December Private Client Letter

As 2023 draws to a close, I am encouraged to observe that the year has turned out much better than many, including myself, had expected.  The economic slowdown, signaled by several traditional indicators such as the Leading Economic Index (LEI), has not yet materialized.  In fact, the third quarter growth in GDP far exceeded expectations and an increasing number of market strategists are shifting their perspectives to a “soft-landing scenario” in which the Federal Reserve’s aggressive and historic tightening cycle will succeed in reducing inflation without crushing the economy.

Real GDP growth in Q3 was recently revised higher to a 5.2% annual rate from a prior estimate of 4.9%, beating the consensus expectations of a 5.0% annual rate and marking the fastest quarter of growth since 2021.  Upward revisions to business investment, home building, government purchases and inventories more than offset a downward revision to personal consumption.

Investors embracing the soft-landing scenario have rapidly shifted to a much more bullish posture.  According to the latest AAII survey, the percentage of bullish investors has surged to over 45% from as low as 24% at the start of November.  In this same period, those investors reporting as bearish have fallen from over 50% to less than 24%.  Given that data such as this has proven to be a contrarian indicator to near-term market movements, one wonders if further upside from here will be limited.

Still, stocks and bonds rallied in tandem last month with the S&P 500 and 10-year Treasuries returning a combined 12%.  U.S. stocks and bonds have only posted combined monthly returns of 12% or more 10 times over the past 40 years, according to data compiled by Bloomberg.  It is notable that a traditional balanced strategy (one having about 60% exposure to stocks and 40% to bonds) performed very well in November - marking one of its best single month results in nearly 30 years. 

Along with rising hopes that the Fed is finished raising rates is a growing view that interest rate cuts could begin as early as April of 2024.  This perspective however stands in sharp contrast with comments made in the latest speech by Fed chair, Jerome Powell, in which he said, “It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease.”

Our base case observes that macroeconomic conditions for 2024 remain uncertain, with worries about sticky inflation and a potential recession entirely reasonable.  Many economists are still concerned that stronger growth and stubborn inflation could lead to elevated interest rates for longer than the market anticipates.  With the current rate of inflation above the Fed’s 2% long-term target, it is doubtful the Fed will reverse course in a few months.  We believe the Fed will be quite hesitant to reverse course unless inflation turns sharply lower or economic activity slows down dramatically.

It is the delayed but ongoing impact of monetary tightening which represents the greatest danger to risk assets as we go into 2024.  Historically, the dampening impact of tighter monetary conditions can take as long as 18 months to appear in the economy and recent surveys indicate consumers are only now becoming less upbeat about economic conditions.

New orders for durable goods, single family home sales, and existing home sales all fell in October.  Real retail sales (adjusted for inflation) peaked in April 2022 and have since declined by 2.1% from that peak.  It is logical to anticipate further declines in consumer spending as excess savings from COVID stimulus payments are exhausted and higher borrowing costs continue in the coming months.  

While analysts have already lowered earnings estimates for the fourth quarter of 2023 by a larger margin than average, consensus expectations for corporate earnings in 2024 remain elevated by historical standards.  According to FactSet, the consensus expectation for 2024 S&P 500 earnings currently stands at about $246 per share.  Analysts tend to be optimistic going into a new calendar year and have on average overestimated expected earnings by about 7%.  If we were to adjust 2024 expectations to reflect the historic overshoot, it is possible that full year earnings next year will come in closer to $229 per share.

Increased input costs from higher inflation have compressed profit margins for U.S. businesses and future earnings growth could come under pressure if the economy begins to slow and unemployment rises. 

Equity investors are discounting current risks with stock prices approaching record levels.  The bullish perspective anticipates that Fed rate cuts will prevent a recession while at the same time ushering in a new period of economic reacceleration.  While economic activity could surprise to the upside in the coming year, such resiliency would likely produce an environment in which inflationary pressures persist. 

Accordingly, it appears that those investors hoping for Fed interest rate cuts just as economic activity rises may be disappointed when these seemingly incongruous paths do not materialize simultaneously.

We remain cautious regarding the direction of markets in 2024.  Apart from notable weakness in certain economic measures, national debt levels are as alarming as is the state of geopolitical instability around the world.  While we hope for the best, we prepare for the worst and believe it is till prudent to be somewhat defensive in our strategies. 

As we move deeper into the holiday season, your team at Clearwater Capital wishes you and your family the very best.  We look forward to serving you in the New Year.

Best,

John E. Chapman

PS.  On December 3rd, 1992, a 22-year-old engineer named Neil Papworth used his personal computer to send the world’s first text message.  He text “Merry Christmas” to his colleague Richard Jarvis, who was attending a holiday party.  Papworth was part of a group within Vodafone that was developing a “Short Message Service Centre” (SMSC).  Not only was Papworth early in wishing his friend Merry Christmas, but he also likely had no idea of the importance of that message.  Text messaging would forever change the way we communicate with one another, and it is estimated that 23 billion text messages are sent every day!