Wesley Chapel, FL

Happy New Year and welcome to 2024!

As one more trip around the sun has been completed, the markets seem to be laser focused on the Fed cutting interest rates this year. What the markets seemingly fail to realize is that when they beg for rate cuts what they are implicitly asking for is a big drop in the markets along with a big spike in unemployment. That’s normally what brings about those rate cuts.

The Fed wouldn’t be cutting rates and thereby punishing savers in a strong economy. It wouldn’t need to.

Since the turn of the century (and the millennium) the Fed has cut rates three times. First in 2000-01, then in 2007-09 and most recently in 2019-20. All three times the economy was in recession and the stock market didn’t put in a bottom until after they stopped cutting.

I wrote about this phenomenon all the way back in November 2022.

Yes, that seems like a long time ago in today’s fast-paced world where long-term might only mean a few months, and everyone focuses on year-to-date returns as if the prior year returns just get thrown out on January 1st because the Gregorian calendar resets.

But as I mentioned last month, and for better or worse, patience isn’t a common trait of humans.

With the benefit of hindsight, I should have been more aggressive in 2023, despite overwhelming economic headwinds that caused banks to fail at the fastest pace in history, and in a market that saw the average stock languishing while just a handful of big companies drove returns for the benchmark indexes.

Lesson(s) learned. I got it wrong.

One thing I missed was how willing the government would be to run up a massive tab borrowing money it can never afford to pay back at higher and higher interest rates. It’s not that I had faith in Uncle Sam to responsibly manage his finances, it’s the sheer magnitude of the deficits that surprise me. I pointed out last month that our annual interest expense as a nation is now over $1 trillion. For context, over the past year we have “only” spent $978 billion on national defense (obviously none of that went to defending our southern border).

I don’t necessarily think it is wise to spend that much on defense either. We spend more on our defense than the next 10 countries… combined. It seems excessive. But that is a whole different discussion. The point is that the interest expense on our debt is now even more excessive – and we don’t even get any fighter jets or aircraft carriers with it.

It’s mind blowing. According to the International Monetary Fund the US government will run a deficit of more than 8% of GDP for 2023, by far the most of any developed country and more than double the 3.7% deficit in 2022.

When I wrote to you last month, I noted that the national debt had recently rocketed to over $33 trillion. Just a few days ago, we broke $34 trillion.

It simply can’t continue at this pace forever. The government’s borrowing and spending was a major factor that kept us from entering a recession in 2023. As we lap last year’s spending numbers, it will be more and more difficult to maintain the rate of spending increases and thus, the rate of change in GDP.

Make no mistake, spending like this is very bad for the future of our nation. But I also won’t make the mistake of disbelieving in the government’s willingness to steal from future generations of Americans (that’s our children and grandchildren) by spending money it doesn’t have to save the economy from a recession in 2024 – particularly with a presidential election coming in November.

Another thing I missed was that higher interest rates didn’t have quite the impact on home prices as I expected. Typically, higher interest rates lead to lower prices for homes. But a follow-on effect from the overbuilding in the mid 00’s leading up to the Great Financial Crisis in 2008-09 is that our country is now wildly undersupplied with new homes. Couple that with many homeowners having locked in mortgage rates at 3% or less and being unwilling or unable to afford to move with rates at 7% and you have a recipe for home prices not falling much, and even rising in some cases despite materially higher interest rates. Home prices are a major factor in the “wealth effect,” which posits that people spend more as the value of their assets rise even if their income doesn’t rise.

Finally, the thing I missed that still amazes me the most is the public’s willingness to believe that 100% of their money in banks was guaranteed by the government, regardless of the amount, and regardless of how recklessly their bank invests and operates.

To be clear, it is mathematically impossible to guarantee all that money. But the majority of the public doesn’t seem to care enough to do much about it.

Sure, some people (most of you reading this) are wise enough to keep the amounts you hold in the bank below the stated FDIC maximum and invest amounts over and above that in US Treasuries at risk-free rates of 5% or more. But there are many, like virtually every single client at Bank of America, who are content with earning closer to 1% (and that is being generous) while risking that they might wake up one day and not be able to get their money out.

This is madness to me and probably you, but 🤷‍♂️. It is what it is.

Along with that behavioral miss, I underestimated the Fed’s willingness to effectively neutralize its own tightening. It hiked rates and reduced the size of its balance sheet thus tightening money supply, only to come to the rescue with billions of dollars to bail these banks out just when the tightening was starting to have an impact. The Bank Term Funding Program (BTFP) as it is called, is currently being exploited by banks who didn’t even need the emergency funding to the point that I expect the Fed to terminate the program soon. That’s right, bankers are borrowing money that they don’t need from the Fed at artificially low rates using inflated collateral values, and then turning around and lending that money at higher rates, and then keeping the difference.

Interfering with free markets always has unintended consequences. It always will.

I could go on, but those are the big things I got wrong in 2023. The point is to learn from them and be better going forward.

That said, I am pleased that in the back half of the year our strategies performed very well, notwithstanding my personal bearishness. According to Bloomberg, the average hedge fund was up 4.35% for the year through the end of November, and the largest hedge fund manager in the world, Bridgewater & Associates, has a fund called Pure Alpha that was down 7.29% for the full year. We thankfully did much better. And even though it is early, we are off to a good start in 2024, too.

