“I think I’m pretty good at long run expectations, but I don’t think I’m good at short-term wobbles. I don’t have the faintest idea what’s going to happen short term.”
– Charlie Munger (January 1, 1924 – November 28, 2023), VP Berkshire Hathaway
Inherently there is quite a bit of randomness in short-term predictions driven by things that tend to wash out over longer periods…things like geopolitical events, unforeseen crises, or even a slight shift in the pace of something known such as the decelerating economy. These make short-term predictions less reliable than long-term predictions. This is a bit of a convenient truth since most of our clients are in fact long-term investors and what we do well, evaluating the world of finance through a value lens, tends to coincide with this longer-term horizon. This is usually why most of the work you will see from us focuses on the intermediate- to longer-term…think 3-, 5-, or 10-year periods. But there are a few things that we have a fairly high conviction about for 2024. Thematically, we believe that 2024 is going to bring:
- A slowing economy
- Lower rates, but more specifically a change in the shape of the yield curve
- A broadly weaker dollar
Now each of these are related to one another, meaning if you get one, the slowing economy, you are likely to get the others. In this quarter’s Market Insights, Looking Ahead to 2024, I intend to address each of these items, as well as identify what we believe has the greatest likelihood of performing well in this environment.
The Great Debate
The economic backdrop continues to be the subject of fierce debate. In fact, I referenced it in last quarter’s Market Insights, The Battleground States of Today’s Macro-Environment, as one of my “Battleground States.” By the Fed’s own estimate, nominal GDP will have decelerated from 7.1% in 2022, 5.1% in 2023 to 3.8% in 2024.
Within that 3.8% forecast, they are allowing for 2.4% inflation, leaving real GDP at a below trend level of 1.4%, not a lot of wiggle room between growth and recession. With a margin for error this slim, it doesn’t take much to tip the scales a bit further into recession. Remember, policy is still restrictive, student loan payments have restarted, and with employment starting to trend lower, this may be what causes theme #2, lower short-term rates.
So, does that mean we see a recession? It doesn’t have to be a bad one, but yes, we see it as pretty likely… mainly because of two factors. First, labor markets have been tight even as the labor force now exceeds prior peaks in terms of size. If we are employing more people and producing more goods, inflation isn’t the result of a supply issue. We are just out consuming our productive abilities. To bring inflation fully into line with Fed expectations, the pressure on wages from tight labor markets needs to subside. That requires some slack in labor markets which is beginning.
The second factor is housing. We have recently started to see housing prices decline from peak levels, but overall housing prices relative to the level of interest rates and, more importantly, to the median income that supports buying a house are very high. A simple way to illustrate the affordability issue is to look at the monthly mortgage payment on the median home in the U.S. That figure is around $2,600 today, compared to less than
$1,300 at the end of 2020. But that is not related to strength in housing as much as it is related to unhealthy internals. The supply of homes available for sale is limited because homeowners with low mortgages can’t sell, as it would be costly to replace that same home at a higher mortgage rate. In fact, I would suggest that the issue with homeowners being trapped because of their mortgages may resolve itself with prices actually falling if rates decline as additional supply gets unlocked. Regardless, you can’t really have a strong economy without transactions occurring in housing. Houses need to change hands, banks need to write mortgages, contractors need to build and fix these homes. All of this is captured as someone’s wages or earnings, booked into our current year economic output, and recirculated into spending on other goods and services. If it does not occur, it’s a big headwind to the economy. It just touches too many things.
One final thought for consideration relating to the economy. As we all quietly hope for a soft landing or even a no landing scenario, I would offer a likely controversial take on this. Maybe we shouldn’t. In our current situation, inflation is likely subdued as the economy decelerates. Unemployment is ticking up just a bit and markets are grinding higher. The economy is growing, albeit at a slow pace. That’s a soft landing. But what happens when we shift up a gear into higher growth mode in a year or so? People spend more, companies need more labor, workers become scarce again which puts pressure on wages and on the availability of goods. That’s inflationary. There needs to be some slack in all markets (labor markets, equity markets, productive capacity, etc.) to account for the recovery and ensuing surge in demand. We may need to reach 5-6% unemployment to allow for the capacity to add jobs during any future expansion. Otherwise, the result is inflation. Similarly, equities need to correct to a level where the valuation is reasonable so that the ensuing recovery doesn’t take valuations to internet bubble levels of 40x P/Es or beyond. That’s the primary problem with a soft or no landing scenario. There is no room to recover without creating inflationary pressures and potentially having to restart the rate hike cycle, albeit from a higher beginning point.
