In this month’s client presentation, we’re taking a look at the markets in general, as well as our investment framework — the framework by which we make investment decisions for you, our clients. As we take a look at the markets, we’ll discuss what we’re seeing happen in the economy, what we expect to happen through the rest of the year, and the positions we want to be invested in to benefit from these actions, or potential actions.
Of course, as always, we cannot predict the future, nor are we asserting that anything we discuss in this month’s presentation is an attempt to do so. But there are benefits to us examining where we are now, how we got here, and any historical or forward-looking trends worthy of our attention.
This conversation is led by our lead investment strategist, Clint Sorenson.
First, we’re going to look at trends in economic growth, monetary policy, and inflation as those three things really work together in tandem — and it’s been a very interesting cycle to say the least. Starting with the COVID-19 pandemic, for some reason, the Federal Reserve and our federal government thought printing almost $10 trillion in the form of economic stimulus, loan guarantees, and balance sheet expansion wouldn’t cause inflation.
We’re not quite sure which economic textbooks they were reading, but that was their operating assumption. But here we are, and we’ve got inflation. Then, in an “about face” on January 2022, after letting inflation really take hold in the economy, the Fed turned around and did the most aggressive rate hiking cycle in history.
They started really trying to combat inflation. It worked to not only knock inflation down, but also it worked to really decelerate credit growth, particularly in areas like commercial real estate. And so we had two consecutive negative quarters of GDP growth that started slowing. Inflation started slowing. It looked like the Fed was going to be able to declare victory, but then last year something strange happened.
We had some bank failures in the early part of the year. If you remember, in fact, from an asset basis, the Fed had to step back in and provide emergency liquidity. They had to provide emergency liquidity to the ECB to help the Credit Suisse UBS merger. But to help UBS rescue Credit Suisse, they had to provide a lot of loan guarantees here in the United States to bail out these regional banks, who are now faced with just unbelievable losses on their balance sheet.
Then the Fed started talking at the end of the year about pivoting towards rate cuts. And so they kind of had their George Bush on the aircraft carrier announcement of victory. Jay Powell (Federal Reserve chair) did that in November. And what happened was shortly after that, we had inflation expectations accelerate. Yes, the market went up and it felt good, but the market is not the economy, the economy is not the market. And when that pivot happened, inflation expectations started moving up and advancing.
And now to start off 2024, we've had a couple inflation reports to get more this week that have been concerning. And we also just got a Michigan consumer sentiment report recently that suggested that consumers are concerned about inflation — and this is happening while rates are high relative to where they would be considered normal.
So because rates are high today, credit growth isn't happening. Credit growth drives our economy, and what's kept the economy kind of buoyed afloat has been this flood of government funding — which the government's been spending about six to 7% of GDP in the form of deficits. That's similar to what we were doing in the Great Depression as a reference.
Now, the Fed has a challenge, as this is all fighting against their attempts to combat inflation. Inflation's finding somewhat of a floor and looks to begin to start accelerating again, we won't know obviously without hindsight, but we could see that trend. Chris, that's what's happened. This stage of the cycle has been very different from what we've experienced previously. You weren't getting the inflationary pressures that you're getting today.
We have a world where every move of the Fed, every word of the Fed, now seems to be accompanied by an acceleration in inflation expectations. This makes their job very challenging in terms of how they monitor and navigate the economy. And I think that that challenge is setting up for some of the most amazing investment opportunities that we've seen historically, because everything's kind of aligned.
If you look at it throughout the landscape, there are a ton of opportunities out there that I think astute investors can take advantage of. And I think this Fed pickle, as we say, this conundrum the Federal Reserve is in, sets us up for some really awesome opportunities because it raises the probability of a mistake. And so we'll see how the Fed navigates it.
But if you look at the economic environment, you're seeing a breakdown in key coincident indicators, which really lagged and because the can's been kicked down the road by government spending, and because of that, you saw a growth slow, but you never really saw a decline.
We have to remind people we had two consecutive quarters of negative GDP in 2022. That's not what I would define as a “soft landing.” And we're still in this environment, the Fed is still tight in the face of that. So, what you’ve had is a temporary rebound and growth that was really supported by government spending — and that growth is really just flatlined. We've slowed and continue to slow economically, and that's going to continue as long as the Fed remains tight.
That is what's going to set up for the Fed to eventually be able to cut rates. It's now a “wait and see” game for them. They know they need to cut, they want to cut. That's the good news. The bad news is the inflation sensitivity and expectations are rising, and it's making it difficult for them to do it now. That means the Fed will probably have to wait longer and cut later — but it'll probably be more aggressive than just one cut.
As always, we refer to the Buffet Indicator as a part of the methodology within our investment framework. Now, I want to put a word of caution. If you read a lot of people on the internet, or listen to a lot of market commentators — these folks like to talk about grand potential outcomes. Meaning they'll say, “Oh! Markets are overvalued. You're going to have a crash of epic proportions, get to cash now or buy gold!”
That’s not what this means. What high valuations mean is that things have moved too far, and that sentiment is at an extreme long-term sentiment. So, if it’s the S&P 500 in this instance — if I bought and held that today, my returns would be well below what they've averaged historically. If we fast forward 12 years from now, it tells us nothing about what's going to happen this year, next year, or the next five years.
If stocks are outpacing the economy, there's something broken — something's wrong, there's more positive greed based sentiment present. If the economy's producing and the markets are depressed relative to what the economy's producing, well, maybe there's too much fear within the marketplace. And so it of sense. What it also does is it creates new paradigm thinking or this time is different thinking and that often results in lopsided sentiment, and you may not be looking at where all the opportunities are right now.
We've underinvested in energy, we've underinvested in materials, and we've underinvested in real assets. Real estate (relative to the S&P 500) is below where it was in 2009 and the depths of the global financial crisis, emerging markets are cheap. International develops cheap values, cheap relative to growth. Small caps are cheap relative to large caps.
There are so many opportunities, we haven't seen it like this in our careers.
And that’s where our conversation truly begins today. Please watch the video for more from our exclusive client presentation.