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December 15, 2023
The Days Ahead:
“The time to buy is when there’s blood on the streets” said Lord Rothschild in 1815 when he advised buying stocks just before the Battle of Waterloo.
Since then, this advice has been the rallying cry for contrarian investors. Some wags suggested he had inside information because he set up a relay of fast horses from the battle site in Belgium to London. Or that he had carrier pigeons bring the news. He did use carrier pigeons but not until later. The real story is that he sensed this was the make-or-break battle in the wars and would end nearly three decades of naval blockades and European conflicts that had stretched from Moscow to Lisbon and Stockholm to Cairo.
The battle was fought on Sunday June 18th 1815 and the first news from the front came in on Tuesday June 20, followed by the official news two days later.
Either way Rothschild was right. Financial markets back then mostly traded in government debt, and, confusingly, debt was called stocks and equities were called “shares”. But once the news was back in London, government bond prices rose around 13% in ten days.
Since then, the most turbulent times, including wars, have been good for financial markets. Here’s the Dow Jones Industrial Index from 1940 to 1945.
We could have selected any number of turning points but just these few show how quickly sentiment changed between initial shock and full mobilization. From the market bottom in 1942, stocks rallied 76%.
In the UK, where the war started two years earlier, stock prices bottomed out during the Dunkirk evacuation in mid-1940 and rallied by 25% in the next few years.
Studies show that markets react badly to bad news whether these are terrorist attacks, tsunamis, hurricanes, earthquakes, airplane crashes or worse than expected economic data. But they then recover albeit at a slower pace. It even has its own name called the “negativity effect”, which basically says that markets will take a big hit initially but then rally and exceed previous highs as more news appears.
That fits with our own experience. Most market setbacks of exogenous (i.e. highly disruptive and not related to market norms) news recover quite quickly. Sometimes this is just an overreaction. In the case of World War II, the U.S. economy expanded by 53%, unemployment dropped from 15% to 2%, income per capita rose 45% and productivity grew 96%. No wonder stocks took off after the initial shock.
We looked at this period because this year we’ve seen the escalation of a European war to levels not seen in 80 years and the outbreak of conflict in the Middle East. But there hasn’t been a calamitous effect on some of the markets.
Here’s the Israeli Shekel against the U.S. dollar.
This is expressed as the number of dollars a shekel will buy. At the start of the Fed hiking, one shekel bought $0.31. It fell to $0.25 at the time of the Hamas attacks but has now recovered to $0.27, a rise of 8%.
The currency is performing as it often has in previous episodes of conflict. First, the Bank of Israel intervenes in the foreign exchange market to halt deprecation. Then there are usually significant inflows from abroad, with both aid and remittances rising sharply. The appreciation is then followed by a reduction in the risk premium.
Israel’s TA-35 stock market index is up 12% since the attacks in October with big gains in finance and technology. One of the largest companies on the Israeli exchange is Nice, which is in customer relationship management, is up 15%. Nextvision, which produces camera stabilizers, is up 27% since October and 300% this year.
We don’t yet know if the economy is coping. There are 360,000 reservists called to active duty out of a workforce of 4.3 million. The construction industry has halted due to a dependence on Palestinian workers without permits, and the hi-tech sector is operating at reduced capacity. Many families are working part-time, and schools and universities face disruption. So, no one quite knows how bad things will get. But perhaps not as bad as first thought.
In Russia, the ruble initially fell over 50% after it invaded Ukraine in February 2022. It has since recovered 73% against the Euro.
As we’ve mentioned before, the EU and U.S. sanctions against Russia are incredibly leaky. China’s exports to Russia rose from $5 billion a month to over $10 billion. Russia’s oil exports fell by 12% but have been flat for over a year. It’s likely that many of its oil exports are not even recorded. Russia faces some inconvenience in travel and importing some goods. But its economy is not hurting.
We’re not minimizing the effect of geo-political events on financial markets. But it seems investors pick up the pieces quickly and look forward. We know now that events like the Berlin Wall, the end of the Cold War and the 1973 Yom Kippur War were very significant. But many others, the Korean War, the Serbia-Croatia wars and even Iraq and Afghanistan, barely register on the rise of stocks, bonds or currencies. The Russia-Ukraine and Israel-Hamas wars may prove very important and very disruptive. But for now, investors are willing to take the risk.
One of the many reasons this recovery is so different from the past is that we never closed down an economy, sent 23 million to the unemployment lines and then rapidly reopened. Anyone expecting a normal recovery was sadly bewildered. Then came Russia’s invasion of Ukraine and suddenly natural gas, shipping, refined petroleum products, wheat and sunflower oil ran into price and supply problems. Prices rose in a classic supply-side shock.
Gradually, the supply pressures eased. Recently, however, they’ve risen again. Here’s the New York Fed’s Global Supply Chain Pressure index (blue) and the number of container units in use.
The Fed’s index is broad, measuring shipping rates, charter rates for container ships, air freight costs and supply service levels from surveys like the ISM.
The recent move up is puzzling. We know that air freight costs are easing because capacity increased. Around 50% of all air freight is carried in passenger aircraft and capacity grew 13% in the year to November 2023. Prices very much depend on where stuff is heading.
Rates from Hong Kong to Europe are up around 6%. Going the other way, rates are flat. Hong Kong or Shanghai rates to the U.S. are up 16% but only up 2% going back. Cyber week sales in the U.S. were up 8% over the year and that’s generally good for air cargo carriers. But it’s not enough to move the Fed’s index.
Container ship rates are also mostly flat. Demand has grown 16% over the year to November. But one measure we noticed for both container (i.e. carrying mostly goods) and carrier ships (mostly dry bulk, liquids and oil) was the uptick in delays. These are now up to five days for some routes and the measure of on-time performance is at 64%, which is very low. Some of this may be because of low rates and so ships save fuel by steaming slowly. But some is because of the Panama Canal.
