We closed 2023 and entered 2024 with a market rally, newly born confidence that the inflation battle won’t lead us into a recession, and relief from what seemed for much of 2023 like perennial personal anxiety for many Americans.
While we enjoy some good news, several systemic economic issues remain unaddressed. Ultimately, how they are addressed will determine the course of our economy in the months immediately ahead.
We’d like to address the recent events and the economic issues needing resolution to give some perspective on the transitions we see ahead.
No Reason To Expect A Major Recession
Just in case the first couple of paragraphs above are making anyone feel uneasy and anxious again (we’ve had enough of that in 2023), we want to be absolutely clear we are not suggesting a recession is imminent, nor do we feel it would be particularly severe if a recession does develop later in the year.
In one sense, we can say that recessions are inevitable, but so are recoveries. If we live long enough, we will all experience both several times over. The more relevant question is always whether the economy is deteriorating significantly enough to trigger a major recession and market pullback imminently. We do not see that in the cards at this time.
Recap Of Where We Are
Throughout the last couple of years, we’ve seen several significant developments.
Inflation expanded, then diminished, but may be rising again. We closed 2021 with the Federal Reserve insisting that “inflation was transitory,” but we quickly plunged into an annual inflation rate of 9% as of June 2022. The Fed then acknowledged that inflation was higher and more severe than they thought, and they began addressing it. Inflation dropped to 6.5% measured in December 2022 and then seemed to have settled around 2.5% in November 2023, only to tick back up to 3.9% as of December 2023.
As explained in earlier commentaries, we were always suspicious of the claims during 2023 that inflation had been tamed. We’ve been in business long enough to remember those same claims in the late 1970s, only then to see inflation roar back to life. To paraphrase a great movie line, “Vampires have to be totally killed, not just a little killed.”
Today’s reality is that inflation is not where the Fed wants it to be or should be. The Fed’s target is 2%. The Fed’s actions over the last couple of years to raise interest rates and withdraw money from the economy have helped, but more work still needs to be done.
The December jump in inflation to 3.9% is evidence of that. We don’t believe interest rates necessarily have to increase from their current levels, but they certainly should not be lowered too soon.
Economic growth is slower than desired and well below what is possible. Across a variety of metrics, the growth in our economy remains sluggish. Slow growth is certainly better than economic contraction, but higher growth rates are possible and would greatly help the country.
The most recent jobs report showed an increase in payrolls – better than the consensus expectations – but the average hours worked by employees actually decreased in December. More people were working, but collectively, they worked less than the month before.
Further, on that point, the quality of the added jobs was low. Many of these jobs came in economic sectors heavily supported in recent quarters by government spending and interventions. Since those are not likely to continue, their impact on the overall economy will diminish. The more permanent type of employment found in other sectors of the economy did not increase as desired.
Manufacturing activity was similarly inflated by government spending in favored areas. Those do not create real growth because they must be “paid for” by decreases in other areas of the economy. Government spending in favored areas boosted jobs (today), but they will be offset by losses (tomorrow) in the sectors not favored by government spending. The net effect is not sustainable economic growth.
Near-term prospects for continued consumer spending are not as strong as they have been. Government payouts, credits, & tax moratoriums to rebuild after COVID-19 have pushed consumer spending up, but they have almost completely worked their way through the system. Consumer spending should gradually decrease during 2024, representing a headwind to future growth.
Government spending decisions need long-term resolution. The combination of political and economic uncertainty we face today hurts the economy and discourages companies from making key economic decisions. While it seems Congress has reached a new budget deal, which buys us time roughly through March, the issue will arise again. Throughout these Congressional spending debates, the now common dire warnings about “government shutdowns” and “defaults” are both wrong and corrosive.
There has never been, nor is there likely to be, a permanent shutdown or a default. In previous Congressional showdowns when a budget deadline was missed, the government reduced spending in some areas, and some government workers were furloughed. When Congress eventually struck a deal, workers returned, back wages were paid, and any delayed interest payments were paid. No real “shutdown” and no “default.”
