“Only when the tide goes out do you learn who has been swimming naked.”
Warren Buffett
“The more you sweat in peace, the less you bleed in war.”
Gen. Norman Schwarzkopf
Inflation. Stagflation. Recession.
Which is it???
The long-predicted recession has yet to materialize. The resilience of the U.S. economy can be traced back to the unusual nature of the pandemic and the aggressive fiscal and federal policy response that followed. Higher asset prices, strong job prospects, and substantial government stimulus have left many households feeling more financially secure. The result has been a steady stream of consumer spending, which continues to fuel economic expansion. Employers have added 2.6 million jobs over the past 12 months, and additional government spending on infrastructure and green-energy projects is just beginning to impact the economy. Moreover, business investments in software and research and development are on the rise, further contributing to economic growth. The most recent inflation figures, clocking in at 3%, have bolstered hopes that the worst is behind us.
However, the fact that recession forecasts have been inaccurate so far does not guarantee they will remain so. Signs of strain are beginning to emerge. The unemployment rate, although still low, has crept up to 4.1%, from a post-pandemic low of 3.4% in April 2023. The pace of hiring has slowed. Job openings, which surged during the pandemic, have returned to pre-pandemic levels. Businesses are not yet shedding workers, but pressures to do so will grow if prolonged higher rates erode profit margins. Low-income consumers have exhausted their pandemic-era savings and are increasingly reliant on credit cards, with delinquency rates rising. The economy also faces risks from sectors unprepared for higher rates that have so far avoided deeper damage in the hope that the Fed will quickly reduce short-term interest rates. Investors in the hard-hit commercial property markets and their lenders, including small and mid-sized banks, could begin to recognize bigger losses if lower rates do not materialize soon.
The U.S. economy has proven it can handle a temporary spike in interest rates, but its resilience to sustained high rates is still in question. Many firms took advantage of lower rates during the pandemic to issue corporate debt, which they will eventually need to refinance at higher costs. This strategy is familiar to homeowners who locked in low mortgage rates at historically low levels, but unlike mortgages, most corporate debt matures well within 10 years. On the public side, the surging national debt is becoming increasingly expensive to manage, with net interest payments now consuming as large a share of this year’s federal budget as defense expenditures.
Strength in the stock market appears to reflect investors’ belief that the U.S. is on course for a soft landing that will lead to a meaningful decline in interest rates. While we are not bearish on the U.S. economy or our inflation outlook, we believe the potential for negative surprises is underappreciated, given that markets have already priced in optimistic expectations. We believe risks in both directions remain magnified.
Look beyond the Magnificent 7 Fab 4
Every so often, financial markets unveil catchy monikers for stocks that captivate investor interest. From the Nifty Fifty of the 1970s to the Dot Com surge of the late 1990s, and from the BRICs of the early 2000s to the recent Magnificent 7 and today’s Fab 4, these labels mark the zeitgeist of investment trends. Historically such exuberance tends to get ahead of itself, since stocks that everyone is excited about are at risk of being overvalued. As history tends to repeat itself, a quick aside is warranted on what lessons history may share for today’s market environment.
The Nifty Fifty, similar to today’s big technology stocks, were a group of high-quality, high-growth stocks that gained immense popularity among investors in the late 1960s and early 1970s. These companies were leaders in their respective industries, renowned for their robust financial health, consistently growing revenues, and earnings. Investors believed these companies were solid long-term investments, often buying them regardless of their high price-to-earnings ratios. However, during the mid-1970s, these stocks experienced a significant downturn as market valuations corrected and economic conditions deteriorated. Despite some companies continuing to grow their revenues and earnings, the high valuations could not be sustained, leading to 60% to 80% losses in their stock price.
Fortunately, the investment landscape is not limited to headline dominators. We believe we can reap the benefits of market appreciation while avoiding the risk of overvaluation by looking beyond the marquee names. While the S&P 500 is trading at a price-to-earnings multiple of 26 times, the average stock in the index is trading at 19.8 times. What’s more, the S&P 500 hasn’t always traded at a premium to the average stock, indicating there is a lot of value beyond the largest companies. In our US large cap and small cap strategies, we favor high-quality, attractively priced stocks, aiming to harness market appreciation without succumbing to the pitfalls of overvaluation. This approach not only diversifies risk but also capitalizes on the potential undervaluation within the broader market.
Opportunities in International Equities
U.S. stocks command significantly higher price-to-earnings multiples compared to their global counterparts, yet around 40% of their earnings are derived from international markets. In contrast, about 20% of earnings for companies outside the U.S. come from American operations. Despite this substantial overlap, the market assigns vastly different valuations to these companies. Discounts today are evident across all sectors. This discrepancy in valuations isn’t limited to the developed world. Several emerging markets are well-positioned to capitalize on global trends, offering valuations that are far more attractive than those in the U.S. Examples include Mexico and Vietnam, which are benefiting from the “friendshoring” of Western supply chains, and countries like South Korea and Taiwan, which are riding the artificial intelligence wave.
Keep Calm and Carry On
There was a time when diversifying into bonds meant sacrificing return. Back when bonds were yielding 1%, allocating away from equities came with a big price tag. In the current market environment, active managers are capitalizing on promising opportunities within high-quality sectors, such as agency mortgage-backed securities. This allows them to achieve yields of approximately 6% while avoiding substantial risks associated with interest rates, credit, and illiquidity.
The markets currently seem to underestimate the risk of a significant recession, suggesting that bonds could offer a cost-effective hedge against this risk. Bonds are positioned to perform favorably in the absence of a recession and potentially even better if one occurs, with the added possibility of price appreciation if yields decline. This makes bonds an appealing option compared to holding T-Bills or cash, from our perspective.
Looking Ahead
As we navigate the complex landscape of 2024, our approach remains focused on vigilance and diversification. The evolving economic conditions underscore the importance of a balanced strategy, one that leverages both the resilience of the U.S. economy, and the opportunities present in undervalued corners of the market. Our commitment to high-quality, attractively priced stocks within equities, promising sectors in fixed income, and uncorrelated alternative investment strategies ensures that we are well-positioned to manage risks and capitalize on growth prospects. While the future may hold uncertainties, our proactive and diversified investment approach is designed to safeguard and enhance our clients’ financial well-being. We appreciate your trust and partnership as we continue to steer through these dynamic times together.
Razmig Der-Tavitian, CFA, CAIA
Chief Investment Officer & Managing Partner
SLK Private Wealth
