First Quarter 2024 CIO Letter: Hinging on Hope & Governmental Growth

Written April 18th, 2024

Three and a half months in and 2024 has been full of surprises. The economic data releases have remained robust, surpassing forecasts and, coupled with central banks’ dovish stances, have ignited the S&P 500 to its best first-quarter performance in half a decade. The NASDAQ continued its ascent, propelling strong Momentum factor performance. The rally permeated many other areas of the market throughout the quarter, enabling our clients to participate well in the quarter’s gains, despite our cautious and defensive tilt to our portfolios today.

It seemed like the ‘Fed Put’ was resurfacing. Globally, most central banks are shifting towards more accommodative policies. In a move that caught the financial world off guard, the Swiss National Bank led the charge as the first developed country central bank to lower interest rates post-pandemic. Switzerland’s prudent reputation led markets to interpret this as confirmation inflation risks had abated, setting the stage for a global rate cutting cycle to begin. While this looks like it could still be the case for many countries, the United States has found itself charting a divergent course in recent weeks.

At the start of 2024, the market was buoyant, anticipating over a half a dozen rate reductions by the US Federal Reserve (Fed)—a sentiment that seemed overly optimistic barring a significant economic downturn. Enthusiasm of the beginning of the rate-cutting cycle which was amplified by Switzerland’s decisive action and the Fed’s conciliatory rhetoric was quickly dashed by a third consecutive, strong Consumer Price Index (CPI) print in March. The market had dismissed January’s stronger CPI report as an anomaly, February’s as a fluke, but March’s data solidified the trend of a return to strengthening inflation.

Dovish Fed commentary had eased financial conditions, the output gap turned positive, and government spending increased meaningfully in 2023. The strengthening in inflation was reasonably broad-based as oil prices began increasing again, insurance premiums jumped, food inflation picked up, and costs for housing, utilities, and medical care rose. The most alarming aspect is that many of the inflating CPI components were essential goods, heightening the impact of the inflationary resurgence. The Treasury market rapidly and violently recalibrated to this new reality (Chart 1), now signaling just under two rate cuts this year. The once-assured June rate cut has been nearly priced out. We may not see any cuts this year.

Following the hot inflation print, Federal Reserve Chair Jerome Powell expressed that recent data had not bolstered confidence, suggesting a return to the inflation target may be a more protracted journey than they had anticipated. It appears we may be back to high for longer and the Treasury market seems to be taking Powell at his word. As rate cuts are priced out of the market, today’s extended valuations leave investors hinging on hopes of a resurgence in earnings growth to bounce back from the stagnant levels of 2023. Thus far, the modest correction in the equity markets to start off the second quarter is not equivalent to the severe repricing in the Treasury market.

US risk markets are hoping for, and pricing in, a ‘soft-landing’ scenario. Equities and corporate bonds are priced for the Fed to land the plane, AI to drive margin expansion, earnings to recover strongly, inflation to decelerate to 2%, further escalations in geopolitical tensions to be avoided, the Fed to be able to cut rates into a growing economy, bankruptcies to remain subdued, and consumer resilience to persist. The bullish scenario is that better-than-expected data buoyed by immigration, consumer resilience, and robust government support, alongside AI’s transformative promises, has manufactured the potential of no landing at all, or a very soft-landing. The greatest bull case for the US economy lies in innovation-driven productivity gains that decrease inflationary pressures, allow corporate margins to expand further, and increase potential GDP. The chance of this becoming a reality is increasing, yet current valuations and expectations may have already factored in much of the positive news. We also believe market expectations are for the impacts to be felt much sooner than is realistic.

Conversely, the risks remain largely unaccounted for in market prices. Geopolitical tensions are rising, US government debt is nearing $35 trillion and climbing rapidly, interest expense on US debt has surpassed defense spending, money supply is contracting, small business optimism just hit an 11-year low, mortgage delinquencies and hardship withdrawals from retirement accounts are increasing, consumer credit score are falling because of delinquencies and high debt balances, and defaults on leveraged loans saw a significant rise last year. Fundamentals in the stock market are relatively weak, yet expectations for growth are high. We continue to ascend this ‘wall of worry’, with fiscal spending and dovish Fed rhetoric providing the necessary traction.

