“This is the strangest life I’ve ever known.”
- Jim Morrison’s “Waiting for the Sun”
Markets have been strong yet US economic growth in the first quarter slowed to 1.4% annually in the latest revision of Gross Domestic Product (GDP). That is down 59% from fourth quarter growth and about 40% slower than average growth in the prior four quarters. The unemployment rate recently edged up to 4%. The Institute for Supply Management’s ISM Manufacturing Index just dipped into contraction territory. The latest annual inflation measured by the Consumer Price Index (CPI) was 3.3%, stubbornly remaining above The Federal Reserve’s 2% target. Geopolitical tensions remain the highest in many years. Interest rates have risen so far this year. Federal debt keeps rising alarmingly (more on this later). Mid-way through this election year, much of the current political buzz is about the possibility of replacing one of the candidates after having won delegates to clinch his party’s nomination.
It is a strange moment and discomforting. Yet stocks have continued to rise with little apparent concern. This year through 6/30, our blended global stock benchmark is up 11.18%. Its components are the Russell 3000 Index, up 13.56%, and the MSCI ACWI ex-US international index, up 5.69%. Valuations remain high with US stocks trading at 22.7x forward earnings estimates. Most of those US stock index gains were propelled by a handful of large, popular US Tech stocks.
This may sound like a broken record, but large US growth stocks outperformed cheap stocks, smaller stocks, and non-US stocks. REITs modestly fell and most bonds produced slightly negative total returns so far this year. Experience reminds us that what goes around comes around, and history’s lesson is clear: investing is a long-term endurance contest, not a sprint. Some portion of the market is always the current hot segment – the latest fad – but steady value and broad diversification is the path that achieves long-term goals.
As we survey this landscape, our biggest concerns are money supply contraction in the short-term, and the federal debt and its implications in the long-term. M2, the most common measure of the money supply, just recovered to positive annual growth in April and May. But from December 2022 through this March, it declined year-over-year. Few are discussing this. Many now think changes in M2 have little impact on the economy (even though a surge in M2 growth in late 2020-2021 was followed by the surge in inflation in 2021-2022, and the peak in the annual inflation rate came 16 months after the peak in M2 growth). We hope dismissing the money supply contraction is correct, but we note that actual declines in M2 are rare, and it last happened in the early 1930s. Given typical lags between changes in monetary conditions and economic effects (inflation after excess growth, economic weakness after excess contraction), the economy appears to be at a critical juncture now.
The Federal debt is our growing long-term concern, the more so because neither leading party’s standard-bearer is concerned about it. It greatly increased during each of the past two administrations, as neither of the main political parties appears to have any will to address it. Debt measured in trillions of dollars is an abstraction difficult to comprehend. To help cut through that, the Congressional Budget Office last year reframed Federal debt and deficits in terms of the average household. In 2022, if the average household earning $74,580 per year spent like the federal government, it would have spent $102,961, running up $28,381 in new debt. It would, however, be difficult for that family to borrow that much since it would already owe $564,749, its share of the federal debt. Many say that for our government, that much debt is not a problem because the dollar is the world’s “reserve currency:” where else can China and other saving nations invest all those savings if not in US Treasury bonds? Our view is that’s fine until it stops being fine. In other words, anything requiring confidence is subject to a loss of confidence at some point along the way, and confidence can be a fickle thing.
Long-term investors need a cool-eyed awareness of near- and long-term risks. But they can’t allow concerns about those risks to paralyze them into simply cowering in cash. In the short term, if it turns out that the Federal Reserve (which controls the money supply) has made a policy error and has been too “tight,” then a regular cyclical recession could be in the offing. But it would not be the first, nor the last, and while not much fun at the time, recessions are always temporary and don’t have to disrupt financial plans (for those that keep their heads and don’t panic sell while markets are down).
And while long-term debt concerns could ultimately precipitate an eventual crisis, the much more likely event is a sustained period of higher inflation than otherwise coupled with lower long-term economic growth. While not anyone’s preferred economic scenario, it doesn’t imply that long-term stock return expectations should be negative, or even lower than bond returns. But it does imply lower stock returns than we’ve generally enjoyed over the last 15 years or so, with likely more volatility along the way.
This does not look like a time to emphasize chasing returns in hot sectors. Rather, this looks like a time to be more concerned with managing risk with very broad diversification and with portfolio holdings representing good valuations and claims on reliable cash flows. We are not predicting storms, but we are working diligently to ensure that portfolios are ready when inevitable squalls arise.