2024 Outlook

As for 2024, I expect the long-delayed recession to arrive in the first half of the year. We might already be in it. Along with that recession I expect markets to drop by 20% (or more) as they typically do during a recession. Whether the government will formally recognize it this time is anyone’s guess – but they didn’t in 2022 when GDP dropped for two consecutive quarters.

By the time markets bottom, I expect interest rates to be much lower because the Fed’s normal response to a recession is cutting interest rates to stimulate economic (GDP) growth. That bottom will likely coincide with a reversal of Quantitative Tightening (QT) to Quantitate Easing (QE). Currently the Fed is reducing the size (albeit not by much) of its balance sheet (QT) by allowing bonds it owns to mature without replacing them. The bonds that it owns are a result of the previous four rounds of QE in which they bought bonds with printed money to push rates even lower than they could cut them!

Once the Fed has cut rates to zero and starts buying bonds again through yet another round of QE, the market will bottom if it hasn’t already, and a massive new rally will begin. Who knows? Maybe they will even print money and give it away again in the form of stimulus checks.

That will be the time to aggressively buy stocks.

Unfortunately for many, that will also bring about the next round of higher inflation.

The best hedge against inflation isn’t gold, or even Bitcoin, although those are both great long-term inflation hedges. The best hedge against inflation is a portfolio of capital efficient stocks – the kinds of stocks we focus on in our core Elevate strategies.

Of course, none of this has to play out as I expect. In fact, the one thing I am sure of is that it won’t. But that isn’t the point of an outlook. The point is to prepare, not to predict.

“The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function. One should, for example, be able to see that things are hopeless yet be determined to make them otherwise.”
-F. Scott Fitzgerald

The main risk to my expectation of a recession in the first half of 2024 is if the Fed cuts interest rates early and aggressively. This is a real possibility even though I think it is unlikely.

Given inflation data that was released today showing that the Consumer Price Index (CPI) increased by 3.4% for the year in December, vs. 3.1% the month before, I think it is even less likely. Inflation has risen on balance, since its low for the cycle back in June.

Core inflation (which excludes food and energy prices) meanwhile was 3.9% for the year, down slightly from 4% in the prior month. But these increases are still will above the Feds stated target of 2%.

I just don’t see the Fed cutting rates before they achieve their stated goal, absent a major drop in equity markets. Even though if they want to avert a recession, that is probably what they need to do.

Despite my personal bearishness and expectation for a recession in the first half of the year, it doesn’t make sense to sell our stocks or refuse to take on new positions, opting to sit in cash and wait for a recession to arrive. It may not.

I will continue to follow the market’s lead, whether up or down, just as I always have. Sure, we’ll have good days and bad days, good months and bad months, good quarters and bad quarters… and those will lead to good years and bad years.

But what I won’t do is force my opinion and outlook onto the markets. That is a recipe for disaster. As evidenced by our recent upside performance, I am totally capable of holding a bearish outlook while at the same time getting (and staying) long stocks.

And so, that’s what I’ll do if the market keeps rallying from here in the face of seriously bad economic data. And when the data changes, I will change my mind.

“When the facts change, I change my mind. What do you do, sir?”
-John Maynard Keynes

Earnings season begins tomorrow with the big banks, including Low-Volatility Strategy holding JP Morgan Chase (JPM.) So, I will be paying close attention to earnings data as it comes in for any reason to change my mind. Speaking of JP Morgan, the company’s CEO, Jamie Dimon said just yesterday:

“I’m a little skeptical on this Goldilocks scenario. I still think the chances of it not being a soft landing are higher than other people… The extra money that [consumers] got during COVID, trillions of dollars, that’s kind of running out. It’s been pushed out for a whole bunch of reasons, but it runs out this year… the government [also] has a huge deficit which will affect the markets… There might be a mild recession or a heavy recession. Obviously, all of us in business have to learn to deal with the ups and downs of the economy… But I do think the cross-currents are pretty high: the money running out, rates are high, QT [quantitative tightening] hasn’t happened yet…”

Before I sign off, lets look at a couple charts/slides:

People are carrying higher and higher credit card balances despite interest rates on those balances having **never** been higher.

The combination above (all time high balances and all time high interest rates) leads to personal interest payments having never been higher, at a **mind boggling** $571.4 billion per year!

More and more people are falling **30 days behind** on their credit card and auto loan payments.

**Fun Fact:** The term "soft landing" is borrowed by economists from the space industry.. it originates from our attempts to "land softly" on the moon. And to date, we have successfully landed (people and spacecraft) on the moon more times than bankers have pulled it off with the economy here on Earth... like, by A LOT too. Only once in 1994 did the bank(st)ers pull it off.
Anyway, spikes in Google searches for the term “soft landing” tend to immediately precede drops in the stock market - and you guessed it, we are in the midst of the largest spike ever right now.

I thought these answers to a recent CBS Poll were interesting…

Until next time, I thank God for each of you, and I thank each of you for reading this commentary.

Clients, I encourage you to click here to access your personalized performance portal to see how your portfolio performed vs. the markets last month.

Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisors

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