September 6, 2024 – As the summer comes to a close, we are facing a split sense of the world around us with two very different faces. In one sense, we have had a great year in the public markets as I’ll discuss below. Equities are up a lot, bonds are finally up for the year, and expectations for a continued market rally are percolating all around as the Fed begins rate cuts this month.
But in a gut check with reality, we are facing a cascade of changes on three key fronts. The changes that we are tracking closely are the global political environment, the consequences of climate change, and the economic uncertainty of massive sovereign debt. All three of these are at levels that we have rarely, if ever, experienced in modern society, and continue to emphasize that assuming the status quo for one’s portfolio will leave you woefully unprepared.
To diverge for a moment on the perils of status quo. In the investment world, most models use the status quo as their starting point. The assumption is that the past is an indicator of the future and future events fall into a pattern that mimic past events. The problem with this approach is the assumptions that are used. While I won’t get into the technical aspects here, my view is that the future will not mimic the past because the past doesn’t account for some of the generational and technological shifts of the past fifty years. Change is happening, and while we are still years away from some of the more severe effects, it is getting close enough that we need to start thinking outside the box.
The cost of climate change on real estate values in certain regions will skyrocket when whole swaths of the housing stock are rendered useless. It isn’t an issue about collapse but about the costs of adaptation and who gets left behind. Insurance is not adequate to cover the anticipated losses and government relief will only exacerbate growing debt issues. I don’t worry about our resilience as a society but assuming the status quo for investment strategies will create unanticipated exposures and losses.
It is the same with the U.S. dollar and its position as the base currency. We have only known of an economy in which the dollar is supreme where the bulk of trade uses dollar settlement and U.S. policymakers can take extreme liberties because of this dynamic. Given the confluence of political dysfunction on both the left and the right with blockchain technology, that day of an alternate base currency will arrive. It won’t spell disaster and will take time to morph into a usable platform, but it will change the way we build investment models and impact the U.S.’s ability to print money. For instance, currency risk is rarely incorporated into dollar-based portfolios and it is assumed that the U.S. will continue to issue Treasuries at a voracious clip, two core tenets in portfolios today.
Getting closer to home, the year was a relatively good one for equities. As of September 5th, the S&P 500 is up 15% and looks as stable as ever. That is, unless you look back to early August when the market lost half of its gains based on a few bad bits of economic data. But not to worry, with the Vix back down to the teens, there must be no reason to worry. Look at fundamental valuations and the implied assumption of a non-recessionary economy, and that narrative quickly looks suspect. [Please reference my July 2024 Live Market Update for data on fundamental valuations].
The good news is that the bond market is starting to look like a bond market. The Bloomberg Aggregate is up over 4.2% for the year, after having been negative for many quarters. The yield curve, while still inverted in many places, is on the verge of going back to a positive slope, and even the currency markets are getting back into balance with the Euro and Yen in more manageable ranges for regular global trade.
The holes in the status quo narrative for the economy are many. Economic growth is positive in many sectors, but it is not uniform nor robust. Low inflation is a great relief now, having dipped under 3%, and looks to be holding steady in this range. That said, a large part of current inflation is shelter, a survey figure and easily influenced by perception as opposed to fact. Granted that the past two years have seen draconian increases in rents in certain cities (NYC is one of the most extreme), those rapid hikes appear to be in the past. My expectation for inflation in the next two years is for it to continue to drop to near-zero, if not negative, given the trending combined with adjustments of estimates to actual.
This brings up an important point on estimates. The data that the Fed uses to guide their policy decisions is equally fraught and likely to be wrong in one direction or the other. That layer of uncertainty, with ample anecdotal evidence of strains in the economy, raises the very real specter that the Fed missed the opportunity to navigate a soft landing by cutting sooner. Keeping rates at this elevated rate, for this long, creates real strains for consumers, industry, and certain banking sectors that are difficult to measure in real-time.
If I were to look into my crystal ball, I see a strong set of Fed rate cuts through the rest of this year and into Q1 2025, which could include a 50bps cut in September to get “caught up” on missed opportunities. According to Bloomberg the market is currently pricing in 200bps of total cuts in the next year, which might be aggressive under the current economic data. The impact thus far has been great for the yield curve, which has steepened dramatically this summer. While the 30/2 year swap rate (what our Structured Notes are tied to) is still negative, we have gone from -100 bps to -34 bps in just a few weeks. Any surprise by the Fed could further accelerate the process of a return to a strong positive yield curve, the normal status for a healthy bond market and growing economy.
The election presents a new set of challenges given the past two months. The Trump campaign has struggled to adapt its message to a Biden-less race, and the Harris campaign has successfully raised half a billion dollars in a few weeks from a broad range of constituencies who felt despondent by the Biden-headed ticket. The Harris campaign is also using an unprecedented chunk of those funds to help down-ballot candidates, a play to control the House and Senate. This might be a lesson for both parties – running a geriatric white man as your standard bearer is going to alienate all but your most loyal base.
Looking across the election analysis from Morgan Stanley, Goldman Sachs, and Oxford Economics, I see a convergence on the view that implementation of the Democratic platform is the stronger set of policies for the economy. While the analysis is more complex, a relaxed immigration policy supports a stronger worker base. Add in subsidized child care, social programs that allow lower-income families greater work opportunities, and subsidies to productivity-generating industries, they all grow the economy at a rate more than negates the impact of higher taxes. On the other side, the Republican policies of higher tariffs and lower immigration drag on the economy. If you include the long-term cost of higher government debt from lower taxes, the calculus is even more pronounced.
That said, anything can happen between now and November such as a bullet and a bloody ear. While some like to use the mantra that elections don’t impact the markets, I strongly believe that this election will determine the long-term direction of the U.S. economy and drag the markets along with it, in either direction. How we use this information with the changes looming will inform our portfolios, planning, and choices as advisors and members of this society.
Have a great Fall,
David
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