Observations by David Robertson, 1/5/24, Outlook edition
Happy New Year! I hope everyone had a nice break over the holidays and got a chance to rest and recharge a little bit.
Since I found the exercise of producing a formal outlook to be fruitful last year, I am going to fire away again this year. Once again this will have a different focus and format than the usual Observations. It is also longer than usual so if you can’t see the piece in its entirety, please access in by way of the Substack app.
There are a lot of different reasons to provide an outlook so I’ll be upfront with mine. For one, I find the exercise of going through and comparing current views to documented views from last year to be useful for identifying changes and mistakes. As such, it is also useful for rethinking and updating mental models and frameworks. Finally, it creates a nice opportunity to highlight signposts from which to evaluate progress during the year.
I am going to start with a couple of points about my investment philosophy and process. That will provide some context on how I think about investment challenges and opportunities. Then, I will move on to an evaluation of the investment landscape in general, and proceed to my outlook on various dimensions of the landscape. I will wrap up with an outlook for various asset classes and some summary comments on the landscape for both investments and the exercise of investing.
For reference, virtually everything discussed here has been reported in previous editions of Observations; this is more of a compendium than any kind of revelation. As always, this is for information purposes only; it is not investment advice.
If you ever want to follow up on anything just let me know at email@example.com.
So with that, let’s dig in.
For starters, and in order to provide some context, it is important to understand what I try to accomplish with investing. My orientation is very much to long-term investment. Think saving for retirement over a horizon spanning years and decades rather than days and weeks. While much of what I do can inform shorter-term trading as well, that is not the focus of decision making. This stands out as a very different orientation than most of what you find on Wall Street or on social media.
In addition, I work from two major assumptions. One is things change. Because things change, it requires an active effort to maintain an advantageous investment position. “Set it can forget it” can work if you are lucky, but it is not a robust strategy. Sometimes stocks are attractive - and sometimes they are not. Same for bonds. Investment success over time depends on rigorous, ongoing research and analysis to make those determinations. It is not an inalienable right.
A second major assumption is it is critical to consider multiple perspectives in order to gain a more robust understanding. Investing with a long-term orientation, for example, means it is important to incorporate perspectives from disciplines that span longer periods of time such as history, politics, and geopolitics. It is also important for equity analysts to understand fixed income markets and vice versa. Different perspectives provide important context for understanding and interpreting various phenomena.
In brief, I employ a three-pronged process that involves a formal valuation model (of stocks, bonds, and bills), consideration of other, uncorrelated asset classes, and the analysis of narratives (I described these in more detail last year). I use these with the purpose of assessing the landscape, identifying opportunities, and managing risk. Ultimately, these inputs shape the asset allocation.
My views on the investment landscape have not changed materially over the course of the year. Last year’s summary remains appropriate:
The dominant characteristics of today’s investment landscape have not changed materially. They are debt, demographics, and valuation. As populations have aged and population growth has slowed down, so too has economic growth. This organic weakness has been papered over by the expansion of debt at an ever faster pace. Low rates and easy credit spawned ever-higher valuations for stocks. This was never sustainable.
One thing that changed from the pandemic years, however, was a transition from monetary policy being the primary driver to stimulate growth to fiscal policy taking over as the primary driver. The increasing prominence of fiscal spending can be seen in the graph below of the output gap.
The Federal Reserve says a positive output gap means “any slack has evaporated and resources are being fully employed, maybe even to the point of overcapacity. In this case, the economy is performing above potential.” The Fed also defines potential GDP as “the economy’s maximum sustainable output”. So, the economy has been producing at an unsustainably high level and it has been able to do so because of increased deficit spending.
This dynamic also highlights a key difference with those who have been less sanguine on economic growth. Yes, higher debt depresses growth. Yes, tighter credit impedes growth on the margin. However, politicians don’t get re-elected by allowing free market forces to drag the economy down the drain. They get re-elected by “doing things” to improve the economy. Often, this involves spending money.
As a result, my view last year that “government has taken over as the engine that drives the economy” is almost trivially true, because that is what governments almost always do. Nonetheless, it was a view that differed from an awful lot of forecasters last year. It will probably continue to surprise people in 2024.
