Market Synopsis – January 2024

Market Synopsis – January 2024

Jan 11, 2024 | 0 comments

2024 Outlook

Before we unpack our outlook for 2024, we would like to take a moment to welcome our investors and readers back from what we hope was a restful time spent with family and friends.

The final month of 2023 saw the S&P 500 rally a further 4.42%. This as a response to 17 of 19 members of the US Federal Reserve (“Fed”) stating that they expected rates to be lower by the end of 2024. This is expected to be achieved through three rate cuts over the course of the year as inflation continues to recede.

Many market participants rejoiced on the news as they believe rate cuts will increase the likelihood that the US economy achieves a soft landing. On the other hand, we have been detailing our somewhat less optimistic view, one in which a recession takes hold in the second half of 2024 for several months now. Therefore, does the “now confirmed” Fed pivot render our expectation null and void?

We still do not foresee a soft landing as the most likely outcome in 2024, the reasons for which we will detail below. Before we do that, to add some additional context, Figure 1 below illustrates that just because everyone is talking about a soft landing, it does not necessarily make it any more likely. In fact, often times the sea of soft-landing articles is followed by a recession.

Figure 1 – Articles discussing soft landings tend to precede recessions

The difficulty in maintaining a soft landing

A soft landing may be on the horizon, but it is too soon to celebrate. There is a big difference between achieving a soft landing and maintaining one. The Kinked Phillips curve, as seen in Figure 2, will help us explain why it is so hard to maintain a soft landing.

When inflation was high and wages were increasing, rate hikes were effective in reducing inflation without increasing unemployment because the economy was on the steep side of the supply curve. As the demand curve shifted leftward, the reduction in job openings had little impact on employment as the job market had an excess of openings relative to the number of job seekers.

Figure 2 – When the economy is near full employment, falling labor demand leads to lower job openings and slower wage growth

The issue is that as demand continues to shrink, due to higher rates and other forms of reduced stimulus, at some point the demand curve will shift left of the kink in the supply curve. At this point all excess job openings will be depleted and unemployment will begin to rise. The ideal outcome would be to hold demand exactly at the kink, meaning inflation would be low and unemployment would not rise. In other words, a soft landing.

Unfortunately, the long lags in monetary policy (see Figure 3), and the fact that the neutral rate of interest cannot be observed in real time makes keeping the labour demand curve at the kink difficult, if not impossible, especially when an economy is at full employment like it is at present. As a result, any monetary policy that is slightly too tight or slightly too loose can easily put the economy into a recession or inflationary spiral.

Figure 3 – The lagged effects of tighter monetary policy will continue to trickle through the US economy

We expect the US economy to succumb to a recession in the second half of 2024 assuming the current 1.4 job openings per unemployed worker continues to decline to 1 at the prevailing rate. When this point is reached, those who lose their jobs will be unable to find new employment and even consumers who are employed will begin to cut their spending in favour of increased savings. As one person’s income is another one’s spending, falling employment will feed on itself, culminating in a recession.

How will the banking system weather the storm?

Delinquencies are on the rise; bankruptcy filings have reached their highest level since 2010, and the 12-month default rate for high-yield issuers has risen from 1.2% to 5.2%. Figure 4 depicts the rise in delinquency rates in the commercial real estate office sector, which we expect will shortly be followed by the apartment sector. In consumer credit, delinquencies on both credit cards and auto loans have been rising for seven straight quarters now. A clear sign that for many, excess pandemic savings are dwindling.

The largest US banks are better equipped to handle an impending wave of bankruptcies. However, the same cannot necessarily be said for smaller regional banks which have loan-to-deposit ratios of around 80%, compared to the more conservative balance sheets of the big banks with loan-to-deposit ratios of around 60%.

Interestingly, this is in sharp contrast to the pre-GFC period in which it was the large banks that had the riskier balance sheets, and thus it was the big banks that fell victim to the slowdown in the over-indebted US housing market.

In addition to delinquencies, US banks also face $685 billion in unrealised losses on held-to-maturity and available-for-sale investment securities. Many of these losses are concentrated in small banks, a result of their failure to adequately hedge duration exposure. These unhedged security losses were a major driver of the smaller US bank collapses experienced in early 2023.

Figure 4 – Delinquencies are on the rise

Will the Fed cut rates proactively?

We had initially anticipated that it was unlikely that the Fed would attempt to front run the cooling labour market by cutting rates before unemployment ticked up. We saw the safer approach being to rather ensure inflation was truly under control before beginning to cut rates, as cutting rates too soon could allow a second wave of inflation to surface. A very real possibility given that the US economy is still operating near full capacity.

The kinked Phillips curve framework suggests that if labour demand starts rising, inflation could accelerate very quickly. In this case the Fed would be forced to lift rates even higher this time, to over 6%. We do not believe this is the most likely outcome in 2024, and thus we assign a reduced probability to such a scenario. Despite these risks, the release of the Fed minutes in December indicated that the FOMC would likely cut rates before unemployment even begins to rise.

2024 is the year of the yen

Given the likelihood of the global economy slipping into a recession in H2 2024, we expect that the Fed, the ECB, and most other central banks will start cutting rates in the coming months. However, the Bank of Japan will probably raise rates once or twice by that point and avoid performing cuts as they work to normalise Japanese monetary policy.

As a result, interest-rate differentials will move in favour of Japan. In addition, the yen is a highly defensive currency, even strengthening against the Swiss franc during both the GFC and in the initial stages of the pandemic.

Considering that the yen is 44% undervalued against the US dollar relative to its PPP exchange rate, one of the biggest discounts on record, it is probable that USD/JPY will drop to levels closer to 115, where it was in February 2022 – see Figure 5.

Figure 5 – The yen is extremely undervalued

Investment takeaways

While we believe a mild to medium intensity recession in the second half of 2024 is the most likely outcome, we remain cognizant that a second wave of inflation remains a possibility, even if unlikely. The impact of the above macroeconomic trends on the businesses we invest in is something that we factor into our assessment of their underlying business fundamentals which filters through into our estimates of their intrinsic values.

Are you interested in finding out more about how our focus on business fundamentals against the macroeconomic backdrop can help you navigate your investments through uncertain times? Connect with Integrity Asset Management and let us help you navigate your investing journey.

For more information on this synopsis or to discuss solutions provided by Integrity Asset Management, please contact us at:

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Source: Bloomberg, 29 December 2023