Happy New Year!

January 15, 2024

Happy New Year! Our warmest regards to you and your families for a healthy and engaging 2024.  Wow, I cannot believe we are already saying 2024!  The old saying that “the days are long but years are short”, seems to be the biggest understatement I recall in recent memory.  Our family had a very substantive year in that everyone is healthy and employed, we enjoyed a couple of nice family trips, and our oldest son got engaged—truly an exciting year for all of us.

We stated at the start of 2023 that there is nothing inevitable in history, since the overwhelming majority of forecasters believed a recession was likely in 2023, which did not occur. So what’s in store for 2024?  While we cannot state with any certainty that a recession is out of the picture for 2024, it still seems unlikely.  Many economic conditions are slowing but consumers that control about 2/3 of the U.S. economy are still working (3.7% unemployment rate), and thus spending, which should drive overall activity to a positive 1.5%-2.5% GDP growth rate. Not robust growth by any measure, but growth just the same. With low inventories and high interest rates, existing home sales are -14% from a year ago (through October), but new home sales are +17% from a year ago.  If consumer spending patterns remain strong, companies should return to greater profitability in 2024. Thus, corporate spending - especially in re-shoring many manufacturing activities - is likely to drive capital spending upwards.  Two of the biggest risks, in our opinion, are that inflation remains high, and overall complacency in the markets that we’ve already achieved the elusive “soft-landing”. Former stock strategist, Bob Farrell famously stated:“…when 4,000 experts agree on the outlook, something else is going to happen.”  We will be on the lookout for greater volatility this year, especially with many stocks priced for perfect conditions that rarely seem to last.

I’d like to spend a moment here on interest rates, since that seems to be the big driver now of both market sentiment and investment flows.  Remember for every bond or loan outstanding, each party has opposing sides of the transaction—one is a lender, the other a borrower. 

After climbing to over 5% recently, the 10-year U.S. Treasury Bond’s yield has fallen to under 4% recently, a 20% decline in a very short period.  With the U.S. inflation rate recently about 3.1%, economists measure the “real interest rate” an investor keeps after subtracting inflation out from the stated rate. Thus, at a 5% rate for 10-year Treasuries, the real rate was close to 2% (5% stated rate minus the 3.1% inflation rate = 1.9%); comparing that to a real interest rate now, of 1%, means the real rate has been cut in half.  For investors who already had purchased longer term bonds this was a huge boom, since bond values generally rise when interest rates fall  - we started such purchases in most portfolios in August. For the U.S. Government, the largest issuer of debt in the world, such a decrease in interest rates is welcome, as it lowers the real cost of borrowing that they must pay.

However, there is a point where ultra-low interest rates, and the accompanying low inflation rates, become a problem. For example, Japan still has a governmental interest policy rate that is -.10%, meaning a borrower PAYS the lender for holding money, or a so-called “negative interest rate”.  There is an extremely dynamic, multi-faceted set of factors at work setting interest rates, including the aforementioned real interest rate expected, the money supply, regulatory policy for lending, and currency exchange rates. No one person can pinpoint a single factor that caused interest rates to move up or down, as the FED only controls short-term rates and thousands of independent investor transactions form the basis of the bond market and resulting interest rates.  Suffice it to say, most would want rates to come down (for example, so my nephew can afford a mortgage on a home), but we want rates to come down for the “right” reasons.  If inflation continues to decline and approaches the FED’s target of 2%, then a normal range for 10-year U.S. Treasury bonds between 3.0%-4.0% makes sense, putting the “real interest rate” between 1-2%. However, if inflation remains stubbornly high (and with re-shoring of manufacturing as well as higher wages, this could happen), then a 4% 10-year Treasury Bond seems low. 

Overall, the return for bond investors could be more favorable in the coming 10 years than the prior 10 years, since we spent much of the 2010-2020 year period with 10-year Treasuries around 2.0-2.5%, whereas the coming 10 years should be substantially higher than that.  Such higher rates are welcome for savers and investors, but can act as a dampener on economic activity, since ultimately high rates choke off marginal projects by making borrowing more expensive. This seems to be a driver of existing home sales slowing, since so many homeowners locked in long-term fixed rates when they refinanced several years ago at very low rates; not surprisingly, they are now reluctant to move or upgrade their home as they will incur a significantly higher mortgage rate.

The last word here on interest rates: Interest costs on U.S. Government Debt now total $659 billion in fiscal 2023, due to both increased borrowing over the last 10+ years and significantly higher interest rates.  Such costs are now the fourth largest government expense, according to the Treasury Department, behind only Social Security, Medicare and defense spending. This is concerning  for our long-term fiscal health as a country, and we believe it must be addressed in the coming decade.