The combination of restrictive monetary policy and limited economic predictability fueled a preference for profit growth “havens” in 2023.
It would be unusual for the narrow market breadth to continue for a second full year in 2024.
We are steering clear of anchoring to highly specific “macro” views about the economy or and pending elections, rather focusing more on attractive valuations and fundamentals.
Toward the end of 2021, the U.S. Federal Reserve began the process of moving to a restrictive monetary policy position. This was intended to quell an inflationary burst whose origins lay in a series of supply and demand imbalances emanating from the Covid-19 lockdowns of 2020, replete with fiscal and monetary largesse, and follows an extended period (~14 years) of ultra-low interest rates and balance sheet expansions by Central Banks worldwide. Market participants have, understandably, had difficulty processing how to appraise these anti-inflation efforts. Are they certain to generate a painful recession? How destabilizing will restrictive rates be after such a long period of low rates? Were Covid lockdown-driven supply outages the primary cause of the inflation bulge over the past two years, or was it too much money supply? Has the world exited a “lowflation” era to find itself in something a bit different? Will policies intended to decarbonize the world economy prove inflationary? Can an economic pole anchored by nations in an “illiberal East” provide a credible alternative to Western dominance? Does gigantic government spending and fiscal deficits, on a scale normally seen during major wars, nullify the restrictive monetary policy?
These are not questions that individually or collectively result in confident answers. All one can say with certainty as of late 2023 is that interest rates at the short and long end of the curve are a lot higher than at any point in the last 15 years, inflation rates appear to be trending down, and the national debt load is uncomfortably high.
It would be unusual for industries that uniquely benefited from the extremely long period of ultra-low interest rates and capital costs, to suddenly assert market leadership.
Outside the United States, the post-Cold War optimism of free capital flows, free markets, and a reduced role for governments in allocating capital and resources has faded. This is most pronounced in the old poles of the Communist Second World, where Russian territorial and Chinese economic ambitions puncture the economic and political order that was expected to endure for decades. Confident answers as to where all this is going are similarly lacking.
Against this background, Cambiar’s internal view has been to resist anchoring to strong views about “macro narrative” questions, despite the noisy rhetoric around them. The U.S. economy more resembles de-mobilization at the end of World War II, replete with all manner of industrial imbalances and international tensions, than any normal business-cycle analysis. These imbalances are finally dwindling down, along with an acute money supply bulge that we believe had as much to do with the inflation problems as any other factor. Net, it has been far more productive to focus on individual companies and industry/competitive dynamics and assess how these might develop favorably or unfavorably, as the case may be. Notably, a classic “defensive” playbook in equities, featuring heavy positions in defensive sectors such as utilities, staples, and healthcare stocks has been ineffectual throughout 2022 and 2023. This probably has as much to do with the 21st Century inverse correlation between bond valuations and stock valuations breaking down (they have become positively correlated) as it does company-specific factors.
Businesses solve problems, such as how best to grow, how to produce better products, how to bring value to their customers, what kind of innovations will be necessary, and so forth. Prices and price discovery are among the primary informational inputs that businesses use to answer these questions. With some degree of consistency, we are seeing businesses solve the price/volume/value and logistics questions that have plagued the environment since early 2020. While there have been moments of acute excess and privation, market leadership has largely been comprised of the same businesses and industries that exhibited strength and robustness prior to the 2020 COVID lockdowns. This includes all manner of digital economy businesses and traditional industrial businesses. Weaker business models and industries with fragmented competition, or sensitivity to financing costs, have been more challenged.
While it is easy to malign a macro-driven stock market narrative, it is clear enough that two big picture elements remain profound matters. The first is whether a return to an ultra-low inflation economy (as was the case from 2008-2019) is realistic, or has the world moved past the lowflation era. The second is whether economic growth can and must stagnate (or contract) to keep inflation sustainably under control. Bond yields, especially longer maturities, appear to be skeptical that lowflation will return entirely, while an inverted yield curve presages lower growth and an unsustainably high Fed Funds rate. It is quite possible that the spectacular increase in Federal Government debt, and substantial “structural” budget deficit position will itself prove to be additive to inflationary pressure. At the very least, 2023 has been the first year in a very long time where the supply of bond buyers needed to meet the enormous funding and issuance requirements has been in some question – also raising questions about what an equilibrium interest rate might be, and whether the correlation between stock valuations and bond yields may more resemble the 1970s-2000 (negatively correlated) versus the 2000-2021 version (positively correlated).