While headline job growth appears strong, a closer examination reveals a different reality. The latest reports boast strong employment figures, but these are predominantly in part-time positions. Although the overall number of individuals working part-time for economic reasons has not risen, those doing so due to slack or business conditions rose by over 100,000.[1] The Current Population Survey, on a seasonally adjusted basis, indicates a consistent decline in full-time employment over the past four months.[2] Government roles, particularly at the local level, have been a significant factor in job and wage growth, with government employment surging by 71,000 in March, well above the average monthly increase over the past year.[3] Nonresidential construction has also shown strength, aligning with the strong spending on manufacturing structures. A weakening employment picture could leave many consumers, already burdened by debt, in a precarious position.

Both direct and indirect government spending propelled the economy forward in 2023. Within Investment spending, contribution of growth from real private investment in manufacturing structures has been strong enough to move the needle, making the largest contribution to GDP growth since data became available in the 1950s. The aging infrastructure was untenable and much of the spending stemmed from the Inflation Reduction Act (i.e. government spending). Removing manufacturing structure spending and private R&D, investment growth would have looked much different last year. Government spending (the blue lines in the chart below) saw vigorous growth last year. Personal transfer receipts also enhanced personal income and consumer spending last year.

Government spending was a significant contributor to employment, GDP, and wage growth in 2023. A time when the Fed was trying to slow the economy to bring price stability back to the economy. While the private sector is seeing some deceleration in wages and salary growth, government wages have only plateaued. Such dynamics pose a formidable challenge for the Fed, complicating its duty to ensure price stability while maintaining financial stability. The sustained flow of fiscal spending may have delayed and may continue to delay a conventional recession until the spigot runs dry, but we believe it simultaneously elevates the risk of stagflation—an environment of stagnant growth with inflation which could have severe repercussions.

Chart 3

That scenario would also likely increase government debt. In their latest fiscal monitor released in April, the International Monetary Fund (IMF) advised that governments should promptly transition away from pandemic-era fiscal policies and implement reforms to control escalating expenditures while safeguarding the most vulnerable.[4] This recommendation aligns with our concerns regarding the unnecessary robustness of fiscal spending in the current economic climate. We believe that should the economy falter, the absence of a recession—an unpleasant, but natural and necessary phase of the economic cycle that purges excess—could lead to prolonged inflationary pressures and inefficiencies and potentially persistent stagflation.  

The IMF also highlighted the pivotal role of US Treasuries in determining funding costs globally and within the US economy. Persistent high rates in the Treasury market could destabilize other fragile parts of the market and amplify risks. “High and volatile government bond yields in the United States would lead to tighter financing conditions in the rest of the world.”4 We are hovering near a critical level on the 10-Year Treasury yield again that has historically triggered a larger sell-off. Analysts seem to agree that it is somewhere between 4.5% and 5.0% but disagree on the exact level. As of this writing the 10-year yield is increasing within this range. 

We are learning more about the appetite of investors for the coming surge in bond supply. While auctions earlier in the year yielded reasonably strong results, auctions since the higher inflation print have been more mixed, further fueling a sell-off in the Treasury market.  The deficit is experiencing mounting pressure from the impact of the demographic shift on Social Security and Medicare spending. Rising interest expenses are compounding the fiscal pressure. As the national debt grows, so does the cost of servicing that debt, especially as the price investors demand to lend money to the government increase, creating a negative feedback loop. The chasm between government income and spending is bridged through Treasury sales. If the economic growth trajectory stagnates, the magnitude of this fiscal dilemma becomes very concerning.

Our previous CIO letter delved into the substantial debt within the system and how it has effectively borrowed growth from the future, leaving consumers, corporations, and the government allocating a significant portion of their budgets to service past growth. In 1983, the Consumer Price Index formula was modified to exclude interest expenses from the cost-of-living calculations. Reintroducing pre-1983 housing costs to the inflation calculation results in inflation that remains excessively high. According to a National Bureau of Economic Research (NBER) Working Paper published in February, titled “The Cost of Money is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly”, we are experiencing inflation rates not seen since the early 1980’s under the historical definition. Introducing personal interest payments into the calculation, inflation rates are double digits, levels unseen since the 1970’s under this definition.[5] This underscores the persistent inflationary environment extending beyond the official figures.

What Does This Mean for Your Portfolio?

The investment landscape is in a state of flux. When I originally wrote this section on April 12th it read: “we updated the below table from our last letter. Valuations have become even more extreme since January, despite rate cuts being priced out of the market. When the bond market and the stock market are sending two different messages, we tend to listen to the bond market. This deviation has feelings of Fall 2021 and 2022 turned out to be a painful year.” It’s been a week, and the stock market has experienced some significant turbulence. Our assessment is that there is potential for further declines in the equity market, which has not yet adjusted as drastically as the Treasury market.