The threat, however, discourages investors from taking risks and managers from making large capital investments. Both are critical to a highly functioning growth economy.
Congressional leaders on both sides of the aisle can agree that the current level of deficits are unsustainable. Each side, of course, differs in how they want to deal with those continuing deficits. The economic reality is that they cannot continue much longer.
Deficits must be paid for. In the short term, the government can simply borrow the money to cover the deficit, but the borrowed funds must be repaid. That repayment can only come from some combination of higher future taxes, higher future budget surplus, or higher future inflation, which reduces the real value of the debt being repaid.
The relationship between government spending and revenue as a percentage of GDP is at the heart of the issue, as demonstrated by the chart below compiled by Scott Grannis.
For the last 53 years, we have established an average spending level (red dotted line), which is consistently higher than the average revenue level (blue dotted line). As a result, we have run deficits in most years. The solid red and solid blue lines show the actual deficit percentage each year, with a handful of surpluses also shown. The recent spending levels – 2021 forward – have dramatically increased the deficit and federal debt to cover those deficits.
This is what is unsustainable. Everyone knows that something has to change; as a country, we will have to move toward generally lower spending levels or generally higher revenue levels. We cannot simply stay as we are. The uncertainty of how our elected leaders will resolve this discourages investors from taking risks and managers from making large capital investments. Both are critical to a highly functioning growth economy.
The Future For The Economy
Short-term, it is reasonable to expect that we will see a continuation of slow growth, but it won’t be as good as it can be. We may see a brief resurgence of inflation, but we do not believe it will get out of control. Finally, there may be a mild recession. Absent a major international blow-up, the Fed’s actions will determine whether we truly achieve a soft landing (inflation tamed without a recession). If that landing is a bit bumpier, we believe any recession would be mild and short.
In the long term, the mismatch between government spending and revenue will be addressed (it has to be), which will largely set the stage for sustainable economic growth. We see the range for long-term economic growth being somewhere between 1.75% and 2.5%, depending on how the mismatch is resolved. That may not seem like much, but it is a significant difference in relative terms of the long haul. It means the economy would be 16% larger in 20 years, 25% larger in 30 years, and a whopping 34% larger in 40 years. Economic growth rates matter.
Long-term, we believe the prospects for economic growth are very strong; we just do not know the growth rate. The rate of that growth will determine the size of our economy and our general living standard.
The Future For The Markets
We believe the market is in a “fair market” range, meaning that stocks as a whole are not undervalued or overvalued. There is no evidence of unwarranted fear or irrational exuberance affecting stock prices. Investors are not discounting prices out of fear, and they are not bidding prices up irrationally.
Stock pricing is ultimately determined by profits and inflation. There are ebbs and flows along the way, and emotional sentiment influences pricing in the short term, but over the years, the market trend will match the economy’s. We’re very confident the market will be higher in 15 to 20 years, but we cannot even attempt to project where it will be in 6 months.
The implications for investment portfolios are exactly the same as we wrote in our last economic commentary. And this is the first time we can remember where we are literally repeating word-for-word that summary.
“Long-term investors will be in great shape sticking with the strategy which matches their life goals. Nothing in today’s commentary should suggest changing your long-term strategy.
Shorter-term goals where the effect of a mild recession or market dip might negatively impact a portfolio demand that investors build in enough liquidity to meet a short-term need even in the midst of a mild recession.
Whether your portfolio is meant to cover long-term goals, short-term goals, or a combination of both, we can develop an investment structure to accommodate those needs. The important thing is to accurately judge what your goals are so there are no real surprises.”
We have entered 2024 with strong returns in the last several weeks of 2023 and the first few of this year. We do not believe a major recession is in the wings, but there may be a minor interruption to the current economic expansion. In the long term, the future of the economy and the stock markets will depend on how we as a country decide to deal with mismatches between government spending and revenue.