2024 Predictions
So, what does well in this environment? I touched on this in a recent Mic’d Up Interview. The tricky part to this is
the single year forecast. So, by the very nature of the question, in my response I am obviously looking for
something that I think will do well, but also something with a high probability of doing well even if it isn’t the
best performer. The likelihood of success is a big component in my response. Based on that, and as I mentioned in the interview, I think short-term treasuries will do quite well. Bonds have rallied substantially since that interview I referenced a moment ago, harvesting some of the gains I was looking forward to in 2024 in the closing weeks of 2023, but I still believe there is a bit of room to run. Why? Let’s start with a beginning yield of about 4.3%. Simple stability in rates would result in an annual return of around that number, 4.3%. Now, if we get the benefit of some Fed rate cuts next year, it isn’t hard for us to see a path to a 7% return. Alternatively, if the opposite occurs, a 1% increase in rates, returns will still be about +2.3%. It is hard to dislike the combination of risk, return, and a high probability of success.
Now, I would not advise reaching beyond treasuries. Corporates and certain mortgage- backed securities tend to be a bit economically sensitive. Plain vanilla is best here, in our opinion.
The second item I would offer would be anything that might benefit from a weaker dollar. There are several favorites of ours on the equity side of the portfolio, including emerging markets value stocks, but for a one year forecast I would again lean toward bonds over equities even though the long-term potential of something like emerging markets value dwarfs that of any non-dollar bond. Again, this reflects the economic uncertainty that investors face, which will likely have a much greater impact on stocks than bonds if the landing is a bit bumpier than expected.
The final item that I’d like to devote a bit more time to than in our recent Mic’d Up interview is closed end funds. As I mentioned during the interview, the attractiveness of closed end funds (CEFs) probably requires the benefit of a bit longer runway than just 2024. Don’t get me wrong, in a soft-landing scenario, CEFs will likely do quite well. If the touchdown ends up being a bit more abrupt than most anticipate we can see them getting a bit cheaper initially, before bouncing back in 2025. Regardless, the 2-year returns earned from discounts and yields like today are typically quite good. To summarize, the universe of CEFS, a mix that is approximately 40% equity CEFs and 60% fixed income CEFs is trading at a discount of around 9% below NAV, double the long-term average, with some segments like municipal bonds trading as cheap as 12% below NAV. In addition to steep discounts, CEFs boast an average yield of more than 8%, nearly 1% above the long-term historical average. From similar levels, the average total return over the next 12 months has historically been 20.13%, 14.74% annualized for the coming 18 months, and 12.77% annualized for the next 2 years. This forms the basis for our enthusiasm. In fact, I would venture that if most investors were to capture only the yield of 8% as their full annual return, they would be quite happy.
Summary
Entering 2023, investors were scorned, not only by poor equity market results in 2022 that approached 20% losses for the US market, but also bonds and their double-digit declines. The early going of 2023 did little to patch this fractured relationship with year to date returns through September of -1.21% on the Bloomberg Aggregate Bond Index. Since then, bonds have gained about 6.5%, with more than half of that return occurring in December alone.
For 2024, our expectation is for a continuation of the recent trend of economic growth, deceleration with the Fed’s own estimate of +1.4% real GDP growth likely proving to be optimistic. This should result in lower inflation, higher unemployment, but ultimately lower short-term rates and a weaker dollar. While we have seen those very things occur since the interview, we do feel confident that the trend can continue in 2024. This should bode well for short-term treasuries, non-dollar denominated assets, and broad-based closed end funds. While this was a fun exercise, I would encourage investors to remain focused on the long-term as one-year ups and downs in the context of a risk managed, properly diversified strategy means little in the larger scope of an investor’s goals. Lastly, I would like to thank you all for your continued trust and confidence and wish you many blessings for a healthy and prosperous 2024.
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Market Insights is intended solely to report on various investment views held by Integrated Capital Management, an institutional research and asset management firm, is distributed for informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. Integrated Capital Management does not have any obligation to provide revised opinions in the event of changed circumstances. We believe the information provided here is reliable but should not be assumed to be accurate or complete. References to specific securities, asset classes and financial markets are for illustrative purposes only and do not constitute a solicitation, offer or recommendation to purchase or sell a security. Past performance is no guarantee of future results. All investment strategies and investments involve risk of loss and nothing within this report should be construed as a guarantee of any specific outcome or profit. Investors should make their own investment decisions based on their specific investment objectives and financial circumstances and are encouraged to seek professional advice before making any decisions. Index performance does not reflect the deduction of any fees and expenses, and if deducted, performance would be reduced. Indexes are unmanaged and investors are not able to invest directly into any
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