Market Commentary Q1 2024

IS THERE ANYTHING LOWER RATES CAN’T CURE?

The Federal Reserve began raising interest rates two years ago in response to the highest inflation in a generation. While pundits debated how much was transitory (supply chain disruption) or structural (the largest monetary expansion on record), it was clear that easy money was stoking the inflationary fire and substantial intervention was required.

Since then, the Fed Funds effective rate has climbed from near zero to 5.3% and inflation (as measured by the Consumer Price Index) has retreated from 9% to 3%. U.S. economic history is fairly conclusive; most rate hiking cycles end in a recession and soft landings are rare. In fact, 1995 is the only successful soft landing since World War II. Combined with an inverted yield curve (where short rates exceed long ones), there were indications suggesting a recession was more likely than not.

Many suspected a wave of high-profile bank failures last Spring could be the first domino, yet here we are 12 months later, and the economy refuses to shrink. Last year, existing home sales fell to levels not seen since 2010, industrial production contracted, and unemployment rose by almost half a percent. But GDP kept chugging along and no one seemed to tell the stock market. 

True, the S&P 500 sold off from August to October of 2023 as interest rates on the 10-year Treasury rose from 4% to almost 5%. But since October 27^th, the market has been up 18 out of the past 22 weeks largely on the prospect of lower rates. In February, the S&P 500 crossed 5,000 for the first time ever and has hit 22 all-time highs in 2024 alone. If you’re looking for an explanation, look no further than the Fed’s December Summary of Economic Projections where they suggested three rate cuts were likely in 2024.

Our continued view is that inflation progress is seldom linear (see the January CPI report) and bond investors lean premature when anticipating cuts. But the consensus seems to be that the economy will avoid a recession, Artificial Intelligence is the next Industrial Revolution, and the U.S. has unlimited borrowing capacity (despite the views of Fitch).

We issued a mea culpa last quarter, saying our cautious stance in 2023 was unwarranted and in the past five months or so, the S&P 500 is up almost 30%. We also said that we expected 2024 to be a less exceptional year than 2023. Yet through the first quarter, the S&P has returned 10% year to date, which is roughly what we expected for the year.

There is ample evidence of froth in the equity markets. After rising 240% in 2023, Nvidia is up over 80% in the past three months and is now the third largest company in the world. The VIX (an index that measures the price of hedging equity volatility) is at a post-pandemic low and prices of cryptocurrencies have gone parabolic. Market strategists are being forced to revise their year-end price targets higher just three months after setting them. 

To be fair, there is some justification for the market’s optimism. Leading economic indicators recently turned positive for the first time in two years. Fourth quarter earnings were stronger than expected and market breadth seems to be improving.

But when markets throw caution to the wind and appear unanimous in their expectation of strong returns, the phrase ‘goldilocks’ comes to mind. It’s times like these that we like to sharpen our pencils, examine our risk appetite, and ask what might the market be missing?

We don’t have an answer for you today, but we’ll keep you apprised as events warrant.

As always, thank you for your confidence and should you have any questions, don’t hesitate to reach out to your relationship manager.

Sincerely,

Bridges Trust Investment Committee

Bridges Trust Company Thought Leadership Disclosure

Market Commentary Q4 2023

The Year Few Saw Coming

“The probable is what usually happens.” – Aristotle

One of the occupational hazards of forecasting is that predictions lack the good manners to make themselves scarce once they’ve been proven wrong. An especially prescient guess might linger for a week or two, but bad calls have a much longer half-life and can follow you for years like an affection-starved labrador.

We bring this up because you might remember last year’s Market Commentary where we described our outlook for 2023 as a “Puddle of Muddle.”  Therein, we highlighted that the Fed had a poor track record of engineering soft landings, that many economic indicators were flashing yellow if not orange and we had subdued expectations for equities when it came to 2023.

