The Days Ahead:

  • Jobs report on January 5, 2024

This Week:

  • This was and is not your normal economic cycle.
  • We look at all good things in the economy: employment, inflation and growth.
  • Budget deficits are high but not as high as people say or think.
  • And total U.S. debt as a percent of GDP has barely risen in years…
  • Just its composition.
  • China has some big problems.
  • Suez and Panama canals are almost closed to big ships….but there’s a solution coming for Suez.
  • Lessons from 2023.

It’s the season for reflection. We like to think of investing as a continuous lesson in understanding, behavior, people and humility. Just when we feel we have the measure of things, markets surprise us. Sometimes those are good surprises. Sometimes they’re bad. Those are not so fun but we try learn from them and put those lessons to good use for our clients. As the young Winston Churchill once wrote “I’m always ready to learn, although I do not always like being taught.”

This year has been generally good, especially if we measure it by the return on stocks and bonds, particularly after a tumultuous 2022.

Here are some of our lessons and reflections from 2023.

This Is Not Your Normal Economic Cycle

We closed the economy, sent everyone home, mailed them money and opened back up in stages. Now, it seems blindingly obvious that we would have inflation. It came in all sorts of things where we were used to seeing no or very low inflation. Like cars and car parts, restaurant prices, and hotels and accommodation. Gradually, those prices stabilized but then wages went up as employers rehired the 23 million people who were jobless. The recession was the shortest on record and within six months GDP recovered. Between 2020 and 2023, the economy grew by $7,700 billion, which is almost as big as the entire Japanese and German economies combined.

Employment Has Been Great

The Fed started tightening in March 2022 when unemployment was 3.6%  and rates at 0.25%. Eleven hikes later, rates are at 5.25% and unemployment at 3.7%. The number of long-term unemployed is around 1.1 million, which is about the lowest it’s been since 2001 when there were 26 million fewer workers than today’s 168 million. Labor force participation for those in the 55-64 age group has never been higher. Many people thought we needed unemployment to rise to 5% or more and a recession to reduce inflation. Turns out we didn’t.

Energy Supply and Prices

After the Ukraine invasion, it was common wisdom that energy prices would rise and stay high. Russia is the world’s second largest oil producer and the third largest gas producer. But U.S. natural gas exports rose 15% in 2023 and exports to Europe are nearly three times more than 2021 levels.

Europe moved from relying on cheap, piped, Russian gas to transported liquid natural gas (LNG) from the U.S., Norway, Algeria and Qatar. The EU depended on Russia for 50% of its gas in 2022. It’s now 12% and headed to zero. Europe’s LNG imports now exceed pipeline imports. From early 2022 to mid-2023, Europe was in an energy crisis with oil, gas and power prices surging. The crisis is now over. European gas prices are down 80% this year and only 15% above the 2014 to 2020 average.

Budget Deficits

It was one of those years when budget deficit fears started up again. “It’s too big, trillions as far as the eye can see, unsustainable, we need to spend less” is a view we hear often.  

“Er…we could raise taxes and close the gap immediately” is one we rarely hear.

We’re going to push back on the deficit hawks for three reasons.

First, most forecasts for the budget deficit come from the Congressional Budget Office (CBO) and, yes, they show budget deficits at around 5.8% of GDP for 2023 and heading up to 6.4% for 2033.

But wait, the monthly Treasury statement shows the deficit at $1,300 billion and the BEA shows GDP at $27,644 so that’s 4.7%. I mean who’s quibbling when it’s only $248 billion of spending that didn’t happen but, still, one of those head scratchers.

Then you head over to the line items and find GDP is projected at 4.3% growth for the next 10 ten years (these are all nominal numbers), receipts (basically taxes) at 3.9% and spending at 4.5%.

That’s odd because for the last 20 years GDP has grown 4.4% on average and government receipts by 4.7%. Why would receipts start trailing GDP growth all of a sudden? Especially as the labor market is in good shape? And the latest numbers for the 2024 fiscal year starting October 1st, show receipts up 19% and spending up 17%. If we exclude interest on the debt, spending is up only 11%. That would suggest a very much better outcome than the CBO.

There’s no good answer to reconciling those numbers so many economists just say, “it’s too big.” Fair enough.

So, second, we’ll look at outstanding debt as a percent of GDP. I mean, if debt goes up more slowly than GDP, then we’re not taking on any more of a burden relative to income. The current number is that total debt is 95% of GDP. A few years ago a famous study found that a burden of 90% meant significantly reduced growth. But the model had an error in it and the whole theory collapsed. There’s some lingering concern that high debt damages long-term growth. But there’s little proof.

Finally, we’d point to the total debt outstanding not just government debt. This takes in household and corporate debt, plus borrowing by government entities like GNMA, FMNA, the Federal Home Loan Banks as well as municipal debt. When we look at those, we find that household debt as a percent of GDP has fallen every year from a peak of 84% in 2009 to 62% in 2023. We also can see that municipal debt has only grown 2% in the last ten years. Or that corporate debt is around 76% of GDP and is unchanged for over 20 years. If we add all those together we get a ratio of around 263% of GDP compared to 252% in 2019 and 251% in 2009.

