Quarterly Letter

January 2024 – Quarterly Letter

By January 31, 2024 No Comments

January 31, 2024

The most pressing question for the market this year is whether the economy will experience a soft landing, a hard landing or no landing. A recession would constitute a hard landing. Interest rates and inflation would fall dramatically, but so would earnings. This scenario would likely lead to a pullback in stock prices of at least 10-20%. No landing describes an economy that is like a run-away freight train. Not only does it not slow, but it accelerates, leading to a substantial increase in inflation. The Federal Reserve would have to slam on the brakes by raising interest rates to even higher levels than today. Higher interest rates, and the prospect of the economy screeching to a halt would likely cause the market to sell-off substantially.

A soft landing describes an economy that is slowing down from its peak growth rates, but growth stays positive. Technically, a soft landing occurs when the Federal Reserve starts to lower interest rates while economic growth is still positive. It’s a relatively rare occurrence. This is the 13th time since World War II that the Federal Reserve has raised interest rates in a series of recurring steps. Out of the twelve previous tightening cycles, the economy fell into recession eight times. A soft landing occurred four times.

So how do we know when the Fed is done raising interest rates? Think of interest rate policy as brakes. Inflation is like the economy’s tachometer. When inflation is high it’s an indication that the economy is “redlining.” The economy is running too hot—above its maximum rated RPM. If we don’t slow down, we’re at risk of overheating and doing real long-term damage to the engine.

The Federal Reserve has stated that its objective is to push inflation down to 2% from its 2022 high of 6%. Once it appears that inflation is at 2%, the Fed will start to cut interest rates. At that point, it will have successfully engineered a soft landing.  The market currently gives a one in three chance that the first interest rate cut occurs by the end of the 1st quarter and a 90% chance of a cut by the end of the second quarter.

In late 2022, when inflation was at its peak, investors were 100% sure that a recession was inevitable. Since the market bottom on October 12th, 2022, the S&P 500 is up 38%. So why were investors so sure that inflation would be stickier than it was? My theory is that most investors looked at the oil shocks of the 1970s as a reference point for how inflation would play out now. This seems reasonable, but it overlooked a critical difference between now and then.

In the 1970s, the Federal Reserve was led by Arthur Burns. Arthur Burns and the Federal Reserve lost credibility in the early 70s when they declined to raise interest rates enough to slow inflation. Burns was appointed by Richard Nixon in 1969. Burns and Nixon went way back. They worked together in the Eisenhower administration in the 1950s. Nixon said at Burns’ swearing in ceremony, “I respect his independence. However, I hope that, independently, he will conclude that my views are the ones that should be followed.” Burns got the message.

In 1971, with inflation running in excess of 5% annually, Nixon urged Burns to cut interest rates, thinking it would help him win re-election. The Fed did just that. Nixon was re-elected and inflation hit double digits by 1974. In economics jargon, inflation expectations were unanchored. Consumers assumed that prices would continue to spiral higher, leading to strikes and wage hikes, which only caused prices to go higher.

Paul Volcker changed all of that in the early 80s. He waged war on inflation and won. Greenspan was extremely careful not to undermine the belief that the Federal Reserve would do whatever it took to control inflation. As a result of the consistent prioritization of price stability, consumers were convinced that the long run rate of inflation would stay around 2%.

This chart only goes back to 1982. Inflation expectations were likely near 10% annually during the Arthur Burns era. Despite the recent surge in inflation, long-term expectations never came close to 3%. Keeping a lid on long-term inflation expectations made it much more likely that the Federal Reserve could subdue inflation without tanking the economy.

The market recently set a new all-time high. One might jump to the conclusion that this is a good time to sell, as the market rarely rallied 38% over the past 15 months. Over the last two years, the market has basically been flat. In fact, it took 757 days to go from 4,800 to 4,900, the longest gap between 100-point milestones since March 2000-May 2013.

The market will move higher or lower based on interest rates and earnings growth. The baseline forecast is for lower interest rates and higher corporate earnings. This is exceptional. Typically, lower interest rates coincide with deteriorating corporate profits. If the economy avoids recession, which seems highly likely, earnings will be higher a year from now. If interest rates are lower a year from now, which also seems highly likely, then valuations will also probably be higher.

Falling inflation gives us one less problem to worry about. As usual, challenges remain. There are still a lot of hot spots around the world, but I expect the market will continue to move higher over the first half of this year. As we approach the election, we’ll probably hit some turbulence. Historically, the market rallies following the election due to the resolution of a major uncertainty.

Eric Barden, CFA