Anyone who’s bothered to look at the stock market this year can see it was short on both puddles and muddles. As of this writing, December 31st, the S&P 500 is up nine weeks in a row and 24% year-to-date. Not to be outdone, the Nasdaq composite is up 43%. The current consensus seems to suggest that the economy will avoid a recession, inflation has been licked and Jay Powell has a pedestal waiting for his likeness in the Central Banker Hall of Fame.

In short, it looks like most economists got this one wrong.  

We believe that the number of recessions predicted vastly exceeds the number of recessions that have occurred, reminding us how economics earned the moniker ‘the dismal science’. Perhaps what was most confounding in 2023 is that many of the most reliable historic indicators (an aggressive hiking cycle, an inverted yield curve, contracting money supply, declining manufacturing surveys) all suggested the same thing. A recession seemed such an inevitability that in February, the Conference Board pegged its probability at 99%. Optimism would have required us to ignore 100 years of precedent and say this time really is different.  

And yet, we’ve said repeatedly that a soft landing wasn’t impossible, just improbable. In the past two months, financial conditions and sentiment have changed markedly. Since peaking in late October at 5%, the US 10-Year Treasury has declined to 3.9%. Last month, equities were up almost 9%, their second-best November since 1980. Powell gave an unusually dovish press conference in December that implied several rate cuts could be forthcoming in 2024. You’re not supposed to be able to raise rates, tame inflation, maintain full employment and grow the economy, but like the occasional buzzer-beater from half-court, the Fed might just have done it.

After spending the better part of two years harping on the subject, readers could be forgiven for thinking that recession predicting is an integral part of our process. It’s not. Our job is to evaluate capital markets, assess the risks and returns on offer, and then construct portfolios that we deem likely to meet client objectives, ever mindful that all investing involves risk. So, we proceed with a multi-decade time horizon in mind which requires a willingness to stay invested through booms and busts. Recessions are an inevitable part of any economy and trying to avoid them is a surefire way to stunt returns.

But if 2023 taught us anything it’s this. It’s better to be pleasantly surprised than bearish and right.       

That leads us to our outlook for 2024. US GDP grew almost 5% in the third quarter, and we expect a material slowdown next year as seven quarters of Fed tightening weighs on economic growth. In November, the Fed’s preferred measure of inflation was the lowest in more than two years and seems firmly in hand. We believe the Fed will cut rates in 2024 but observe the market has repeatedly over-anticipated their timing. After declining for more than a year, we expect corporate earnings to return to year-over-year growth, although estimates of 12% strike us as optimistic. We expect geopolitical tensions to remain high and the number of fiscal issues (budget deficits, high debt-to-GDP and the looming expiration of the 2017 tax cuts) all need to be addressed.   

If 2023 was the most improbable of years, we expect 2024 to be more average. A recession could still materialize, but it’s looking less and less likely, and should it happen, it may be manageable given robust labor markets and relatively healthy consumer balance sheets. We would point out that it’s unusual for progress to be linear and doubts about inflation or growth are to be expected.

Over the past five years, the S&P 500 has delivered an almost 16% total return annually. Our expectation for future returns is significantly more modest. Many of the pressures weighing on stocks in 2023 have now reversed (higher rates, higher inflation, negative earnings growth), but a soft landing is still a landing. In other words, we expect 2024 to be less exceptional than 2023 when it comes to both the economy and equity returns.

Authored by – Bridges Trust Investment Committee

Market Commentary Q3 2023

MARKETS DECLARE PREMATURE VICTORY

The Fed began its war on inflation in March of 2022, and 11 rate hikes later, progress has been nothing short of remarkable. While history would suggest that a soft landing was a long shot, we’ve seen meaningful iprovement in inflation, minimal job loss and instead of a slowing economy, GDP growth has accelerated. Last October, a Wall Street Journal survey of economists pegged the odds of a recession in the next twelve months at 63%. Flash forward to today and the economy may have grown as much as 3% in the third quarter, which is markedly above trend. Tight monetary policy is supposed to slow the economy as higher borrowing costs discourage consumption and incentivize saving. Apparently, the US consumer didn’t get the memo.

