in late 2021 to under $17,000 after the bankruptcy announcement, but it has since recovered somewhat. Matt Damon, Steph Curry, Gisele Bündchen and others previously pitched cryptocurrency exchanges, and this bankruptcy debacle shows the importance of financial advice from experienced professionals rather than celebrities. It is also ironic that the NBA’s Miami Heat have changed the name of their home arena from the FTX Arena to the Kaseya Center.
The FTX bankruptcy has not posed systemic risk to the traditional financial system, a so-called “Lehman” moment that helped precipitate the 2008 Great Financial Crisis. This experience clearly highlights the value of established exchanges like the New York Stock Exchange and the regulatory infrastructure protecting investors.
Crypto performance for 2024 has staged a strong recovery although it remains a speculative asset.
Russian invasion of Ukraine and Hamas attack on Israel:
The immediate impact for Ukraine has been the loss of life and devastation of civilian targets. The war has been a humanitarian disaster with the UN estimating that at least 9,000 civilians have been killed. In addition, energy and food prices rose sharply, curtailing economic growth, threatening regional food supplies and increasing recession risks. After the initial energy price shock, oil and natural gas prices have moderated. Russia ranks as the 11th largest country in the world, but Russia produces 10% of the world’s oil and over 25% of global palladium. Russian accounts for nearly half of EU natural gas imports and almost a quarter of oil imports. Russia and Ukraine account for nearly 30% of global wheat exports, one-fifth of the corn trade and 80% of sunflower oil production according to the USDA. Prices have skyrocketed and raised concerns about food security, especially in the Middle East and North Africa.
Similar to the Russian attack on Ukraine, the Hamas attack on Israel has caused a large loss of life. From an economic perspective, Israel is a relatively small country, comprising 0.5% of global GDP. The obvious risk is if this expands into a regional conflict.
Geopolitical risks have been highlighted as the security structure in place since the end of WWII for the war in Ukraine and the continuing wars in the middle east. Although these wars are devastating, the S&P 500 has been up an average of 15% in the in the 12 months following the start of recent conflicts.
Short-Term Positive:
Household debt levels are in good shape. The household debt-service ratio is below 10% of disposable personal income, and well below the average level going back to 1980. Cash as a percentage of total household debt is also well above average historic levels.
U.S. corporate balance sheets are strong with U.S. corporate debt to after-tax profits low compared to historic levels. Interest coverage on debt is at the highest levels since the 1990s.
–Corporate earnings surprised to the upside during 2021 and 2022, but earnings growth was weak at only 0.4% in 2023. FactSet sees 2024 earnings growth recovering strongly to 10.9% and revenue growth at 5.1%. If inflation remains higher than expected, then broad-based consensus earnings growth could be revised downward.
–Geopolitical risks. Although wars are tragic, history shows that the market generally has positive performance a year after hostilities begin.
–Retail sales. Retail sales gained a solid 0.7% in March, and are up over 4.0% year-over-year based on a strong labor market.
–The $430 billion Inflation Reduction Act-IRA (down from the original $3.5 trillion and then revised down to $2.2 trillion Build Back Better plan) passed in August along party lines. The legislation covers climate change, health-care spending and tax increases over the next 10 years. The legislation was described as reducing the budget deficit by $300 billion, but analysis by the Congressional Budget Office shows the package is expected to reduce the budget deficit by $102 billion.
–The $1 trillion infrastructure package was previously passed in November 2021 with bipartisan support, and economists believe that this spending has the potential to increase economic growth and productivity. Growth and productivity gains will be modest, however, since the funds will be spent over a number of years.
–Some of the stimulus dollars moved into the markets. This provided short-term investment demand to push prices higher. Although there are no more stimulus payments, there continues to be significant retail “cash on the sidelines” that can help stabilize the market.
Short-Term Negative:
–The US Dollar has been strong in 2024. This strong dollar negatively impacts domestic, foreign developed and emerging markets. The stronger dollar hurts domestic companies with significant foreign sales. Moreover, foreign purchases of oil and other imports are typically transacted in US dollars, and this hurts their local economies.
–The Conference Board’s Leading Economic Indicators was down -0.3% in March. Although the Leading Economic Indicators have been mostly negative for the last two years, the Conference Board is no longer forecasting a recession later in 2024.