The table in question underscores the challenges that lie ahead for market returns from these valuations and the importance of a cautious and strategic approach in the current market landscape. The yellow boxes are the April 11th next twelve months (NTM) Price to Earnings (P/E) ratio and the current 2024 Earnings Estimates. The red and green figures reflect the potential market returns from the April 11th close as changes occur in earnings growth and the multiple the market is willing to pay. So much needs to go right to achieve market returns above the 5+% risk-free rate.

Our cautious market outlook is anchored on how stretched current valuations are and our belief that achieving the forecasted 12% earnings growth this year will be difficult with a slowing economy and narrowing margins. The market has already absorbed a lot of multiple expansion. In our view, it is more likely that reality disappoints. S&P 500 returns turn ugly quickly when expectations are missed in the table (up and left). A profound 24% correction would be needed to realign with the 20-year average P/E ratio, even assuming expected earnings growth comes to fruition. To surpass short-term treasury market returns, earnings per share (EPS) growth must exceed 15%, multiples would need to expand above 22, or a blend of both.

Last twelve months (LTM) P/E is above 25. This means that if we have another year of stagnant earnings growth, proving current estimates for 2024 earnings growth much too robust, then the market is extremely expensive. Valuations are a terrible short-term timing tool but tend to prevail in the long run. As it stands, the US market appears exceedingly expensive, exuding optimism. The Bank of America Global Fund Manager survey is currently reading the most bullish since January 2022. Investors are optimistic about an acceleration in global growth and the earnings outlook. Allocations to cash and to bonds have fallen considerably, with bond allocations posting their biggest month over month decrease since July 2003. With lofty expectations and positioning stretched, there is substantial room for disappointment.

Considering these uncertainties, we identify two attractive alternatives: short-term treasuries, with yields above 5.45% (as of April 18th), and gold. We have maintained a position in gold since SCA opened in July of 2022 and have increased the position since August of last year. We recognize its value as a hedge against inflation, geopolitical risks, and its non-correlation with equities, offering portfolio diversification. Central banks’ robust demand for gold, along with interest from Chinese citizens amid local market concerns underscores its appeal.

Within Treasuries, we entered the year with most of our fixed income exposure on the very short (one or two months out) end of the curve as we believed the market was too optimistic about rate cuts. We also initiated a floating rate Treasury position to capture some of the move in the curve. We have since begun extending our Treasury position again slightly as opportunities have emerged.

While skepticism is warranted, there are some emerging signs of bottoming in China which could bode well for European and global growth. Inflation looks under control in much of the rest of the world and valuations are also more compelling abroad. Currently most of our underweight to equities in client portfolios comes from our severe underweight to international equities. We believe that some of these countries are nearing better parts of their economic cycle and are selectively beginning to look for opportunities.

We remain defensively positioned, ready for market volatility. We continue to know exactly what we want to own and the prices we are willing to pay. The second quarter has given us some volatility to work with and some of the opportunities we like are nearing attractive levels. Navigating the market with judiciousness and caution will be imperative to weather the changing tides and identify investment opportunities. Being active, nimble, and selective in investment decisions will be crucial.

Things are changing rapidly. We are monitoring the environment closely. Absent a worsening economic picture, we will be buying into the weakness as valuations become more attractive. Until then, we are getting paid well while awaiting these opportunities.

As always, please reach out to the Stone Creek Advisors team with any questions.

Kasey

[1] https://www.bls.gov/news.release/empsit.a.htm

[2] https://www.bls.gov/web/empsit/cpseea06.htm

[3] https://www.bls.gov/news.release/pdf/empsit.pdf

[4] https://www.imf.org/en/Blogs/Articles/2024/04/17/why-our-world-needs-fiscal-restraint-in-biggest-ever-election-year

[5] The Cost of Money is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly”. Marijn A. Bolhuis, Judd N. L. Cramer, Karl Oskar Schulz, and Lawrence H. Summers. NBER Working Paper No. 32163. February 2024. JEL No. D14,E30,E31,E43,E52,G51,R31 < https://www.nber.org/system/files/working_papers/w32163/w32163.pdf>.

MGO One Seven LLC (“MGO One Seven”) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). Registration with the SEC does not imply a certain level of skill or training. Services are provided under the name Stone Creek Advisors, LLC, a DBA of MGO One Seven. Investment products are not FDIC insured, offer no bank guarantee, and may lose value.