Core inflation peaked last September which happened to coincide with an S&P 500 trough of 3600. In the year since, progress has been persistent and long-term inflation expectations remain a well-anchored 2.2%. A series of bank failures in March initially looked as if the Fed had ‘broken something,’ and while the banking system is still quite challenged, a financial crisis has failed to materialize. Despite the Fed’s poor track record of engineering soft landings, data increasingly suggests it’s a distinct possibility.

Markets tend to get ahead of themselves, and it recently erred by assuming the Fed would immediately pivot from rate hikes to rate cuts. Students of history know that hiking cycles are rarely surprise-free, and if the 1970s taught us anything, it’s that the risks of premature easing outweigh the risk of over pumping the brakes. Being sure isn’t enough, central bankers have to be certain. So, when markets began anticipating the Fed would begin cutting as early as this Fall, we remained skeptical. Asking an economy to grow, inflation to fall and interest rates to come down struck us as a really big ask.

It’s this expectation of ‘higher for longer’ that has recently taken steam out of markets. Starting in early May, the S&P 500 was up nine weeks out of eleven. Since the Fed Meeting in late July, the market has been down seven weeks out of nine. Yields on the benchmark 10-year Treasury troughed at 3.3% in April and have since risen to 4.55%, the highest since 2007, and expectations for rate cuts in 2024 have declined by two-thirds. We’re not sure why investors would expect the return of cheap money when core inflation is still north of 4%, but expect it they did.

When it comes to the outlook for the next twelve months, we remain circumspect if not outright cautious. While economic data currently paints a rosy picture, we look under the hood and see more than enough to give us pause. Estimates for 4Q GDP are an uninspiring 0%. Thanks to production cuts from the Saudis and the Russians, oil prices are up 34% in the past three months complicating further inflation progress. Thanks to rising deposit costs and the prospect of higher charge-offs, bank lending has nearly ground to a halt, which acts as a significant damper on economic growth. The potential for a government shut down, an ongoing auto strike and the resumption of student loan payments could further derail the Fed’s hard-fought progress. While the yield curve isn’t as inverted as it was, in our opinion, it remains the best recession predictor available and investors shouldn’t ignore it lightly. In other words, we may not be out of the woods quite yet.

As for equities, they’ve been largely range bound for much of the past two years. Earnings growth is currently negative and estimates are for a herculean 12% growth in 2024. Outside of the pandemic recovery and a one-time benefit from lowering the corporate tax rate in 2018, the S&P 500 hasn’t grown earnings 12% since 2011 (also a recovery year). Higher interest rates suggest a lower justified multiple on earnings as investors have competing alternatives for their capital. Higher inflation suggests a lower multiple as inflation erodes the purchasing power of said earnings. 19 times this year’s earnings (which aren’t growing) and 17 times next year’s (which seem likely to disappoint) strikes us as optimistic given our expectation for the economy to slow. The equity risk premium (the earnings yield equities offer over prevailing interest rates) is flashing orange if not red.

We have become increasingly constructive on fixed income this year given some of the most attractive (or at least most positive) real returns in decades. Measured over longer periods, we typically expect equities to outperform fixed income. That is still very much the case, but our estimates of excess return are more narrow than they’ve been in some time. We suspect the equity market may be forced to lower its expectations should it confront a slowing economy, increasingly stubborn inflation or a resolute Fed, which could lead to more attractive prices. Consequently, we’ve reduced equity exposure for many of our clients on the margin.

Given the strong performance of the equity market this year, we’re aware that this derisking has come at a cost, but we suspect we’ll see more attractive entry points in 2024 and beyond. While it seems counterintuitive to hope for volatility, we view it as an opportunity to allocate capital to great businesses at potentially more reasonable valuations.

We thank you for your support and if you have any questions, please don’t hesitate to reach out to your Relationship Manager.

Sincerely,
Bridges Trust Investment Committee

Bridges Trust Company Thought Leadership Disclosure