As we mentioned back in August, traffic on the canal fell from around a normal 46 ships a day to 28. That’s now down to 22 and headed to 18 in February. The draft on the ships is also falling from 50 foot to 44 foot. An unladen Panamax ship (not to be confused with an unladen swallow) draws 46 feet and it’s smaller version 39 feet. The loss of draft means that ships must carry less cargo.
The problem is a drought which has lowered water levels in Gatun Lake. It’s the only source of water to raise and lower levels on the 12 locks on the canal. Shippers have already responded by raising prices or re-routing ships. The price of a regular container ship to pass through the canal is usually around $180,000 but recently auctions have gone as high as $2.4 million. Several ships recently paid over $4 million. Even a “normal” crossing with an expected delay of 10 to 15 days, will cost around $636,000 (see here…you can play with assumptions), which is over double from a year ago.
There are some workarounds. Around 40% of all ships passing through the canal are taking goods from the Eastern and Gulf states of the U.S. to the western states. So, U.S. West Coast farmers are hauling by truck or rail to Houston and then transferring to ships headed north or over to Europe. The U.S. is a major exporter of grains at around 8% of all exports. More farmers are using rail to transport foodstuffs to Seattle and then ship on to Asia from there. But that adds cost and is one reason grain food exports are down 12% to 25% this year. In theory, shippers can reroute around Cape Horn but that’s four times the distance for a New York to Los Angeles route and only the largest and most expensive ships can make that length of voyage.
We’re not sure how this will play out. This is more than a seasonal blip. It looks like there will be access problems and high prices for Panama Canal crossings for at least the next 6 months. It may be that other supply chains become cheaper or that we start to see some pressure on goods prices. But it’s a problem with no easy fix.
The Fed met for the last time in 2023. Since March 2022, when it lifted the Fed Funds rate above zero for the first time since March 2020, the Fed has met 15 times and hiked 11 times, the last being in July. Since then, Fed discussion has been about whether inflation was falling, the economy slowing enough and if the labor market was overheating. The answer seems to be yes, yes and no. The Fed made no rate changes but did update its 2024 forecasts.
This is the “dot plot” provided by the Fed. It’s hard to read.
The yellow numbers in blue boxes are the key to the story. The first number to look at is the 5.1% for September, changing to 4.6% this week. This implies the Fed expects cuts of around 0.75% over the course of 2024. They also reduced the 2025 number from 3.9% to 3.6% implying a further 0.3% cut in 2025. That’s really too far out to be taken too seriously but the change in 2024 is significant. Back in June the numbers were exactly the same for 2023 but went up in September and down in December.
Something changed their thinking and we think it’s the progress on inflation. In June, the Fed thought broad inflation would be 3.9% in 2023 and 2.6% in 2024. They now think it’s going to be 3.2% and 2.4%. That’s a meaningful decline.
There were also some small but significant changes in language. Instead of:
Later Chair Powell he went on to say that he felt confident it was on the right path and that the economy was likely at or near the peak rate cycle.
The range of inflation forecasts for 2024 among the 19 Open Market Committee members is 2.3% to 3.0% meaning no single member thinks the 2% target is achievable before 2025. That’s a cautious position but at the same time, they also don’t see unemployment rising very much.
The Fed operates under a very traditional Philips curve model which says that there’s an employment to inflation trade off. The lower the rate of unemployment, the higher level of inflation and vice versa. What the December 2023 Fed seems to be saying is “good job on inflation, long may it continue, but unemployment may be too low, and wage inflation too high, so let’s hedge our bets about low rates in 2024.”
That’s fine. A little caution is normal especially given the “transitory” inflation talk in 2021 when they misread the signals. From where we sit the inflation outlook and wage growth look fine. The 10-year Treasury liked what it saw with rates closing below 4%, at 3.99%, for the first time since July.
The next few meetings will talk about caution, watching the data and employment. The hikes are over. The next move will be down but probably not until May or June next year.
There’s usually some stock market seasonality that pushes up both large and small caps towards the year end. It’s to do with a combination of portfolio rebalancing, tax loss harvesting and traders closing out their books for the year end.
This December has been strong with the S&P 500 up nearly 5% over the month and small cap stocks up 11%. European stocks have joined in as well with a rise of 7% of which around 2% is because of a weaker dollar. The dollar headed lower against the yen and the euro which have risen 7% and 5% in the last few weeks.
The fixed income market liked all the data this week especially the inflation reports and the Fed’s clear message that they like what they see and don’t expect to raise rates. The 10-year Treasury rallied on Wednesday afternoon and kept powering ahead on Thursday to reach 3.94%. Remember, less than eight weeks ago, it was at 5% and the world was worrying about more inflation, more tightening and no relief on rates. The futures market for rates at the end of 2024 moved down 0.5% in a day. The rally in everything makes sense in that context.
We have to remind ourselves that things move quickly these days but the last few weeks have been a wild ride.
The ECB joined the party on Thursday with an expected “no change in rates” and a caution that inflation was fine but that they would not “drop their guard”. That’s fine. We know EU inflation is falling fast because of oil prices and a slowdown in the major economies.
To cap it all, the Atlanta GDP Now forecast, a real-time estimate of current growth, rose to 2.5%, up from 1.2% a week ago.
We expected things to do well in the last few weeks of the year. They have. But we’re all ready for a rest.
Art of the Week: Cecily Brown (b. 1969)
Please read important disclosures here.
Christian is a Partner in the North Bay office. Prior to joining Cerity Partners, Christian was Chief Investment Officer for Brouwer & Janachowski. He oversaw...
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