The challenges of debt and demographics are by no means limited to the US; they extend across much of the world. Many other countries, however, have worse demographics than the US and do not have the advantage of having the global reserve currency.
This means two things. First, as growth in the global economic pie slows down, the nature of global relations changes. The dominant world view shifts from “a rising tide lifts all boats” to “a zero-sum game”. This results in increasingly nationalist policies which in turn results in greater competition for the remaining share. It also tends to lead to “The unwelcome resurgence of war”, as the FT put it (h/t Adam Tooze on Substack).
Second, since the US was the underwriter, or at least facilitator, of much of the global growth by means of its global reserve currency status and increasing trade deficits, the effects of many of its public policy initiatives ripple out beyond its shores. For example, if liquidity tightens in the US, it tightens outside of the US as well (all else equal).
This background helps to understand a great deal about US policy direction and approach to international relations. The US can no longer afford to be the global consumer of last resort without sacrificing its economic and military preeminence. As a result, it has re-oriented its relationship with the rest of the world
This re-orientation features policies to reduce its debt burden through inflation, a tougher stance on trade, and an industrial policy to rebuild productive capacity, among others. While other countries are also implementing many similar policies, the US stands out as having a less onerous debt service burden and greater policy flexibility due to the reserve currency status of the US dollar.
All of this is good for the relative performance of the US. EU countries, for example, will have greater difficulty trading off weaker growth and higher inflation. China will have difficulty fending off deflation without devaluing its currency.
Finally, the changing structure of markets has become an extremely important variable in the landscape as well. Several important changes include the proliferation of passive investing, the increasing use of derivatives, and the increasing use of share repurchases by corporations.
The proliferation of passive investing has squeezed out active investors and eroded the price discovery mechanism in the process. As market activity has come to be dominated by derivative-based trading, fundamentals of the underlying securities have become less important. The tail is now wagging the dog. The increasing use of share repurchases helps provide a constant bid for share prices.
These structural factors have significantly changed the way the market works. Stock prices no longer move primarily on the basis of changing economic inputs, but rather are more affected by the flows of money from sources like passive funds, derivatives dealers, and corporations.
The excess liquidity created by the Fed from Quantitative Easing (QE) also changed behavior. In an era of low rates, QE compelled investors to go further out on the risk curve in order attain attractive returns. This created a habit of chasing returns. Although Quantitative Tightening (QT) has since served to unwind the excesses of QE, there is still way too much money in the financial system. Until that normalizes, the chasing is likely to continue.
With underlying economic fundamentals providing only the loosest foundation for asset prices, those prices bounce around with little apparent rationale or direction. Lots of noise and little signal. Brent Donnelly captured the market zeitgeist well when he described, “It has been quite the year in macro as every single theme had a half-life measured in weeks …”
Looking to the new year, I believe many of the factors that have been supporting asset prices will begin to reverse. The most important driver has been liquidity. I believe we have reached the end of the line in terms of the frequent and fairly arbitrary infusion of liquidity to keep market afloat.
In 2024, the US Treasury will need to issue a net $2T in debt for the year. While there is some flexibility to increase the proportion of bills, there will be a need to increase longer-term bond issuance as well. When that happens, investors will need to sell something in order to buy bonds. That “something” will be stock and other assets. It’s time to start paying the bill for past excesses.
Another important factor is flows. As Baby Boomers continue to retire, they are likely to de-risk by selling stocks and buying bonds. Assuming corporate profit margins decline from record highs, there will also be less cash flow with which to repurchase shares. The tide of flows of money into stocks also looks to be turning.
Before moving on to the implications of this landscape, I would like to highlight that my views are an amalgamation of insights from strategists such as Russell Napier, Ben Hunt, Peter Zeihan, James Aitken, John Hussman, and Michael Pettis, and a whole host of others. The vast majority of these insights can be found in previous editions of Observations. I invite you to take a look if you find them interesting.
