The Fed and consumer will decide where the economy goes from here
Introduction by Jonathan Dane, CFA, CFP®️
The resilience of the US economy and market in 2023 surprised most economists. Instead of a recession, US economic growth accelerated. Instead of a market slowdown, the stock market accelerated on the back of large-cap tech and growth companies. And by year-end the “earnings recession” for S&P 500 companies appeared to be waning as the rally broadened to other sectors.
Heading into the new year, the economy is growing at a solid pace, the labor market is tight, inflation is decelerating, and the housing market shows early signs of a rebound. Economic data indicates that higher interest rates have yet to make a significant impact. Stocks trade near all-time highs, and bonds just staged their best quarter since 1989. There is a growing sense of optimism, but can the economy live up to that optimism?
The theme we are most focused on for ‘24 is consumer spending, and where it goes from here. In our view, the US economy underwent a structural shift post-COVID resulting in elevated services spending; a trend which we expect to persist. Combine this with a fundamental housing shortage, and we continue to see tailwinds for economic growth in ‘24.
Bottom line – maintain your investment discipline this year and look for pockets of volatility for opportunistic investments.
US Equity Commentary by Stu Strasner, CFA
Food, energy and defense spending may continue to have an inflationary impact going forward. Exposure to companies that benefit from these trends could be helpful to your portfolio.
Stepping back, the collapse of the Berlin Wall in ‘89 ushered in a new era. It was predicted then that defense expenditures in the US would be dramatically reduced once the Cold War was over. The pundits were correct (for a time). Now, however, the threats are more multi-faceted and omnipresent. Concerns remain over the humanitarian impact of the Eastern European breadbasket (Ukraine and its environs) going offline, as well as cyber security and threats to the grid. This is likely to drive defense spending higher, and in return inflation.
Oil market concerns have also softened with the US at a record high production level. But the bulk of this production is from reservoirs in shale formations which are notorious for: 1) stunning decline curves (e.g. within 12 months production can decline by as much as 80%), and 2) outsized production for M&A appearances. All of which is to say, energy inflation is still a very real potential headwind the Fed must combat going forward.
Six investment themes for 2024
The Fed’s transition from hawk to dove will be a key driver of fixed income markets in ‘24, as well as volatility in the stock market (in addition to the US Presidential election). Corporate earnings are on the rise, which should fuel further equity upside, but consumer spending needs to hold up as well. In addition, equity alternatives are attractive again, but will require greater diligence as return dispersion amplifies. Overall, we are optimistic for the US economy and see opportunities in risk assets for investors, especially those sitting in cash.
Below is a summary of our six investment themes for 2024.
THEME 1: Cash is no longer king
The (brief) era of cash as the most attractive fixed income investment is over. With the Fed likely done raising rates headwinds on traditional fixed income are subsiding and creating attractive investment opportunities.
THEME 2: Inflation is still too high, but should continue to drip lower
The Fed’s aggressive rate hike policy helped to drive inflation lower in ’23, but despite the improvement inflation remains above the Fed’s target of 2%.
THEME 3: Weakening consumer could be a challenge for the economy
Consumer spending remains strong, but credit card debt balances and delinquencies are on the rise.
THEME 4: Political elections will spike geopolitical volatility, but have limited impact on market
Elections tend to create volatility and noise, but ultimately have little impact on markets
THEME 5: Equity market earnings likely heading higher as rally broadens across sectors
With equity earnings momentum trending higher into ‘24 we remain optimistic on the outlook for US equities. That said, we think the rally is likely to broaden and suggest a focus on companies with strong balance sheets and earnings momentum.
THEME 6: Private investment diligence will be even more important as return dispersion rises
Higher for longer rates are likely to lead private investment managers, especially those in PE and real assets, to re-think their playbooks for value creation. The best will still shine, but those that relied on financial engineering and “multiple arbitrage” may face compressed returns.
We continue to see private investments as a core component of our investment strategy. That said, the combination of retail momentum into alternatives (private credit, interval funds, etc.) and elevated rates will likely make historic return profiles difficult to achieve for many going forward.
We see opportunity in lower middle market private equity, but caution investors about blindly investing. As operational controls and core growth become primary value drivers we expect many managers will face return compression. Similarly in real estate and hard assets, rate headwinds are likely to continue to weigh on returns.
Within venture we see opportunities emerging, but remind investors to focus on DPI vs. IRR. We expect exit timings to be extended and caution investors going into the space that capital return may take longer than anticipated.
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All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.