-Recession and Market Performance. The S&P 500 dropped -39% from the January 3 2022 all-time-high to the October 2022 bear market low. Performance has rebounded since October but was down -18% for 2022. The S&P 500 surged 26.3% in 2023, and a recession does not appear imminent. Nevertheless, there have been 17 bear markets since World War II and the average decline has been -31%. Of the 17 bear markets, 9 were accompanied by a recession, and the average recessionary decline was -36%.
–Consumer inflation remains a problem as inflation isn’t dropping as quickly as hoped. The March headline Consumer Price Index was at 3.5% over the last twelve months. The core CPI, net the volatile food and energy sectors, was up 3.8% year-over-year. Although inflation has trended down from levels not seen since the early 1980s, the Federal Reserve policy to raise rates appears to have been successful so far. Although inflation has declined significantly, there is no assurance that inflation will quickly move back to the 2% target level.
–Geopolitical: The Ukraine/Russia and the Hamas/Israel conflicts are clear negative developments. The market previously dismissed this risk, but the invasion forced up energy and other commodity prices, and the broader impact is clearly negative.
–The so-called Fed Put gave investors a measure of downside support for the markets over the last decade. (In the options market, a “Put” position increases in value when markets decline and thus provides an upside offset or hedge against market drops.) Although there was no actual market “Put”, the Federal Reserve purchased massive quantities of bonds and kept interest rates abnormally low to support the economy and the markets. Now that the economy is strong and inflation is above the Fed 2% target, the Fed no longer has the latitude to keep interest rates low to support the market. Instead, there is a need to maintain higher interest rates to mitigate against inflation. Although interest rates are moderating from higher levels in 2023, they remain sufficiently high enough so that consumer and corporate spending growth rates decrease, the economy slows, and long-maturity bonds and stock market performance face increasing headwinds.
–The Federal Reserve’s monetary stimulus kept interest rates low but it had the effect of distorting markets by shifting investors towards risky assets. Monetary and fiscal stimulus have been at unprecedented levels but the economy is slowly adjusting to more normal interest rate levels. Commercial real estate appears to be the most negatively impacted sector.
–Asset price inflation for both stocks and bonds pushed market prices well above average fundamental valuation levels by year-end 2021. Valuation levels moderated in 2022 but are now relatively expensive again based on the strong 2023 stock market performance. It will be important for corporate earnings to grow strongly throughout 2024.
–Investors took out record volumes of margin debt to finance their stock purchases. Buying stocks on margin is extremely lucrative as long as stocks continue to move up, but a market downdraft causes heavy selling to meet margin calls. Option volumes are also at record high levels according to the Options Clearing Corporation. Purchasing Options in a rising market allows much larger gains than buying stocks, but losses are amplified in a sharp sell-off. Market makers who sell options to investors typically hedge their position by purchasing the underlying stock. When markets decline and option purchases decline, market makers sell their stock holdings. Margin debt and option purchases provide upward momentum, but these trading tactics also cause severe negative volatility.
–Evergrande is a Chinese property developer that defaulted on bond payments in its $300 billion debt holdings in 2021, and filed for bankruptcy in 2023. Evergrande has been ordered in 2024 to liquidate, and this has significant negative implications. Country Garden and other Chinese property developers are also experiencing cash flow problems, and the property sector is a clear drag on the Chinese economy. The market fears “contagion” that spreads throughout the Chinese economy and into international markets.
Longer-Term Fundamentals:
Federal Reserve “Tapering” Increased Interest Rates and Negative Performance:
The Federal Reserve’s belated recognition of inflation risks and its policy shift has spooked markets and caused negative returns for most asset classes in 2022. The shift to higher interest rates is described as the end of easy money.
The policy shift was publicized by the Fed on December 15, 2021 with commentary that they are ending their bond purchases and introducing a policy to raise short-term interest rates to combat inflation. The government bond purchases began at the height of the pandemic to help support the economy and markets when businesses were closed and unemployment skyrocketed. The government bond buying helped reduce interest rates. (Interest rates on existing bonds declined because Fed purchases drove up bond prices and correspondingly reduced interest rates.) Starting in March 2022, the Fed pushed up interest rates at the fastest pace in the last 40 years. As of July 2023, the Fed Fund Rate had been pushed up to a range of 5.25% to 5.50%. Since rate increases impact the economy with a “long and variable lag”, neither the Fed nor anyone else can know exactly how much the economy will slow and inflation will decline. At this point, the economy has shown remarkable resilience and the Fed now appears to be embracing a higher for longer policy stance.
