The Economic Landscape

April 02, 2024

Those of us that live here in Southern California can attest to the fact that we’ve had a lot of rain this year, and particularly a lot of rain in short periods of time. Several news outlets reported as of early March, San Diego had already received as much rain in the past 5 months as they typically receive in their normal 12-month reporting period; at one point, some stated they received the most rainfall over any two-day period in recorded history.

What these statistics started me thinking about is that the reporting of these anomalies comes from about 150 years of samples – think of it as 150 “occurrences.” In the grand scheme of things, that is simply not a lot of occurrences. Compared to other scientific phenomena, let's say gravity, where we can do measurements an infinite number of times or some chemical reaction that can be repeated thousands of times. The data we hear reported as an “obvious new trend” is often based on such limited data sets.

An even more limited scope of data is witnessed in the economic statistics we see reported, which are based off dramatically fewer occurrences. For instance, there were 12 recessions in the 1900’s and three so far in the 2000’s. Thus, any study of recessions over the last 120+ years, are based off of 15 occurrences – not a lot of data. Another off-repeated commentary is that all 6 recessions we’ve experienced since 1976 have been preceded by an inverted yield curve, meaning shorter-term interest rates are higher than longer-term interest rates – which is generally the opposite of the interest rate structure. Six occurrences! All we are pointing out here is that many stories that you hear about are just that, stories. That is why we believe it is important to have a firm grasp of economic history, but more importantly, to study, comprehend, and draw logical inferences from the underlying data of where things stand today.

The economic landscape is a mixed picture, but in our opinion more positive than most are giving credit. Unemployment remains low, inflation, while still elevated, has cooled, and the University of Michigan Consumer Sentiment survey has increased a full 23% over the last year, indicating an improving level of confidence. Corporate earnings are by and large holding up well, home starts increased 11.6% month over month in February, and importantly home sales increased for two months in a row in January and February – the first time that has occurred in two years. Other data seems to support an expanding economy, including car sales that increased 6% from January to February 2024, and TSA checkpoint data this year is consistently 5-10% above year-ago levels. Importantly, the FED stated this week (March 20, 2024) that they expect some moderation of interest rates to occur this year. On the downside, the federal debt continues to concern us, political logjams in the United States abound, wars in Ukraine and Gaza could escalate at any time, and gold has reached a new all-time high-typically a sign of economic hardships ahead. Lastly, uncertainty over elections in many countries, including the United States, could lead to greater volatility.

How do we take all these things into account in managing portfolios? We still favor U.S. stocks more than foreign assets; thus, we are overweight the U.S. We believe interest rates have likely peaked for this cycle, and last fall, as well as earlier in 2024, we began adding more to longer-dated bond categories that have the potential to do well in a stable to declining interest rate environment. Importantly the technology-led nature of the U.S. stock momentum seems to be broadening out; for example a broad swath of financial and industrial companies (measured by the S&P Financial or Industrial ETF) has nearly kept pace with the rapid increase in technology stocks (measured by the S&P Technology ETF) over the last six months. This broadening out-of-market participation generally helps our client portfolios as, by and large, we are much more diversified across the entire market spectrum in most client portfolios; we generally have resisted getting too focused on the mega-cap 7 stocks that have been all in the news over the past 6-12 months.

What are the biggest concerns we have at this point in the economic cycle? Besides the previously mentioned wars, political unrest and the national debt, we have a couple of main concerns:

  • that stocks overall have too much good news already priced in and earnings will not keep pace to support the lofty valuation;
  • that the FED may be cutting interest rates too soon, stoking an already growing economy and an inflation that could re-assert an upward price pressure; 3) the unknowable event, such as a geo-political event abroad or here at home or an out left-field financial

More specifically, on each of these topics:

Valuations. The S&P 500 trades at a lofty price-to-earnings ratio (PE) of 21+ times current earnings, while a more normal PE range is 16-18. The combination of high valuations and the noise that comes in a presidential election year could mean volatility is likely to increase.

Interest Rates. The main impetus for the FED to cut interest rates is the idea that the current “high” interest rates are overly restrictive to the economy. However, most of us who have owned a home for more than 25 years may easily remember when a regular home loan was in the 5-7% range, and there was nothing unusual about it. The economy has absorbed these higher rates, corporations seem to be doing fine, and the biggest stress of high-interest rates seems to be consumers who are over-extended, banks too heavy into office or other commercial real estate lending, and debt servicing by the federal government itself. And the historical period of the 1970s saw the FED cutting interest rates in 1974-75 as inflation ebbed, only to watch reaccelerating inflation ignite less than two years later.

Financial or geo-political shocks. Economic problems in a relatively balanced economy are often induced by an outside shock to the system or some catalyst from within. The biggest financial risk we see is the amount and concentration of commercial real estate properties that will need refinancing in the coming year or two. With occupancy rates declining in many sectors, defaults will likely rise, causing many regional banks to take write-offs. As an example, the building we currently occupy recently reverted to the lender when the ownership group could not re-finance (happily, no issues for us!). Suffice it to say that outside shocks to the system can lead to a stall in economic activity.

All in all, we are still constructive on the U.S. economy, we think a recession is still off in the distance, sentiment is turning positive and most markets have started the year off strongly, boding well for the rest of the year in our opinion. The simple fact that the bond side of most portfolios is now paying substantive interest rates gives us further confidence for the future. Unemployment is low by historical standards, and thus, most who want a job are bringing home a paycheck.

To quote recently departed legendary investor Charlie Munger: “Spend each day trying to be a little wiser than you were when you woke up.” We intend to continue on our journey.