By David Matias
January 26, 2024 – As we start a new year with new hopes, I can only say that I’m happy that 2023 is behind us. It may have been a good year on the surface — markets are up and accounts are making money — but on a more human level it was a year of terrible. It was a year in which I began to understand how societies fail and totalitarianism is not just an aberration of the past.
Without being too political, the results from the New Hampshire primary show that there is a serious risk of another Trump presidency, with all the associated drama, chaos, and a loss of basic democratic principles. Fortunately, there is a movement to stop him, and it will gain urgency as the election nears. That said, the world beyond our borders may shape the result and we need to be prepared for the worst. Which brings me to the more salient topics of markets and economics.
While I don’t have the data to support this next statement, I believe that the word “Inflation” was the most used term in finance last year. Having been born in the late 1960s, I was not a spending adult when the last bout of inflation hit the U.S. economy. Despite all my education and experience in finance, there is one basic aspect of inflation that I didn’t understand until now. When you have a year of high inflation, such as we did in 2022 prices don’t come back down. Every week, you pay the same elevated prices for the same items irrespective of what happened with your paycheck. Put another way, a bad year of inflation is a permanent drain on people’s wealth.
So, while gas prices have come back to prior levels, and it costs nearly the same to heat our homes, our rents are up a lot, and going to stay there. So is the cost of dining out or buying the week’s groceries. The Fed’s actions to fight inflation, while effective thus far, have an insidious underbelly. Those who are most vulnerable to higher interest rates are also least able to adjust to them. Namely, the working middle class is struggling. The data is not pervasive yet, but we are seeing the first signs of broader distress through a dislocation in the consumer credit market.
Namely, medium-term consumer loans that have been paid regularly, on-time, for the past two years, are now defaulting at alarming rates. In the modern history of consumer credit, this has never happened before. If a borrower is halfway through a loan having made all their payments, why would they suddenly risk their creditworthiness by defaulting now? The answer is not obvious, yet, but it is likely the combined impact of higher rents, food, and revolving credit card debt which follows Fed rates. The end of the student loan payment moratorium may also be playing a role.
Put simply, we are seeing the very first signs of a storm brewing in the middle of our economy – middle-class consumption. With nearly 70% [1] of the U.S. economy dependent on the consumer, this does not bode well for continued economic growth in 2024 despite the solid data thus far.
It is still early, and the data is just starting to trickle in, but there is a silver lining in all this — Fed policy. The Fed did something in 2022 that we haven’t seen in a generation – hike rates at a voracious pace. By doing the same in reverse, the Fed has the ability to short-circuit this brewing storm. It may be too late for many by the time that Fed policy reverses, but they now have an important tool to use in stemming a hard recession.
Economically, 2024 will come down to this dynamic between the Fed, the consumer, and the economy. Typically, we look at productivity gains as an ameliorating factor, such as artificial intelligence. But does A.I. save the day? I doubt it. A.I. is still not intelligent. It is a wonderful productivity tool that takes predictive modeling to a new level. But it is not going to replace our economy nor our society just yet. The same with crypto – a wonderful intersection of math theory and money theory but not a viable replacement for the dollar, sovereign currency, or a new world of economic egalitarianism. The concern is that asset bubbles have formed, which they always do, and with faster trading and fleeting interest from the social media-driven investor community the opportunity for disruption in the public markets is growing.
Going forward into 2024 we are maintaining our current posture while adjusting to the ever-changing interest rate environment. An under-emphasis on public equities persists while putting some of that risk capital into private opportunities. Within the bond market, we have many of our Treasury positions cycling out at a time when interest rates are declining. The repositioning of that money may take time as we see how the next few weeks and months of economic news and Fed policy develop. In the areas where we do take specific views, such as structured notes, private fintech vehicles, and climate change resilience, we see these developments as supporting our strategy. In short, Fed rate cuts will be a strong tailwind for portfolio returns, while sub-sectors of the economy continue to thrive.
One parting thought: technology is wonderful on many levels – it brings us light indoors, warmth in the winters, connectivity in a vacuum, and lifespan with joy. But it takes decades to grow, fail, rebuild, and thrive. There are no shortcuts to evolution, whether carbon-based or silicon-based. Understanding this cycle helps to avoid certain risks while identifying new investment opportunities. That is our focus.
-DBM
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[1] Source: U.S. Bureau of Economic Analysis