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Implications and outlook: Macroeconomic
The main theme for the economy this year will continue to be the transition from credit-driven growth to organic demand-driven growth. This is being nudged along with help from fiscal spending and will be more noticeable among industrial and capital goods companies than in consumer spending. As a result, it will feel very different.
Credit strains will persist and in many cases manifest in bankruptcies and losses as the persistence of higher rates will continue to take its toll. At the same time, however, wages will continue to rise and inventories will rebuild which will create a “surprising” tailwind for the economy. Because of these opposing forces, there will probably be some turbulence along the way, but the economy should be just fine unless some major event pops up. The main thing to keep in mind is modest real economic growth is basically a policy objective.
Economic growth in the US is likely to be stronger than in most other major economies and will be led by investment spending. This will, eventually at least, drive a rotation into capital goods and industrial companies and may even boost commodities as well. The boost from increased investment in the US, however, is likely to be at least partially offset by weakness elsewhere around the globe.
The big wildcard for 2024 will be employment. Despite concerns through 2023, unemployment remained at low levels. I expect the same to be true through 2024 with a couple of provisos. First, the continued tightening of credit conditions will continue to impinge upon overleveraged companies which could eventually force them to layoff people. Second, if the stock prices of large public companies fall during the year, those companies may respond by cutting costs and reducing staff.
In sum, I expect economic growth through the year to be uneven but OK. A good signpost to monitor will be bank lending. If that picks up, it will be a good sign the economy is transitioning successfully. I think the biggest mistake to avoid will be relying too heavily on the inverted yield curve as a useful indicator of recession.
As expected, inflation came down during 2023, but as I also stated last year, “The bigger issue for long-term investors, however, is not what happens with inflation over the next few months but over the next many years.” While the advocates of “transitory” inflation are taking their victory laps, all the seeds of higher future inflation (that I described last year) continue to germinate.
The main factor is that higher inflation has become policy. Sure, people hate inflation. Yes, inflation is a political problem and you have to look like you are doing something about it. At the end of the day, though, the least worst way to reduce excessive debt levels is by allowing inflation “to gradually erode the value of that debt”.
I continue to believe one of the most important factors clouding the debate about inflation is the conflation of consumer inflation with monetary inflation. Consumer inflation is a backward look at the change in consumer prices. Interesting, but pretty uninformative about what is going to happen in the future.
Monetary inflation, as described by Michael Howell, involves “the actions of the Central Bank in devaluing paper money”. Such actions can, and normally do, eventually lead to consumer inflation, but the process can take years. As a result, the pattern of monetizing excess spending isn’t especially useful for predicting short-term trends in consumer prices. However, it is observable and useful for understanding longer-term tendencies to debase the value of money. And … it’s happening.
The biggest issue I see going into 2024 is that inflation is expected to be incredibly benign - and I think that is far too optimistic given the backdrop of monetary inflation. This suggests the strong possibility of a significant upward assessment of inflation expectations some time during the year.
This is not to say I expect runaway inflation either, though. The US is relatively self-sustaining in terms of energy, major commodities, and industry. Further, having the global reserve currency will help deflect the brunt of inflationary blows.
Nonetheless, monetary inflation is a long-term policy and therefore is likely to be around for years. As a result, it is likely to remain a fact of life for investors, business people, and consumers for a long time.
I haven’t seen any evidence over the last year to dissuade me of the view that government has become much more interventionist or that the Treasury and Fed are coordinating over monetary policy.
Nor do I see evidence that monetary policy will be reverting to very low rates and an “all-in” liquidity flush program like what we saw in the pandemic or after the GFC. I noted last year, “if interventions are required, they will likely be much more surgical and limited than in the past,” and that’s exactly what happened during the mini-banking crisis in March.
I continue to see the number one job of both the Fed and the Treasury as ensuring financial stability. In the context of high debt levels, that means preventing and/or managing financial crises, but mainly it means ensuring the growing volumes of Treasury debt get issued without any major glitches.
With several sources of Treasury demand drying up (such as foreign buyers), developing new demand will be paramount. We are already seeing regulatory changes that will require banks to hold more capital. That will help, and I expect there will be more.
