To start the year, I wrote a philosophical piece about the need to build culture. I think that’s the more important emphasis than the short term state of the market.
However, here’s a look at the near term setup in the economy and markets as well as some historical perspective. The short term is challenging, but the longer term outlook is sound.
- The economy is not as bad as everyone thinks. And it’s not as bad as I would have expected if you would have told me interest rates would climb 4% last year.
- We expect slight gains in GDP this year. IE- the “soft landing.”
- The job market and consumer spending have held up better than expected. I’ve never seen a recession with 3.5% unemployment.
- Some companies are announcing layoffs. But on balance, people are employed, and wages are rising – but not quite as fast as inflation.
- Short story: most people can pay their bills.
- The banks are capitalized. Most likely, assets in bank book values declined similar to marketable securities. Aren’t bank portfolio values down 10-15%? These do not all have to be marked to market. On the plus side, banks will get significantly higher interest spreads. We bet it all comes out in the wash.
- Getting to higher interest rates is painful, but the higher interest rate environment is desirable in our opinion. It gives savers a return on money and allows the market to price risk better. In other words, a low interest rate environment makes people sloppy with money, but they pay more attention to risk when money isn’t free.
- Home prices and rents seem to be falling, but it takes some time for this to show in the inflation data. This has been a major component of inflation, and likely this factor is headed the right direction.
- Labor seems to be the stickiest of the inflation problems.
- There are still about 1.7 job openings for every applicant. This was about 2:1 last year. Typically the ratio is about 1.5 openings for each job applicant. This is heading the right direction. The labor market is slowly rebalancing as corporations cut costs.
- However, layoffs thus far seem relatively small, and companies seem inclined to look forward to better times when they’ll need an intact workforce to capitalize on growth opportunities.
- Microsoft announced plans to lay off about 5% of its work force. That’s significant. But I bet companies can maintain earnings without those workers. At 3.5% unemployment, we’re employing some people that don’t do much.
- We need a new immigration bill to increase legal immigration and to track workers with temporary status. This is a bipartisan problem and will require a bipartisan solution.
- 970,000 people became citizens last year, the highest number since 2008. However, these people have been in the system 5+ years and were not new entrants to the job market.
- The Federal Reserve is not stupid. They probably waited 6 months too long to raise rates. But they understand the situation.
- We- and most of the market- expect the Fed to raise rates a few more times.
- However, if inflation keeps trending down, perhaps rates will settle at just over 5%. That’s a lot less of a change compared to last year.
- We do not expect rates to be immediately cut after reaching the top of the cycle. That’s because the job market is too tight.
- Expect rates to stay in the 4.5%- 5.25% range for a while unless the economy and job market performance is quite poor.
Bonds/ Fixed Income
- Bonds are poised for good performance this year, unless rates are hiked a lot further than expected.
- In our view, there are windows when you can add to longer term bonds like 5-10 year corporates, 10-20 year municipals and even longer duration corporates and treasuries.
- However, at the moment the bond market is in a strong rally that might not fully account for peak interest rates or the length of time rates may stay up. We think you should buy duration on dips.
- In the very short term, we favor short term investments like money market accounts and 1 year US treasuries. Money market accounts are paying close to 4%. The one year treasury is around 4.7%.
- If the 10 year US treasury yield approaches 4%, we can probably find good prices on longer duration income investments like municipals or preferred securities. At 3.5%, long term bonds seems a little expensive.
- We think stocks are a bit overpriced in the short term. Forward P/E’s of 17x expected earnings is above where markets normally bottom.
- Fixed income is a real alternative to stocks for the first time in 5 years. So, perhaps multiples should be lower.
- Corporations announcing cost cuts like layoffs have lately been rewarded by the market.
- Stock performance often anticipates economic performance. Thus stocks often bottom before companies put in the worst of their earnings.
- Margins should be under some continued pressure from labor costs and higher interest rates.
- Stocks can probably hold these prices or grow if economic performance is a bit better than expected. Honestly it has been so far.
- Stocks may sell off sharply if we have a bad inflation data point or if earnings are temporarily quite poor. So far, earnings haven’t been that great but they haven’t been too bad.
- Realistically, we see the real world situation as much improved from a year ago. Now we are discussing normal market questions like how to price stocks versus their earnings expectations. Rather than whether western democracies will hold up.
The American Empire
- Our view is that American support of Ukraine is necessary morally, and that it aligns with America’s interests in the global economy.
- If the United States does not act to keep the global peace, why should the US deserve the share of the global markets or the dollar its share of global transactions?
- Allowing Putin to annex Ukraine would be an abdication of leadership that would undermine the premise that the world is safer and higher functioning under democratic norms and American leadership.
- Whatever the Biden administration shortcomings are, they have rallied NATO to the defense of Ukraine and checked Putin’s empire building.
- This also set the stage to re-frame relations with China in a more positive direction. The administration acted aggressively to affirm support for Taiwan and to block China’s access to modern semiconductors.
- The US is attempting to build a NATO-like union in the Pacific to counter China’s growing influence.
- Suddenly, after the Biden/ Xi summit. the conversation with China became a lot friendlier and more forward looking. People need to talk to each other face to face.
