Genius abhors consensus because when consensus is reached, thinking stops. Stop nodding your head.
– Albert Einstein
CNBC headlined on April 12th, “Dow tumbles 475 points, S&P 500 suffers worst day since January as inflation woes erupt.” Three days later, UBS advised investors to prepare not for Fed rate cuts but quite the opposite, suggesting that “Fed hiking rates to 6.5% is a real risk.” The financial markets had stepped into 2024 with 65% of market participants expecting three or more rate cuts during the year. By April 18th, that share had fallen to 20%, surpassed by the 30% expecting none or actual rate hikes. The S&P 500, which started the month boasting a handsome 10.3% return, saw that gain cut by more than half by April 19th, though it recovered modestly by the month’s end, showing a decline of 4% for the month but still +6% for the year.
The financial markets are doing their best this year to play the role of Pinocchio to the Federal Reserve’s Geppetto. Investors with memories reaching back to the start of 2023 may recall that virtually the entire fraternity of economic forecasters predicted the onset of an economic recession during the year. Instead, the US economy became the focus of much admiring commentary, with US economic growth rates of 2.7% for the year inhabiting a separate universe from Canada’s ½% and Germany’s -0.3%. Let us occupy most of this commentary with thoughts on why this was and, perhaps more importantly, the likelihood of its continuance.
It would be very difficult to discuss the current state of the US economy without focusing attention on the federal government’s fiscal response to the shuttering of much of our national economy in 2020. Looking at a chart of federal spending reveals two massive increases: the second quarter of 2020 and the first quarter of 2021. From that point, federal spending fell sharply, remaining relatively stable until 2023 when it began to rise again, albeit at a more modest rate, powered higher by the inflation-based adjustment in federal benefits payments (think Social Security). Those increased benefits were funded by higher levels of borrowing by the federal government, with those increased benefits then circulating through the US economy. This likely explains a great deal of our higher rate of economic growth last year.
A bit more history, but this part is measured in increments spanning decades. In the 1970s and 1980s, the inflation-adjusted economy grew at an average annual rate of 3%. The 1990s were a decade of transition, and in the 21st century to date, we’ve seen that rate decline to 2%. There is much in economics that isn’t simple, but explaining the source of economic growth is. There are two factors that are the sources of that growth: the number of people working and the level of their productivity. In the three years ending in 2023, our population grew by 0.845%, and productivity by 0.602% at an annual rate. That gets us to 1.447%. That is the rate we are likely migrating back to, and any notable variances from that rate of growth are likely to be temporary in nature.
A misfortune being experienced by some of our fellow citizens who make a living in the real economy is their obligation to pay higher prices for the goods and services they consume, without a corresponding increase in their income to cover those higher prices, due to stagnating wage growth. The result will likely be lower levels of consumption, declining rates of economic growth, and falling levels of inflation. The higher rates of growth for federal transfer payments are now behind us, so we’re likely to find the economic climate considerably chillier than what we’ve been experiencing. This is not necessarily a forecast of economic recession, but growth rates starting with “1” will likely soon be upon us.
So, what about the financial markets? Intermediate to longer-term interest rates may decline, though possibly not by a significant amount. Think mortgage rates starting with a 6 and possibly a 5. Prepare to say goodbye to 6% six-month certificate of deposit rate “specials.” As unemployment rates begin to rise, the Fed will likely cut interest rates by 2% or possibly more. The stock market, which is only just now starting to align with the future state of this reality, could rise by another 15%. This is the world that investors inhabited from the time of the Global Financial Crisis of 2007-2009 to the pandemic of 2020. Nothing has really changed as the final rippling effects of the pandemic subside, and this may well define our future. For investors, these are prospects they may find pleasing in their experiences.
60/40 portfolios that returned 7.8% in the first quarter gave back 2.35% of that return in April, ending the month with year-to-date returns of +5.4%. The negativity was sourced almost solely from the previously discussed decline in the equity markets, with the slightly superior performance of foreign markets offset by the 6% decline in the small-cap space. Fixed income was slightly positive, thereby protecting portfolios from experiencing more pronounced declines.
Mark H. Tekamp