Welcome to Election Year! 2024 is bound to be eventful. According to The Economist, it is the biggest election year in history with key elections in 76 countries and plenty of potential implications stemming from the results [1].

The fourth quarter was a wild ride. The summer correction continued through late-October when the market became fixated on the potential for central banks to begin cutting rates as inflation cooled. In the United States (US), investors priced in an expectation of six rate cuts for 2024, leading to a substantial shift in the anticipated 2024 year-end Federal Reserve (Fed) funds rate—dropping from 4.54% in mid-October to 3.88% at the end of 2023. Concerns related to the global debt burden seemingly dissipated and bonds came roaring back. Treasury Secretary Janet Yellen played a pivotal role by modifying the Treasury's auction strategy, selling more Treasury bills, and decelerating the sales of 10- and 30-year Treasury bonds following disappointing auctions. This was well-timed given the potential for the Fed to begin cutting rates in the next year. If all goes well, they will be able to roll the T-bills into longer-term Treasuries at lower yields. We do not believe the market will get its six rate cuts without a meaningful recession, though the three being signaled by the Fed may be reasonable.

The Math of It

We view everything through a risk versus reward lens. Most of the letter is dedicated to the risks we see in the current environment, but the potential reward side of the equation matters a lot. Our Director of Investments, Peter Borello, CFA, has constructed an insightful table underscoring the obstacles facing potential returns and underscores the need for a cautious and strategic approach in the current market landscape. The yellow boxes are the current next twelve months (NTM) Price to Earnings (P/E) ratio and the current 2024 Earnings Estimates. The red and green numbers are the market returns from the close on January 23rd 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 revolves around how stretched current valuations already 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 may not turn out as perfect as what is being priced in. S&P 500 returns turn ugly quickly when expectations are missed in the table below (up and left). A profound 20% 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, EPS growth must exceed 15%, multiples would need to expand to at least 22, or a blend of both.

Implications of Rising Geopolitical Tensions

The current global landscape is fraught with geopolitical uncertainty. Tensions are at their highest level in recent history. The potential for these tensions to escalate and proliferate is building, posing a threat to stability. Geopolitical events are inherently unpredictable and can yield far-reaching consequences—disrupting supply chains, natural resources, agriculture, and trade routes—thereby fueling inflation and possibly necessitating central banks to remain on hold.

Two major trade routes are being impacted today, risking a reignition of inflation. Attacks in the Strait of Bab al-Mandab, a key route to and from the Suez Canal, have surged since mid-December, causing many shippers and energy companies to avoid the area, and increasing shipping times and costs. While not geopolitical, the Panama Canal, another major shipping route, is grappling with a severe drought that has reduced the number of ships that can pass through the canal each day. One shipping firm, MSC, has more than tripled its shipping rate for a 40-foot container from India to the US East Coast.

The outcome of the mid-January Taiwan election potentially escalates tensions with China. The economic consequences of a Chinese invasion of Taiwan would be significant and hopefully disastrous enough to Chinese growth to deter them. According to Bloomberg Economics estimates, a Taiwan Blockade that cuts off Taiwan’s trade from the rest of the world could have a -5% impact on global growth. A full-scale invasion of Taiwan involving the US could reduce global GDP by 10%, more than the pandemic and the Global Financial Crisis. [2] The impact on the semiconductor industry could be catastrophic, disrupting supply chains for laptops, phones, and autos. The Taiwan Strait is also an important global trade route.

So Much Debt, Yet No One Seems to Care

Debt is a double-edged sword, enabling present consumption at the cost of future consumption. When interest rates are low, cumulative debt is low, and it is paid off over an extended period, it is not an issue. However, consumer debt, specifically credit card debt, is quickly ballooning with higher interest rates. As more of consumers' income is channeled into debt servicing, the capacity for spending elsewhere diminishes. Consequently, this casts a shadow over future GDP growth, undermining the economy's potential by constraining consumer spending. We are in the future.

