At their December meeting, the Federal Reserve signaled a notable change in monetary policy, suggesting a possible reduction of 0.75% in the Fed Funds rate for 2024. This move, which mirrors the dovish sentiment of the market, sparked a wave of bullish activity on Wall Street. Prompting the Fed’s pivot is the rapid deceleration in inflation rates from 5.1% in 2022 to less than 3.5% for 2023. These developments have shifted analysts’ expectations from anticipating a recession to expecting a soft-landing, where central banks effectively counter inflationary pressures without precipitating a recession. While probable, we believe these expectations are overly optimistic. There exists a noticeable disparity between present market valuations, which appear to tolerate no margin for error, and the inherently uncertain nature of such forecasts. This gap between current market prices and the probabilistic nature of these expectations creates opportunities for strategic investment decisions.
Soft-Landing: Not out of the woods yet
Supporters of the soft-landing narrative highlight several upbeat signs: a downward trend in inflation, an end to Fed rate hikes, a robust stock market, strong employment, and resilient consumer spending. However, they often disregard the fact that last year’s economic strength was largely attributable to deficit-fueled fiscal support and the depletion of savings accumulated by households during the pandemic stimulus era. As fiscal support wanes, the impact of stringent monetary policies is expected to become more pronounced, as borrowing costs for families, businesses and governments are set to increase significantly. What’s more, should the economy deteriorate, the prospects for future fiscal or monetary interventions are limited by soaring debt levels and the inflationary pressures instigated by previous stimulus measures.
Even for those who disagree, a closer look at historical patterns suggests caution – the US economy has a track record of slipping into recessions precisely when the consensus leans too heavily towards optimism. How can that be? Key economic areas, particularly the labor market, demonstrate long lag times to reflect the impact of Fed rate hikes, typically between 18 to 24 months. As such, parts of the economy are only beginning to feel the full brunt of the Federal Reserve’s rate hikes. Therefore, declaring the economy has successfully navigated through these challenges may be premature. Research by PIMCO, a leading asset manager, indicates that out of 140 tightening cycles in developed economies since the 1960s, nearly all instances where policy rates were raised by 4% or more, as seen in this cycle, have culminated in recessions.
At the end of 2022, expectations were firmly entrenched in the belief that a recession was an inevitable conclusion. Rewind to a year prior, and the prevailing sentiment was that the behemoths of the tech industry would remain unscathed amidst rising interest rates. The dominating consensus, much like today’s widespread anticipation of a soft-landing, has been disproven in the prior two instances. Looking ahead, the certainty of achieving a soft-landing remains to be seen. Even if this optimistic scenario does materialize, the potential market gains may be limited, given that such an outcome appears to have already been accounted for in current market valuations.
Interest Rate Paradox: Market enthusiasm meets Fed caution
The market is exuberant, expecting a 1.5% reduction in the Fed Funds rate in the coming year, in stark contrast to the Fed’s more measured projection of 0.75%. Paradoxically, this intensifies the Fed’s apprehensions regarding inflation as the market’s preference for lower interest rates serves to ease financial conditions. This heightened concern, in turn, could lead to a postponement of the very rate cuts that market participants are anticipating. Such a scenario underscores the complex interplay between market expectations and central bank policies, highlighting the intricate balance the Federal Reserve must maintain in its policy decisions. The Fed is exercising caution to avoid the errors of the 1970s, when expansionary policies and external factors resulted in a sharp resurgence of inflation.
Equity Markets: Valuation gaps hint at untapped opportunities
2023 stands as a year marked by the triumph of a select few over the many. Dominating the scene were the “Magnificent Seven”—Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta—whose collective stock prices surged by an impressive 87%. This stark outperformance has overshadowed the remaining 493 companies in the S&P 500, a dynamic largely fueled by the excitement around artificial intelligence.
This phenomenon presents investors with unique challenges. First, the dominance of the Magnificent Seven has led to an unprecedented level of concentration within the S&P 500, where they now represent nearly 30% of the index’s total value. To put this into perspective, the market capitalization of these seven companies is larger than the stock markets of Japan, France, China, and the U.K. combined.
Second, much of the price appreciation of these stocks is due to heightened expectations, pushing their valuations to nearly 35 times earnings. This is in stark contrast to the 21 times valuation multiple for the remaining 493 stocks in the index. Current valuations might be justified if we were on the precipice of these new technologies unlocking productivity gains. This outcome remains uncertain and, should it materialize, is likely years away. Starting valuations are the best indicator of future investment performance. Using today’s valuations as a guide, the prospects of these stocks look bleak.
This situation has led to one of the widest valuation dispersions in the S&P 500 seen in decades. Despite the allure of these tech giants, there is untapped value in other parts of the market. We believe a focus on attractively priced, high-quality stocks will generate attractive returns in the years to come.
Bonds are back!
Conventional wisdom states bonds are only for those seeking safety, but current dynamics warrant even the risk-seeking to consider the asset class. To evaluate the relative appeal of stocks versus bonds, analysts often compare the earnings yield on stocks against the yield of the 10-year Treasury. This differential, known as the equity risk premium, is a barometer of the additional return investors require for choosing stocks over bonds. The premium has been on a tightening trajectory, reflecting market confidence in a soft-landing scenario. Investor emotions are also at play. Bonds registered their worst year on record in 2022 due to a sudden rise in interest rates from historically low levels. With bonds performing as poorly as stocks in 2022, and stocks vastly outperforming bonds in 2023, many have shunned the asset class all together. The combination of a historically low equity risk premium and the crash protection bonds provide during recessions make bonds an attractive allocation in today’s climate.
Many have opted to own Treasury Bills in lieu of bonds. In the current environment, holding cash appears attractive due to high interest rates and the ability to reinvest as new opportunities emerge. However, there are risks associated with this strategy, as the yields from cash are not stable. We advocate for longer-duration bonds as they offer resilience in investment portfolios. They provide appealing yields that can be secured for an extended period and may also increase in value during a recession. We maintain a focus on high-quality investments within our fixed income strategies. We remain overweight U.S. agency mortgage-backed securities, which are attractive due to their high quality, government support, strong liquidity, and favorable valuation. We are particularly concerned about lower-quality, floating-rate corporate debt, like bank loans and some older private credit assets, as they are exhibiting signs of stress due to rising interest rates.
Historic Opportunity in Closed-End Funds
Closed-end funds offer a historic opportunity for the disciplined investor. These vehicles, distinct from the more prevalent open-end mutual fund, can trade at a premium or discount to their net asset value. Many closed-end funds today are trading at historically wide discounts, presenting a potential opportunity for outsized returns. This gap also translates into higher immediate yields, since the funds we acquire at 90 cents are still reaping the income benefits of a full dollar’s worth. One of our partners has decades of experience investing in closed-end funds, employing a strategy that seeks to take advantage of these discounts.
Uncorrelated Alternative strategies remain a valuable stabilizer
Macroeconomic uncertainty continues to be a significant concern. Stocks and bonds, inherently tied to the macroeconomic landscape, are particularly vulnerable to fluctuations in growth and inflation rates. In response to these challenges, a strategic approach involves diversifying our investment portfolios with additional sources of return that are not correlated to specific macroeconomic outcomes. Our Liquid Alternatives strategy exemplifies this approach. Over the past two years, it has demonstrated its effectiveness by providing a stabilizing force amidst market volatility. The key benefit of this approach is a more resilient investment portfolio, capable of withstanding various economic scenarios and delivering more stable long-term outcomes for investors.
Razmig Der-Tavitian, CFA, CAIA
Chief Investment Officer & Managing Partner
SLK Private Wealth