The biggest opportunity for the Treasury, however, will be luring investors in with relatively higher yields on longer-term Treasuries. This means managing the yield curve such that short-term rates are comfortably lower than longer-term rates (i.e. 1-2%). While some of this will probably be accomplished with short-term rates coming down, I suspect most of it will happen with longer-term rates going up.
I expected this process to start last summer, and I believe it did, but it reversed in the fall when the Treasury decided to pull back on coupon issuance and ratchet up T-bill issuance instead. In terms of longer-term rates, this was Treasury’s “get of jail free” card. Lower long-term rates going into year-end certainly eased financial conditions and lowered the risk of instability. Higher bill issuance is also draining the Fed’s Reverse Repo facility (RRP) faster and perhaps that is a policy goal as well.
Regardless, time is running out on the ability to defer higher coupon issuance. When that hits, investors are going to demand higher yields.
Another important aspect of monetary policy will be the continuation of Quantitative Tightening (QT). This program is important to maintain institutional credibility but mainly is necessary to retain tight control of money. This will serve to gradually, but persistently, reduce liquidity.
As we make our way through the new year, I do believe the Fed will lower rates at some point. If consumer price inflation remains acquiescent, it will have some flexibility as to lowering rates further or not. Regardless, however, I believe the biggest surprise of the year will be how little the Fed cuts during the year.
Interest rates fall out fairly directly from monetary policy. On the short end, the Fed will probably make a couple of cuts during the year, and may be able to make more if inflation stays low.
I think the bigger story will be with longer-term rates which I expect to go up. We saw a good preview of that in the summer and into the fall. I interpret the reversal from early October through the end of the year as more of a situational anomaly than an indication of the longer-term trend.
As a result, as the year progresses, I am expecting a steeper yield curve to develop and this should create a healthier backdrop for banks. I do not expect short rates to return anywhere close to the zero rates of past years.
At some point down the road, the persistence of fiscal dominance will cause long-term rates to push even higher. This will invite policy responses to cap long-term yields at or below the level of inflation. When that happens, long-term fixed income securities will become extremely unproductive investments.
Given the trend of increasingly interventionist public policy, politics is almost certainly going to play some role in determining macroeconomic outcomes. That said, I suspect the role could surprise a lot of people.
One of the trends I have been following closely the last couple of years is the set of issues and policies that find significant support in both major parties. For example, the pushback against corporate power has supporters on both sides of the aisle. More broadly, the support of labor vs. capital is also largely bipartisan. More protectionist trade policy also has broad support across the political spectrum.
This is especially interesting as relations between the two parties is as acrimonious as ever. Issues such as the debt ceiling and the upcoming presidential election promise to be ugly, partisan brawls. So, as the parties are growing further apart temperamentally, in many ways they are actually coming together ideologically.
The increasing areas of common ground suggests a couple of interesting possibilities. One is that several general policy directions are likely to remain in place regardless of who is in power. The debt still must be dealt with and it’s pretty clear now the pendulum is swinging away from the neoliberal order. Another possibility is that the areas of agreement become strong enough to fundamentally re-orient political affiliations in the US. Interesting times indeed!
Two big factors continue to impinge upon the geopolitical landscape. The first is the persistence of aging demographics and high debt burdens which change the state of play to a much more competitive orientation from a more collaborative one. The second is the effort of the US to forge an alternative path from the “Washington consensus” or, loosely, the neoliberal order. Bottom line: The US just can’t afford to operate under those conditions any longer.
In general, this means more conflict around the world - and that is exactly what we are seeing. It is still an open question as to the degree to which the US is willing and/or able to project economic and military leadership. Mainly, it looks like two major axes of power are forming: One comprised mainly of the West including the US and Europe and one mainly in the East comprised of China and Russia.
Large country dynamics remain fairly similar. China still “has a bigger debt problem and a bigger real estate problem than anyone else”. While the country seems to be getting more serious about addressing its problems, they are big, honking problems that are going to take years to resolve. The degree to which China suffers deflation and the potential for a devaluation of the yuan will remain ongoing questions.