The labor market has yet to roll over, but hiring is slowing. If unemployment increases, the already burdensome debt servicing costs may become even more formidable for individuals, severely curtailing their ability to spend. This downturn in consumer spending would reverberate through the business sector, dampening sales growth for companies, some of which are grappling with their own debt challenges. Government, heavily reliant on income and corporate tax revenues, may also be negatively impacted. As the economy loses steam, interest expenses loom ominously, exacerbating the impact of burgeoning debt.

The massive pandemic borrowing spree has laden government balance sheets with suffocating levels of shorter-term debt, a vulnerability compounded by the anticipated slowdown in global growth, which is poised to diminish tax receipts while escalating debt servicing costs. The ballooning US fiscal deficit, standing at a staggering ~6% of GDP, has doubled relative to historical levels, surpassing the highs witnessed during the Global Financial Crisis and could worsen as growth slows. This surge in the deficit, recently fueled by growth in interest expenses, is further compounded by the mounting pressure from the impact of demographic shifts on Social Security and Medicare spending. The chasm between government income and spending is bridged through Treasury sales. If the growth trajectory stagnates, the magnitude of this fiscal dilemma becomes very concerning.

The Coming Challenge of Surging Debt Issuance
Much of US debt is fixed rate, meaning the pain is only felt by the borrower when the debt needs to be rolled over at higher rates. There is a massive debt maturity wall over the next three years. Corporate and government debt issuance will increase substantially, coinciding with central banks continuing to reduce their bond holdings. Therefore, the onus falls on external investors to satisfy the ballooning financing needs of governments and corporations. Will the market be able to absorb such a substantial supply of bonds? Higher US yields would likely raise borrowing costs for other governments, corporations, municipalities, and consumers. The US, UK, and Euro Zone are set to sell a net $2.1 trillion of new bonds in 2024, 7% more than last year. [3]

The commercial real estate (CRE) market may become a more significant issue this year and next as they move through the middle of their maturity wall. According to a National Bureau of Economic Research paper by Erica Jiang,14% of the $2.7 trillion of CRE bank loans are larger than the value of the buildings they finance. For office loans, this number is 44%. Even 10% of these loans defaulting could result in $80 billion in charge-offs and cause many bank failures. [4] Some office properties may be unable to find someone willing to give them capital. The Wall Street Journal referenced a report by Moody’s Analytics which estimated 19.6% of office space in major cities in the US was not leased in the fourth quarter, the highest vacancy rate since they began tracking the data in 1979.[5] Losses in the CRE market could spill over as distressed property sales pressure valuations. Lower valuations could hurt local government tax revenues.

What Has Changed?

The Fed is landing the plane as the lags in monetary policy take effect. As we advance into 2024, the impacts are expected to become more pronounced with the persistence of positive real rates. Approaching the ground always carries risk. The data is becoming more difficult to read, a common occurrence towards the end of the cycle. The priority lies in staying attuned to the primary data influencing both the economy and the markets. While leading indicators continue to soften, lagging data remains robust.

Encouragingly, the potential for a soft landing is gaining traction. The Fed’s focus has shifted towards concern about staying too restrictive too long and away from its inflation focus. The risks have become more balanced, or even tilted towards growth and financial stability concerns. This is partially attributable to the certainty that comes with nearing the ground. The likelihood you are going to land increases, it’s just how you land.

• No Landing: Growth remains above potential GDP, but the Fed is unable to bring inflation to their target, requiring them to keep rates high. This would be painful for the bond market where yields have already moved much too low. The equal-weighted index may be the winner as the rally extends beyond the Magnificent Seven.

• Soft-Landing: The economy avoids a recession and inflation continues to cool. Inflation easing as much as it has made the Fed’s job easier, giving them the ability to cut rates as the economy slows, potentially avoiding a recession altogether. Lower inflation in some areas abroad has also reintroduced the ability for the US to import deflation from abroad, something they have been unable to do since the pandemic began. In our view, this is the upside scenario with the highest probability and the narrative the market has fully priced in. The bond market is likely to react poorly as we believe six rate cuts will not materialize in 2024 in this scenario. Inflation ticking back up in the December reading did give a bit of a pause to this scenario, for a moment.