- Clearly China’s internal strife over covid policies and their observing Putin’s mistakes in Ukraine has helped to re-cast US/ China relations.
- This is positive for the global economic outlook. However, the trade relationship will have new boundaries, and some critical supply chain elements will be built within friendly borders.
- It is a mistake to sell F16’s to Turkey and F 35’s to Greece. We really can’t trust these countries, and they have a long simmering feud with each other over Cyprus. Not every country should be welcomed into NATO.
- However, we can read the tea leaves. American Defense contractors are going to sell a lot of arms to American allies.
A Historical Perspective
- WWII happened because western democracies were passive in the face of Hitler’s aggression, especially regarding the Anschluss of Austria in March of 1938 and the invasion of Czechoslovakia.
- Hitler bet (with a small army) and he bet correctly that England and France wanted to avoid war at all costs and that they were too divided internally to fight another war so soon after WWI.
- This allowed him to aggregate quite a lot of people, natural resources and production capacity- quickly, and at very low cost- into an army that would have been defeated by France and England had they chosen to act sooner.
- However, by the time they did act, all out war was upon them.
- Neville Chamberlain, the UK prime minister, became a by-word for the appeasement of Hitler and failure to defend alliances formed after WWI. At the time of Hitler’s annexation of Austria, France did not even have a sitting government.
- Putin is running the Hitler playbook almost like he copied it out of a book. Putin claims that he is defending ethnic Russians who have been ill-treated in foreign countries as minorities. Hitler claimed himself the defender of oppressed German peoples scattered throughout Eastern Europe. Putin claims about Ukraine that it never was a real country, much like Hitler claimed Austria was simply part of a larger German empire and never should have existed as a state. Putin tells the story that invading Ukraine is a necessary defense against western aggression—that it is a defensive move necessary to Russia’s survival. Putin claims that his actions were necessary to stamp out Nazi-ism, just like Hitler claimed Nazism was a necessary counter to Russian communism. Hitler deliberately tried to set France against Italy by his intervention in the Spanish civil war prior to WWII. Hitler propagandized western democracies to amplify internal divisions much like Putin has done in the United States and Western Europe. Both Hitler and Putin levered their state churches into supporting their agendas. Hitler’s armored convoy sent to occupy Austria stalled on the way to Vienna. It could have been destroyed on the road.
- Reading suggestion: I’m reading The Rise and Fall of the 3rd Reich. Also, read the Hemingway novel For Whom the Bell Tolls for an American perspective on the Spanish Civil War in the 1930’s. (Hemingway went as a journalist and then fought in the war). It’s a fiction. But it’s color on the conflict that was a precursor to WWII. Hitler used the Spanish Civil war to set France against Italy and pave the way for his annexation of Austria.
Outlook for Democracy
- The western democracies of today are much better established and are much stronger than the democracies following WWI. Putin miscalculated the state of the west, believing the West would not have the political capital to stop him.
- We have had generations of evidence that the conditions of life are better under western democracies than they are under autocratic systems-both economically and in terms of personal freedoms.
- Will the center hold? Yes. This was a question 1 year ago. Now, we are well on our way to proving it.
- The better question is: how is autocracy sustainable? People all around the world, including in Russia and in China have experienced the contrast in lifestyles, some personally through travel and trade, some through the internet. Nationalist propaganda has an effect, but so does knowledge of the alternatives.
- Putin rails against Ukraine on his borders and he rails against gay marriage and transgendered people in the west. Why are these the themes and how are they related? They represent choice as a contrast to not-choice. His rhetoric about traditional Christian values is an argument for naked power. The question is whether people will be free to live how they choose. Ukraine has chosen to be free or die. People with choices on his own borders show a direct contrast with autocracy, and it cannot be accepted. They are very likely to live better and to outperform a kleptocratic system. It is a threat to Putin’s existence as a dictator, not Russia’s.
- I find it hard to believe that Russian and Chinese people will accept the poverty and isolation of their past as their outlook for the future. This is not a sustainable approach. Markets will have a serious affect. People can’t un-know stuff.
- There is a legitimate debate amongst Americans about the degree of support we should provide Ukraine- a fair and honest question. I also hear some cynicism about our involvement comparing this to Vietnam. Yes, this is a proxy war. However, I think the differences are clear and this conflict, unavoidable.
- There are some actors on the far right who have proved themselves to be traitorous mercenaries, playing on domestic conflict to enhance career opportunities or to monetize anxieties. Some are elected officials, some are pundits. These people are not to be trusted. I wouldn’t get my information from Tucker Carlson. If you’re voicing Putin’s arguments at this point?!– history won’t judge you kindly.
- Had the United States and allies supported Ukraine in 2014 when Putin invaded the Crimea, most likely we would not have war in Ukraine on this scale today. Appeasement was not a strategy that led to peace. We don’t need further proof of that strategy. We saw how it played out.
- Putin’s argument that the west forced him into this is nonsense. He’s been a murderer and an aggressor for almost two decades.
- History will show that Biden had the courage to act- unlike his predecessors- and this will be his legacy.
- Also: yes, he should step aside and let someone younger run in the next election.
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All economic and performance data is historical and not indicative of future results. All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC.
Jeremy L. Strickler, CFP®