In other words, total debt hasn’t changed much. Just its composition.

Anyway, we’re not minimizing the growth in government debt. And we do believe that bond markets will look at it closely in 2024. But government deficits don’t necessarily cause inflation, higher interest rates or “crowding out” (when other borrowers are pushed to the back of the queue.)

Japan Rises

We’ve mentioned before the 30-year period of Japan’s deflation, low rates and slow growth. Every year investors hope that this will end. But it never seems to be and the bet that Japan will restart growth and see real wage growth constantly disappoints. For decades it’s been known as the widow-maker trade.

We started to see some change in 2023. Interest rates and inflation are higher, although they remain well below the U.S. and EU economies. Japanese stock market regulators started to talk more about de-listing companies if they didn’t produce a plan to raise their stock prices to a price to book value of above one. Some 53% of companies trade below one. Three quarters of Japanese banks trade below 0.3 compared to U.S. banks at 1.04.

How can they fix it? Well, the recommendations are:

  • Invest more in R&D and intellectual property
  • Sell off subsidiaries or…
  • Return cash to shareholders via share buybacks and dividends.

The good news is that companies are well placed to do so as half of all Japanese companies have cash balances greater than their liabilities.

Japanese stocks went up nearly 30% in 2023, to have one of their best returns in years. This meant around 19% for a U.S. investor because of a weaker yen.

Many investors remain underweight Japan. There have just been too many false starts over the years and the number of analysts following the market has dwindled.

But 2024 should bring further changes in economic and regulatory policy. The market remains cheap, at about a 50% discount to the U.S. using the cyclically adjusted price earnings ratio. It should prove interesting in the next 12 months.

Slow Train to China

China’s grand reopening fizzled quickly in early 2023. Consumers were in no mood to spend and the property market went from bad to worse. New housing starts collapsed by 50%. Several property companies went bust and those that didn’t had to be propped up by local governments. The property sector will take years to even out and the regulators have already set up a “whitelist” of companies to receive support. If you’re not on it, you’re on your own.

China’s unemployment for those aged 16 to 24 is so high, at over 22%, that the government said it would no longer publish the numbers. Some 47% of college graduates live unemployed with their parents.

It’s not all gloom. The Chinese electric vehicle market is the most successful in the world. It started, with the help of ample government subsidies, long before U.S. and European car makers, and they’re well ahead in technology, design and range. China’s auto exports tripled in three years to around 4.8 million units, surpassing Japan at 3.8 million and Germany at 3.2 million.  

The Central Economic Work Conference, the government’s vehicle for economic planning, also doubled down on expanding domestic demand, funding the green economy, semiconductors and life sciences. We can perhaps look at the idea of central planning as hopelessly outdated but in China it will mean that banks will have to tow the line and channel loans to favored industries. It will probably work but will take some time.

Debt Ceilings

We have to admire the way consumers and markets kept their head over the debt ceiling negotiations, which went on from January to June. The Treasury used its well-thumbed playbook of “extraordinary” measures to keep the money flowing and markets stayed unflustered. A deal was done and the U.S. Treasury then managed to replace the depleted Treasury General Account and sell $1,000 billion of new securities without upsetting the price or the auction process.

Consumers mostly kept spending and employers kept hiring. Perhaps we’re all getting too used to the brinkmanship.

It wasn’t totally costless, though. Fitch, one of the three major credit rating agencies, downgraded U.S. debt to AA+ from AAA.

We face a government shutdown in January. It’s possible that Congress will not be able to pass an appropriations bill which would mean a continuing resolution that pegs spending to 2023 levels. That would mean a 9% drop in non-defense spending. Off-budget items like social security and Medicare are not included. Still, that would mean a cut in real terms which could produce some drag on the economy.

We’ll stay optimistic on this one. We seem to have come through worse in the past year or so.

Central Banks Pull It Off

We tip our hat to the big central banks, starting with the Fed. They kept the rate hikes coming without too much pushback or market overreaction. Inflation has fallen, employment stayed strong and, apart from a scare with Silicon Valley Bank and Credit Suisse, no major disruptions to the banking system, money markets or exchange rates.

The Fed pivoted in its December meeting by revising down their end 2024 forecasts for the fed funds rate. The ECB did much the same. The Bank of England and Bank of Japan have special problems that they are dealing with but, so far, no missteps.

The bar for cutting rates remains high. After all the Fed is some 1% north of its inflation target. So far, communication from central banks has been solid. That puts us in a good place for 2024.

A Very Good Year

Last year we inverted Frank Sinatra’s gem “It was a very good year” to complain that, no, 2022, was dismal for investment returns. This one has been much better with a strong year end rally.

We see a good year ahead as well. After all, having been around long enough to see the S&L crisis, the  emerging markets debt crisis, the 1987 crash, the Kuwait invasion, the collapse of the LTCM hedge fund, Argentina’s defaults (this is number 3), Y2K, the crash, the GFC, the near breakdown of the euro and EU, Brexit, government shutdowns (lost count), impeachments (losing count), decades high inflation, auto bailouts, bank bailouts, airline bailouts, nationalization of Fannie Mae and Freddie Mac, Russia invasion of Ukraine, war in the Middle East, a global pandemic, and still come through with healthy capital markets and returns…then all we can say is  “what’s the worst that could happen?”