• Turbulent Landing: Some damage is done, a wing and a wheel fall off, some bumps and bruises, but everyone comes out in okay shape. The mild recession wrings out some of the excesses, taking inflation out of the system, and giving the Fed cover for the six or more rate cuts necessary to rescue the economy. Europe looks headed this way and we believe this remains the most likely scenario for the US.

• Hard Landing: A more severe recession, likely accompanied by a default cycle. This could still happen, but tempering inflation has put more tools back in the Fed’s toolbox to help mitigate the risks. The potential willingness of the Fed to cut rates before inflation hits 2% helps avoid this scenario. Many potential black swan events remain that could still trigger a hard landing.

While US growth has remained surprisingly resilient, helped by government spending and a consumer padded with pandemic savings, many other countries’ economies are deteriorating. Growth is slowing much more quickly and obviously in Europe than in the US and Euro Zone core inflation has cooled to 2.5%. This is partially because Europe is more economically tied to China. European Central Bank’s (ECB) President, Christine Lagarde, confirmed cutting rates this summer may be realistic, but suggested the market was getting ahead of itself on rate cut bets which could hinder their progress on inflation. Tensions in the Red Sea could reverse the disinflation trend, which would put the ECB in a much more difficult position.

Chinese growth is slowing quickly, and inflation no longer seems to be an issue. Youth unemployment in China is over 20% and demographics in China are worsening by the day. China’s transition from a manufacturing driven economy to a sustainable consumer driven economy is proving to be difficult. Thus far China’s policy support has done little, but we will see if the newest measures help stabilize the market and economy.

The Implications of Slower Growth and High Debt Loads

We spent some time in the Congressional Budget Office's "Workbook for How Changes in Economic Conditions Might Affect the Federal Budget: 2023 to 2033,"[6] and isolated inflation and the 10-year yield. While recognizing that real-world scenarios are multifaceted and interconnected, dissecting these elements in isolation offers insights into potential drivers of decision-making. In the spreadsheet, a mere 0.1% decrease in the 10-year yield can narrow the cumulative budget deficit forecasts for the period 2024-2033 by $302 billion against the baseline projections. Inflation 0.1% above projections has a nuanced effect on the budget deficit, widening it by $5 billion overall but initially narrowing it by $9 billion from 2024 to 2028. In this analysis, prioritizing lower rates, even if it means foregoing some disinflation, helps meaningfully narrow the deficit. Net borrowers do not want to be rolling over debt at today’s rates.

With the cycle rolling over and potential GDP growth (the growth rate an economy can expand at without triggering inflation) slowing, the ability of economies to grow their way out of debt is diminishing. The potential GDP growth rate has slowed immensely over the last decade and a half. Consequentially, it takes less growth to stoke inflation, potentially leading to more volatility, more frequent central bank policy interventions, and shorter cycles. The Output Gap measures the amount of economic slack. A positive gap means economies are growing above potential GDP which theoretically stokes inflation and prompts tightening. A gap below zero means there is slack in the economy and the economy is free to grow without inflationary concerns. Most of the world has moved below zero over the last few quarters, but the US reentered positive territory and Japan is close.

What Does This Mean for My Portfolio?

The recent developments suggest a higher chance of avoiding a severe recession, undoubtedly positive news. However, challenges lie ahead. Much of the good news is priced in. Last year earnings fell short of expectations, leaving multiple expansion to provide the outstanding market returns. There is a lot of concentration within the S&P 500 today. The Magnificent Seven represents 28% of the S&P 500 and is trading at over 40 times trailing earnings. Achieving significant index-level returns in the current environment of high valuations and lofty expectations is likely to be challenging moving forward. In our view there is much more risk of meaningfully negative returns than positive returns from here.

Much of margin expansion over the past few decades was attributable to declining effective tax rates and the decline in bond yields and interest expense. However, today’s landscape is different. There is not any juice left to squeeze on the interest expense side, that is moving the other way and given the budget math, taxes are more likely to move higher than lower. Margins typically roll over towards the end of the cycle as wage inflation surpasses revenue growth. Pertinently, the NY Fed’s Empire manufacturing survey release was a negative signal for corporate profits. The data was the weakest since May 2020 and the third lowest since the series began. New orders, shipments, and unfilled orders were exceptionally low. Prices paid increased, but prices received eased.