Japan has also worked its way into the geopolitical spotlight by virtue of the mass sums of capital it has invested abroad and the potential for that capital to start making its way back home. When it does, it will create a headwind for risk assets across the world.
While geopolitical risks have always been around, the environment of heightened competition makes them more potent. As the US continues to forge its way to a post-neoliberal order, its use of the US dollar to further its aims rankles a lot of other countries. By the same token, China’s determination to spark economic growth through even greater trade imbalances is also grinding on nerves. In addition, there are a number of hotspots and proxy battles around the world. Putting all this together results in an unusually combustible mix.
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Implications and outlook: Investments
The long-term outlook for stocks remains negative on the basis of extremely high valuations. This means future returns (over a ten year period) will be low and by my measures are currently negative.
The short-term story is a lot more mixed and mostly due to liquidity. Currently, money supply is still excessive, but is getting worked down. This may provide enough of a window for major stock indexes to do alright early in the year. As excess reserves get worked down and as Treasury bond issuance increases, however, the liquidity environment for stocks is likely to get a lot darker.
The silver lining is that I expect a rotation into more economically oriented stocks like industrials and commodities. Timing will be an issue, but those stocks are relatively cheap and much more likely to perform as business conditions improve.
Bonds remain unattractive on both a yield basis and a policy basis. On a yield basis, Treasury bills produce a better return. On a policy basis, I fully expect financial repression to be pursued - which means inflation will gradually but persistently erode the value of bonds. If you want to know who is going to pay off the huge piles of debt, it’s going to be you - if you own bonds.
That said, the path to higher yields could be bumpy and there may be opportunities along the way to realize some attractive yields. Such opportunities are likely to be fleeting, however, and the scales will be tipped against bond owners.
Treasury bills, i.e., cash, are the outstanding investment option in the standard asset allocation mix right now. With the Fed expected to lower rates this year, current rates well over 5% are unlikely to last. That said, I wouldn’t be surprised if mid-single digit rates prove to be more durable than the market expects. Unless that rate range changes materially, cash should be the benchmark by which to judge any allocation to risk assets.
I described the general case for gold last year and everything still applies:
Gold has proven to be an excellent diversifier over time, often serving to limit drawdowns in times just like this when stocks and bonds do not look attractive. Further, gold plays an important role in wealth retention in times of turmoil.
A couple of interesting things happened with gold this year. One was gold stopped tracking the inverse of real rates so closely. Another is foreign central banks materially ramped up their purchases of gold. These things are not wholly unrelated.
As the prospect of financial repression becomes increasingly imminent, so too does the prospect of fiat currencies losing their value. This is exactly when gold provides a valuable hedge. This is a bigger concern for China than the US right now, but it’s just a matter of time. It looks to me like gold is right on the doorstep of a long bull market.
I still believe in the long-term case for commodities and am still in a quandary as to when and how to increase exposure. With economic growth in most of the world being decent, demand is there. China has been toying with deflation though, and is still the world’s marginal consumer of many commodities. Further, some funds have been long mainstream stocks and short commodities to boost returns.
That positioning means there is every possibility that commodities could abruptly turn at some point. This will be the ongoing debate: Jump in now on the expectation of future returns at some point, or wait for a better entry point and risk not getting enough exposure.
Investments such as real estate, private equity, and venture capital have long been pitched to advisors and retail clients as diversifying investments. They do add a few slices to the allocation pie charts and help create the impression of diversification. Bottom line though, these are all highly correlated to equity markets. As stocks turn down, these assets will feel additional pressure as well.
Also, as I noted last year, strategies that involve leverage, illiquid investments, securitization, and structured securities will face a painful decline. The new range for interest rates undermines the financial viability of these vehicles. As debt matures, it will be virtually impossible to roll over. As this happens, these strategies will gradually disappear.
If I had to capture the key forces of the market in two phrases, one would be, “There is still too much money in the financial system”. This means there will continue to “bouts of speculative behavior and lurches in different directions”. Time is running out, however. As liquidity conditions tighten, the prospects for risk assets will become a lot darker. I think of 2024 as “The year things get real” and “The year of consequences”.