The combination of restrictive monetary policy and limited economic predictability fueled a preference for profit growth “havens” in 2023. Some inevitable cooling of volumes and pricing power is inbound, while the severity and duration of the cooling remains uncertain. This… is our best explanation of the acutely narrow market breadth that has prevailed in 2023, as an extremely small group of stocks (the so-called Magnificent 7 or M7) have powered S&P 500 returns along with global averages. The M7 stocks have in common a strong presence in the digital economy of 2023 and likely beyond, though it is worth recalling that this kind of logic has found favor in past stock market eras only to prove errant in subsequent years.
Proponents of greater stock market breadth may recall a quote of Roman poet Horace:
“Many shall be restored that now are fallen and many shall fall that now are in honor.”
Our crystal ball remains murky, though a bit less than it was a year ago. We expected stocks to struggle to find direction in 2023, and for investor confidence in earnings, the appropriate discount rate, or the path of monetary policy to be lacking. Accordingly, we anticipated a low conviction, rotational market, characterized by multiple compression and asset price deflation as the higher cost of capital fed into valuations, until such time as less restrictive monetary policy could credibly be implemented. That view has generally held correct, with the equal-weighted S&P 500 P/E multiple compressing to 15x earnings (a bit below longer-term averages) at the end of October, down from a well above normal >20x in 2021. We could not have anticipated the rapid failures of several major regional U.S. banks in the first half of 2023 along with the demise of $800+ bn Credit Suisse, nor the relatively smooth absorption by the financial system of their demises. Nor would we have anticipated the significant multiple expansion of the M7 stocks amidst this backdrop.
Looking forward, it would be unusual for the narrow market breadth to continue for a second full year. Possible, but unusual. Likewise, it would be unusual for industries that uniquely benefited from the extremely long period of ultra-low interest rates and capital costs, to suddenly assert market leadership. Improved stock market breadth and less restrictive monetary policy likely coincide. We see a path toward this in 2024. Should the path to easier monetary policy become altogether clear, we suspect stocks would react broadly and quickly – making it difficult for investors on the sidelines to capture much of the improvement in breadth or valuation. This places a high value on committing capital throughout 2024, and sticking with it as the year unfolds.
(updated on January 8, 2024)
We penned the above letter in the middle of the 4Q23, prior to Christmas and the final Fed meeting of the year. The final Fed meeting was an important one as Fed chair Jay Powell’s statements strongly suggested that not only was the Fed done hiking rates but that it anticipated some decreases in 2024. Market pricing signals, such as a sharply inverted yield curve already implied Fed cuts in 2024; nonetheless it is a material bit of information to receive confirmation from Fed decision-makers directly. Stock and bond markets surged on the prediction of less restrictive future interest rates, with higher beta stocks leading the charge. It is also worth pointing out that the loud and pervasive calls for an inbound recession (which started in the first half of 2022) have yet to materialize. With no outright recession yet in sight, at some point continuing to call for one becomes difficult to justify. This late year surge put markets into overbought territory, at least on a short-term basis.
Our overall thoughts about managing in 2024, inclusive of the Fed’s most recent meeting, are not meaningfully different from much of 2023. Namely, we are steering clear of anchoring to highly specific “macro” views about the economy or for that matter the potential impact of elections, and focusing more on attractive valuations and fundamentals where we see them, aiming to be particularly mindful about focusing on businesses that possess pricing power due to their own unique products or the market structure of what they sell.
The Recession That Wasn’t
Rather than thinking about “the economy” as a singular whole, we believe it will continue to operate along multiple “tracks”, with key stock market sectors such as technology and industrials driven more by the pace of innovation and implementation and less by macro variables such as interest rates and in some cases governmental policies. There are several factors that have come together to buffer the impact of higher interest rates. Although classically interest-sensitive sectors such as housing and commercial construction have contracted, as one would have expected, this has been substantially offset by growth in new industrial facilities in the form of “re-onshoring” and various government-policy urged strategic capacity adds in industries such as semiconductors, batteries, and unique materials. Most post-WW2 recessions feature significant employment losses in construction and related materials. Given the sizable activity pipeline in industrial construction, it appears difficult to generate the aggregate employment losses normally associated with recessions, even if commercial and residential construction continues to weaken into 2024. Second, elevated government spending appears “locked-in” for the next couple of years. This is stimulative to the private sector. A large public sector deficit entails a large private sector surplus – that is a foundational economic identity. Third, given the length and duration of ultra-low interest rates, and especially the extreme conditions that prevailed in 2020-21, most corporations termed out their debt cheaply, while most homeowners with mortgage debt refinanced during this window to obtain exceptionally low payment rates. These functional factors buffered the impact of much higher interest rates from a wide swathe of the economy. Taken together, we believe forecasts of a large economic contraction are challenging to believe absent some new and as of now unforecastable global disturbances. That said, a longer-term period of slower trend growth in the USA and other advanced nations due to poor demographics and higher prospective interest rates seems quite plausible.