So How Did We Do?

Well, the year’s not over but last time we showed this chart, it was not pretty.

Graph showing total return of the S&P 500 on the horizontal axis and the total return of a long maturity Treasury bond on the vertical
Source: FactSet, Cerity Partners

This shows the total return of the S&P 500 on the horizontal axis and the total return of a long maturity Treasury bond on the vertical. Ideally, you want both to go up and see a year in the top right-hand corner. Last year was firmly in the bottom left and the worst calendar year return since 1929 for a combined stock and bond portfolio.

This year, as of December 20th, 2023, were at +24% for the S&P 500 and +3.4% for a Treasury portfolio. Which is a nice change from 2022.

Some Things We Learned Along the Way

Past readers will know we try to put some accumulated learning in our last note of the year. Fortunately, the investment world is a good teacher and just when you think you’ve got a handle on what and how things will happen, a 2022 comes along to put you in your place. Then we see 2023 and all seems fine again. As Sam Mussabini, a coach to 11 British Olympic gold medalists, and in Chariots of Fire, said of the 100-meter sprint, it’s “tailor made for neurotics”. Sometimes the investment world can feel that way but we try to rise above it.

Anyway, here are some things we’ve found helpful along the way. We don’t claim any wisdom. Just years of hanging around smart people.

  1. Markets tend to return to the mean over time
  2. Markets go up by the stairs and come down in the elevators
  3. Markets do not correct by going sideways
  4. There are no new eras, so excesses are never permanent
  5. Everyone buys the most at the top and the least at the bottom
  6. Fear is stronger than long-term resolve
  7. Bear markets have three stages: sharp down, a rebound and a drawn-out downtrend
  8. When all the experts and forecasts agree, something else will happen
  9. Bull markets are more fun than bear markets
  10. Never trade on headlines
  11. Being early and right is the same as being wrong
  12. Prices change more often than the facts: don’t confuse the two
  13. The plural of anecdote is not data
  14. Dividends are like marriage but buybacks are like dating
  15. It is very rare that drastic market events require immediate action
  16. Intelligent people do stupid things, especially if it’s easy to do those things
  17. The low inflation and easy money era was fun but it misallocated a lot of capital
  18. Inflation goes up like a rocket and down like a feather (also new)
  19. The past tells us that markets will surprise us
  20. And from Charlie Munger, who left us in 2023: Invert, always invert: Turn a situation or problem upside down. Look at it backward

The Bottom Line

There’s a distinct end-of-year feel to the markets. Perhaps we’ve had too much good news and information to digest it all. This week we saw consumer confidence bounce up, but that has a lot to do with lower gas prices and a bounce in the stock market. The Fed fought back from last week’s excitement about lowering rates in 2024, with several Fed commentators saying “hey, there’s  no urgency….calm down” and another, Chicago Fed President Austan Goolsbee, saying he was “confused” with the market’s reaction.

We’d side with one of our favorite economists, Ian Shepherdson, that Fed comments have a shelf life measured in minutes. The Fed is data driven and if the inflation, growth and employment numbers show a need for cuts, then that’s what they will do. Comments from Fed Governors between Fed meetings are like the early Apple maps….they could tell you what country you were in but you’d end up on roads that didn’t exist or being told to “turn into oncoming traffic”. You know, better than a horoscope, but worse than a coin toss.

Shipping Woes: We’ve written a few times about the problems in the Panama canal, where capacity is half of what it should be and is heading down. That will end up costing producers.  Now the Suez canal is all but closed to large vessel traffic with several global shippers, like Maersk and Hapag-Lloyd, diverting traffic around the Cape of Good Hope adding some 7,000 miles and 21 days on to a typical journey. Charter rates can be up to $160,000 a day so it adds up. We’d note that it’s only container ships that are affected in Suez. Tankers and bulk carriers are not targeted.

Meanwhile, the cost of a container has risen 23% in a month and considerably more for one that has to travel through Suez or Panama. It now costs around $3,074 to use a container on a trans Pacific route, up from $2,500 two weeks ago. About 17% of world trade passes through the two canals but around 40% of inter-U.S. trade uses the Panama Canal. We’ll keep an eye on it. The good news is that the Suez problem is relatively easy to fix and a combined naval operation is underway.

We close out the year with returns of 23% on the S&P 500, 12% on small cap stocks. Small cap stocks are up 22% since their lows just six weeks ago. European stocks are up around 19%. The 10-year Treasury is now at 3.8%, from 5%, again just six weeks ago. It supports the old adage of “it’s not timing the market but time in the market”.

Thanks to all our readers for their comments and feedback in 2023. As we take a brief hiatus, we will resume weekly publications on January 12th, unless there’s breaking news, of course. Warm wishes to all our readers for a joyful holiday season and a Happy New Year.

P.S. We’ve been showcasing women artists, past and present, for several years now. Let us know if there are any artists you’d like to see featured.

Art of the Week: Cecily Brown (b. 1969)

Please read important disclosures here.