U.S. Economic Statistics are solid and inflation concerns are moderating. Economic statistics dropped precipitously due to the government-induced shutdown in early 2020, but then rebounded well above consensus expectations. Most recently, economic reports are showing a stable growth rate.
-Retail sales have been stronger than expected over the last year despite rising gasoline and food prices. Fiscal stimulus has ended but U.S. households accumulated over $2.5 trillion in excess savings during the pandemic, and this drove strong consumer spending throughout 2023. Real wage gains are now sustaining consumer spending so far in 2024.
-Unemployment (at a 50-year low of 3.5% in February 2020) spiked to 14.7% as the pandemic shut down the U.S. economy, but now stands at 3.8% for March 2024. Job creation for March came in at a solid level of 303,000 new jobs. The overall employment trend remains positive as companies scramble to find workers to meet strong demand.
-Industrial production gained 0.4% in March and it is now up 0.5% over the last year. Industrial production has been hurt by weaker manufacturing performance.
-Housing had been strong due to low mortgage rates, but new construction is currently negatively impacted by rising mortgage rates and rising construction costs. These rising costs impact housing affordability, especially at the lower price points for younger families.
-Inflation has been low over the past decade, but is currently at historically high levels. The overall March Core Consumer Price Index came in at a trailing 12-month 3.8%.
-The Eurozone reported 0.2% quarter over quarter gain for the fourth quarter due to painful ECB rate increases, but inflation slowed to its lowest level in more than two years. The UK is currently experiencing a modest recession.
-Japan’s gross domestic product gained 0.1% in the three months to December from the previous quarter, weaker than economists’ forecast for 0.2% growth. The economy contracted -0.8% in the July-September quarter.
-China reported 2024 Q1 GDP of 5.3% annualized GDP growth, showing that their economy is slowly recovering from their COVID containment policy. Chinese economic performance is a major factor for overall global growth.
Performance: U.S. stock indexes moved up to record-high levels based on government stimulus and optimism with COVID-19 vaccine in 2021, but performance in 2022 was negative. Energy, industrials, financials and small cap stocks performed better as the market rotated away from some of the tech darlings. After the huge 2022 sell-off, stocks recovered strongly in 2023. Small cap stocks are cheaper and have more earnings upside as the economy recovers from inflation.
Longer maturity bonds underperformed in 2022 as interest rates rose, but are performed better in 2023. While fiscal stimulus was necessary due to COVID restrictions and lockdowns, there is a growing concern related to persistent inflation and to huge government budget deficits. Investors are less willing to accept historically low longer-term government debt, and this is pressuring long-maturity bond prices lower as yields move higher.
–Climate change constitutes a significant longer-term global challenge. Although governments and corporations are taking steps to mitigate the impact, recent increased energy costs have caused a consumer backlash. It is much easier to talk about reductions far out in the future, than it is to implement current steps to make actual changes.
Market valuations are down but are not cheap. At this point, markets are trading on recession fears and the prospect of weaker corporate earnings growth. Various valuation metrics (like Price/Earnings ratios) are down, but could decline further if earnings growth is negatively impacted by inflation. It is important to remember that valuation doesn’t predict short-term performance, but valuation definitely impacts long-term performance potential. In other words, markets could move up or down on a short-term basis, but the longer-term performance might be a 5% average long-term return/year rather than the historic 10%/year return.
Stimulus packages helped in the short run, but debt keeps growing. Three stimulus bills have been enacted since the beginning of the pandemic in March 2020. These bills are summarized below:
-The $2.2 trillion CARES Act, passed quickly in March 2020, provided $1,200 direct payments and enhanced unemployment benefits.
-The $900 billion Pandemic Relief Bill passed in December 2020. This provided $600 in direct payments to eligible individuals and $300/week in extended unemployment benefits through March 2021.
-The $1.9 trillion American Rescue Plan passed in March 2021. This plan included $1,400 direct payments to most Americans and extended additional unemployment benefits through the summer.
The U.S. federal debt stands at $34 trillion, and is expected to continue to grow for the foreseeable future. Although current interest rates remain low, future inflation could cause rates to rise, and this would cause sharply higher debt service costs. This is clearly a headwind on a longer-term basis.
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