“Prices reflect near perfection yet today’s world is particularly imperfect and dangerous.” – Jeremy Grantham
The first quarter of 2024 saw a continuation of the strong financial returns which have characterized markets since the fall of 2022. Falling inflation, stabilizing interest rates, solid earnings growth and a sprinkle of “AI” have combined to drive equity markets to new highs in the first quarter. While equity market returns broadened from both an individual security and sector perspective in the quarter, the Magnificent 7 continued to have an outsized impact with five members contributing almost half of the 10.6% return of the S&P 500. Financial markets reflect a growing sense of confidence (or is it complacency?) that the Federal Reserve will successfully engineer a soft landing. Serious financial publications, like the Financial Times, are publishing articles with economists suggesting the business cycle may have been repealed. While we will buy into the changing nature of our economy, count us as skeptics on the elimination of the business cycle. With markets pricing in “perfection” or something close to it, to borrow from Jeremy Grantham, where we may find ourselves, in the context of the business cycle, is a critical question.
Our partners at BCA Research have recently laid out the case for caution depicting the economy potentially following one of two paths, that of “fire” or that of “ice”. Importantly, either case represents less favorable conditions for financial market returns versus the prevailing expectations.
Below, we summarize both scenarios:
- In the case for “Fire”, easing financial conditions, rising equity and real estate prices (boosting household wealth) and continued stimulative fiscal policy set the stage for stronger economic growth. With the economy operating close to full capacity, a reacceleration in the economy likely pushes inflation, and thus interest rates higher.
- In the case for “Ice”, weakening employment trends, slowing bank lending, commercial real estate challenges and the depletion of excess savings on consumer balance sheets pose risks to the soft-landing scenario. Under this scenario, a weakening consumer ultimately kicks off a negative feedback loop of falling demand pressuring earnings resulting in rising unemployment.
While the economy has been surprisingly resilient in the face of rising interest rates, our continued caution with respect to markets remains. Valuations remain elevated, investor complacency is high, the economy is walking a tightrope between fire and ice, and geopolitical pressures continue to intensify. We are not, however, calling for the “sky to fall”. Recognizing markets are elevated, the level of speculation in low quality businesses prevalent in the tech boom in 1999 or the meme stock/SPAC market of 2021 does not appear present today. Our caution is based on two premises: first, that full valuations suggest lower forward return expectations for equities; and second, there is now a real return associated with being patient. Investors are able to earn 4-5% returns in risk free assets while patiently waiting for opportunities to commit additional capital to investments with positive future return expectations.
We continue to position portfolios with an emphasis on quality across asset classes in client portfolios. In a period of heightened uncertainty, we will maintain an unwavering focus on managing your assets to participate in rising markets while protecting capital in more challenging markets. We thank you for the confidence you continue to place in our firm.
Please do not hesitate to contact your wealth advisor or a member of the Investment Advisory team with any questions.