The second phrase I would use comes from last year’s report and is still apt: “It is a uniquely bad time in history to own stocks and bonds, and yet that is what dominates most portfolios”. I know a lot of people don’t care, but long-term investors should. The prospect of declining liquidity and frightfully high valuations means conventional investment portfolios are likely to come in well below expectations. Better to figure out what to do about it now than after it’s too late.
Looking back on 2023, a couple of observations stand out. First, one of the most positive factors for performance was the trades I didn’t do. This was especially true in commodities which I have been watching for quite a while but also true for several other ideas as well. The things that worked during the year, by and large, were not the kinds of things I wanted to own long-term.
Another observation was the wild swings in the market. It is easy to persuade oneself to hold off on buying something until the evidence becomes clearer. Market activity last year showed how quickly and dramatically things can move once they start though. I’m thinking mainly of gold here, but we also saw it with 10-year yields and other assets. The point is, if you really want to have something in your portfolio long-term, don’t get too cute with timing the purchase.
As we progress through the year, one of the things I will be monitoring most diligently will be the uptake of Treasury bond issues in the new year. I believe this will be a powerful driver of the liquidity environment and therefore a key indicator for risk assets. That said, I expected this to become an issue far earlier than it has. If the Treasury can pull another rabbit out of its hat and forestall the consequences of excessive borrowing, then the threat to risk assets could be delayed again as well.
Also, I still believe the US dollar will remain an important signpost. A strong dollar serves US geopolitical interests, helps mitigate inflation domestically, and promotes labor vs. capital. With the exception of “some periods of relative weakness, such as at year-end, to ensure no financial accidents happen”, as I noted last year, a persistently weak US dollar would be a cause to re-evaluate.
Implications and outlook: Investment advisory
I would be remiss in describing implications of the investment landscape if I did not also discuss implications for everyday investors. If there is one thing all the liquidity and all the fiscal spending has done over the years it has been to make investing super easy in a sense. Strong markets have not only compensated for a lot of laziness, incompetence, and outright recklessness, but in many cases has actually rewarded such tendencies.
I believe 2022 served as a good indication of what to expect from markets going forward. It will be tough to make much money in stocks or bonds and even tougher to so by just sticking with passive indexes. As such, mistakes will be especially painful. Conventional exposure to a 60/40 (stock/bond) strategy simply will not come close to meeting return expectations. In short, as I said last year, “it is a uniquely bad time in history to own stocks and bonds, and yet that is what dominates most portfolios”.
Because liquidity has been the main driver of stocks, the major indexes are now comprised mostly of hugely overvalued tech companies, high beta stocks, and low quality (i.e., profitless and/or overleveraged) firms. Not what I want to be betting on for a comfortable retirement or a productive investment portfolio!
While many of the factors behind my rationale have been in place for a while, I have higher than usual conviction that the investment landscape will get more difficult for a couple of reasons. One is because 2022 served as a useful “proof of concept” for the policy of higher rates. The economy did not crap out and the world did not stop spinning on its axis. It’s OK to have rates that are not hovering around zero.
The other reason is the realm of excess liquidity is running out. The costs are exceeding the benefits. As that happens, investors are going to face a decision they really haven’t had to in years: They’re going to have to decide between owning one asset vs. another asset. No longer will they be able to just chase whatever story is trending at the moment. When that happens, a long, probably relatively slow, process for market prices to gravitate to their underlying economic value will begin.
Finally, I’d just like to say I do what I do for a couple main reasons. One is I find exceptionally few conventional Wall Street sources useful for a long-term perspective on the market. As a result, I would be exploring other sources to learn what is really going on in the market anyway.
A second reason, though, is because I don’t think the investment industry has done a very good job of helping investors achieve better outcomes. I’ve seen it first hand too many times. As a result, and especially in a time of a confusing and changing investment landscape, I think it is important investors understand exactly what they are getting involved in. There are no guarantees in life, but at least we should hope for a fair chance at getting ahead.
Good luck and best wishes for a successful 2024!
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