The Debt Problem
There is one big forecastable problem that will have to be reckoned with at some point in time: an outsized pile of public sector debt and a structural budget deficit that is becoming incrementally more structural the longer this goes on. The United States ended 2024 with a gross public debt of $34 trillion or 123% of GDP, and a budget deficit of 6.3% of GDP with extremely low (3.7%) unemployment. The gross debt load as a % of GDP is about the same as at the end of WW2, with far poorer demographics and seeming political will to act prudently. The large stock of new bonds that will need issuance, plus the refunding of the existing pile of debt, appear likely to exert upward pressure on bond yields. We saw a glimpse of this during the second half of the year, as new bond auctions went rather poorly given the large supply of new bonds relative to demand, pressuring the stock market. We strongly suspect this is not the last time this issue will rear its head.
Whether it’s too many bonds or simply the shifting of financial sands, a key financial bulkhead of the 2000s and 2010s has broken in the 2020s: the inverse correlation of stocks and bonds. Bond prices rise when yields fall, especially longer-duration bonds, and yields have tended to fall in the face of economic weakness. Economic weakness usually causes stock prices to fall. This combination made portfolio risk hedging cheap and easy for most of the last 20+ years. Starting in mid-2022, this inverse correlation flipped to become positive, with stock prices and bond prices declining in tandem, much as they did from the early 1970s to the year 2000. If bond yields will tend to be pressured by the high debt load and ongoing fiscal largesse, this leads to a rather confrontational long-term relationship between government spending, Federal Reserve policy, and the stock market. We don’t have any clear idea how this particular problem gets resolved; perhaps some combination of broad-based taxes and interest rate controls seems the most likely instruments to use. This is a man-made problem that will demand a man-made solution. Getting to a solution is apt to be very noisy.
The (generic) history of election years is that stock market returns are often higher than long-term averages, but there is a gut check or two along the way. Recent memorable elections within-year gut checks include 2020 (COVID lockdowns, very quick recession, huge monetary expansion), 2016 (commodity price collapse to start the year), 2012 (ongoing European financial crisis most of the year), and 2004 (slow and inconsistent recovery from 2001 recession). As the 2024 election approaches, it is likely that the noise around “election uncertainty” will become quite loud. We’ve heard this before, in fact in almost all previous election years, and will point out in advance that this is “fake” uncertainty (kind of like fake news). There has always been an election scheduled for November 2024, since back in the 1700s in fact, with an uncertain outcome. It’s a false narrative that nonetheless tends to push markets down in the summer and early fall heading into the actual election, and usually leads to opportunities.
There are two spectacularly memorable bear market election years from a stock market perspective: 2000 and 2008. We would remind clients that these two deep and still memorable stock market debacles had their roots in asset-price bubbles, i.e., the bear markets had neither recessionary nor electoral causes. Asset prices can and do fluctuate from so-called intrinsic value, leading to opportunities and risks. When large asset classes deviate very far from sustainable prices, (that’s what a bubble is), big problems occur, including recessions. Our view is that if there was a bubble asset class going into 2022, it was government bonds and various securities that price closely off of these such as corporate bonds and real estate, and some very speculative public equities such as so-called disruptor businesses. Arguably, the deflation of these bubbles is ongoing. We are much less certain whether bubble conditions presently exist in private debt markets, private equity markets, or AI stocks as the most recent possible vintage. We would just say it’s possible that bubbles reside in these areas. Importantly, we do not at present see the potential for the implosion of key financial infrastructure (such as the interbank lending market in 2008), limiting the possible downside scenarios.
Thank you for your continued confidence in Cambiar.
Certain information contained in this communication constitutes “forward-looking statements”, which are based on Cambiar’s beliefs, as well as certain assumptions concerning future events, using information currently available to Cambiar. Due to market risk and uncertainties, actual events, results or performance may differ materially from that reflected or contemplated in such forward-looking statements. The information provided is not intended to be, and should not be construed as, investment, legal or tax advice. Nothing contained herein should be construed as a recommendation or endorsement to buy or sell any security, investment or portfolio allocation. Securities highlighted or discussed have been selected to illustrate Cambiar’s investment approach and/or market outlook and are not intended to represent the performance or be an indicator for how the accounts have performed or may perform in the future. The portfolios are actively managed and securities discussed may or may not be held in client portfolios at any given time.
Any characteristics included are for illustrative purposes and accordingly, no assumptions or comparisons should be made based upon these ratios. Statistics/charts may be based upon third-party sources that are deemed to be reliable; however, Cambiar does not guarantee its accuracy or completeness. Past performance is no indication of future results. All material is provided for informational purposes only, and there is no guarantee that the opinions expressed herein will be valid beyond the date of this communication.