Warren Buffett's quote— “Only when the tide goes out do you learn who has been swimming naked”—serves as a poignant metaphor for the current environment. Some may have always been naked, some may have taken their pants off in the ocean, but until the tide goes out it is not always obvious. Some investments were always bad investments, some management teams took missteps along the way, but panic is not what causes the loss of capital.  It is what is done in the years leading up to the panic—excessive use of leverage, investing in unprofitable projects—that causes the pain when free money is gone, growth rolls over, and panic sets in. Near zero interest rates enticed governments, companies, and consumers to go on a debt-fueled spending binge with little consequence. Low rates inflated valuations in public and private markets and investors stretched their risk tolerance for returns. This worked in the ultra-accommodative world that remained in place too long. However, as rates rise and debts need to be refinanced, the vulnerabilities of those who overextended themselves show. As the tide recedes, it may become apparent who was prudent and who succumbed to the allure of easy credit. In this new world of higher rates for longer, the importance of sound financial stewardship is pronounced. 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.

S&P Global just released data that 2023 corporate bankruptcies were the highest since 2010. [7] We expect bankruptcies to increase as more debt comes due. Aside from CCC rated bonds and below, which are modestly elevated, investors are demanding very little yield over Treasuries for the additional risk. So far in January the US corporate bond market has sold $150bn of debt, the hottest start to a year in over 30 years as corporate borrowers take advantage of the narrow spreads. [8] The market seems to be digesting it well so far.

Valuations are a terrible short-term timing tool but tend to prevail in the long run. The US market appears exceedingly expensive, marked by soaring optimism. Bank of America's Global Fund Manager Bull/Bears survey, a reliable contrarian indicator, has reached its highest level since November 2021. Marc aptly dubs it the "do the opposite indicator," reflecting its value in gauging market sentiment. Currently, 79% of fund managers anticipate a soft or non-existent landing, signaling a conspicuous level of buoyancy in the market. With lofty expectations such as the projected 12% earnings growth for 2024, substantial room for disappointment exists.

While the probability of a soft-landing has increased in the US over the last year, many risks exist that are not priced in. We remain concerned about the economic outlook and still believe a recession is likely to materialize as money supply contracts rapidly, the manufacturing sector slows, oil prices fall, the job market begins to cool, and everyone starts digesting the maturity wall. Given these risks, we are being very selective about where we allocate capital today. Parts of the market are pricing our outlook much better than the overall index is. We have exposure to these areas today. We took some opportunities created by the selloff in October to increase our equity exposure but remain modestly underweight equities due to our cautious outlook.

Despite the uncertainty, there is still an alternative today with short-term treasuries yielding over 5%, an attractive option in the current climate. We know exactly what we want to own and at what valuations. We are prepared for volatility. Absent a worsening economic picture, we will be buying into that volatility as valuations become more attractive. Until then we are getting paid well to wait for opportunities to emerge.

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

Kasey

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.

[1] https://www.economist.com/interactive/the-world-ahead/2023/11/13/2024-is-the-biggest-election-year-in-history

[2] If China Invades Taiwan, It Would Cost World Economy $10 Trillion - Bloomberg

[3] https://www.bloomberg.com/news/articles/2024-01-13/world-economy-latest-fed-to-lead-pivot-toward-interest-rate-cuts

[4] https://www.nber.org/papers/w31970

[5] https://www.wsj.com/real-estate/commercial/offices-around-america-hit-a-new-vacancy-record-166d98a5?mod=hp_lead_pos8

[6] https://www.cbo.gov/publication/59027

[7] https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/us-bankruptcies-hit-13-year-peak-in-2023-50-new-filings-in-december-79967180

[8] https://www.ft.com/content/20041cec-a83f-4f41-8cf3-b40d3464c922