Quarterly Letter Excerpt: Economy and Markets

If something cannot go on forever, it will stop. Economist Herbert Stein articulated this principle nearly forty years ago when discussing growing trade deficits with lawmakers. This humble insight can be applied to many situations. These days it feels as though post-pandemic economic strength will go on forever. Yet, we know that it won’t. It can’t. Our central theme of “normalization” is evident over the past eighteen months, and eventually the business cycle will overcorrect causing recession (not to be feared entirely as contractions cleanse the system). But that day isn’t today. Indeed, as we exit the first quarter the US economy is doing fine. Better than fine really, it’s quite robust. Consumer spending is resilient, jobs are plentiful, businesses are investing, and government budgets are expansionary. Real GDP grew by +2.5% in 2023, accelerating from the previous year, and estimates for Q1 sit around +2%. While these are backward-looking figures, more current information – like spending data from credit and debit card companies, retail sales, services PMIs, jobless claims, and even (recently) improving consumer confidence – suggests that momentum has carried into 2024.

But why the potency? The simple truth is economic strength is closely tied to jobs, which remains solid. And because the economy is strong that keeps the labor market strong as business profits support employment and wages. It’s a virtuous loop. And while signs of normalization (there’s that word again) in the labor are present, like softer demand for workers and increased supply, layoffs are low and hiring is steady. This balance is beneficial nurturing a more secure foundation. Until this situation changes, economic expansion should continue. The critical question is now, can we successfully move from too tight to well-adjusted in the jobs market without the pendulum swinging negative? Time will tell.

Inflation’s stride has also cooled over the past 20 months, from over 9% to roughly 3%. While much progress has been made, Jerome Powell asserts more work and greater confidence in the trend is needed to declare victory. We agree. The Fed’s target is ~2% and the “last mile” won’t be easy. Still, our long-held view endures – the contemporary war against inflation will be won.

Speaking of the Fed, last July we opined that the central bank was done hiking interest rates. Be it lucky or good, that view proved correct. We continue to reason that the Fed won’t need to raise rates further. We’ve gone from 0% to ~5.5%, a ton of credit tightening, and without a jump in unemployment. Job well done. The new Wall Street parlor game centers on how long the Fed will maintain its current stance before lowering rates. The answer hinges on the trajectory of the economy, employment, and inflation. Our best guess is the first cut will occur in the second half of this year.

All told, “soft landing” odds have increased compared to a year ago, a time when our preferred forward indicators signaled maximum caution. Several indicators have improved, meaning there’s been considerable diminution of risk over the past year. At this point we see recession odds at about a coin toss (down from over 80%). Historically, in any given year it’s ~15%.

In bonds, the action will likely be on the front end of the yield curve as big moves further out have mostly occurred. While things can move cyclically based on data and mood, structurally speaking longer duration securities appear sensibly priced for the current environment.

Meanwhile, firms are in good shape with profits holding steady in 2023. Despite “no growth”, revenues were higher last year due to an advancing economy and increasing prices. But so too were costs, in many cases more than revenues, resulting in compressed operating margins and inert profits. Looking ahead, analysts predict energetic earnings growth of +11% in 2024 and +13% for 2025, driven by a healthy economy and margin re-expansion. Those are high bars. From our perch, margins may have indeed bottomed if we can avoid a downturn. Thus the near-term direction of profits will largely hinge on the macroeconomy. Regardless, our primary attention is the longer-term outlook. Especially for those investments we own on your behalf. And here, we are optimistic for the years ahead.

For its part, the stock market has continued its momentum, driven by expectations of no recession and Fed rate cuts. Despite unease over the looming election, investor attitudes are (unsurprisingly) cheerful on the back of impressive recent performance. Moreover, the inflation problem is under control and geopolitics, while tense, sit more at a simmer than a boil. Yet risks remain if fundamentals, including lofty earnings expectations, fail to deliver.

On valuation, there’s some level of enthusiasm to be sure, particularly in areas like AI. However, at this juncture, this verve is probably more rational than irrational (paging Alan Greenspan and Bob Shiller!). As declared, the economy is sound, inflation is falling, the 10-year Treasury yield is off its peak, the Fed has finished raising rates, corporate earnings are ample, and technology is bliss. Given this backdrop, although the stock market is not exactly cheap, it is also not overly expensive when you consider where key factors like inflation, interest rates, and profits are expected to be in the coming years. Moreover, there is still approximately $6 trillion in cash “on the sidelines,” mainly in money market funds, a portion of which (not all, but some) will likely seek higher returns when the Fed eventually begins to ease.

Bottom line: while short-term estimates vary, our longer run outlook for US equities remains wildly bullish.

As always, there is perpetual motion in economics and financial markets, so it’s vital to make decisions based on the available information. We find great joy in this important vocation. Which I suppose leads us back to where we began, with Mr. Stein’s observation … but with a twist. What happens if something, like the work of a steadfast financial advisor, can go on forever? Thanks for your unrelenting trust.

Albion Financial Group is an SEC registered investment advisor. The information provided is intended solely for educational purposes and should not be construed as an offer or solicitation for the purchase or sale of any particular securities product, service, or investment strategy. Past performance is not indicative of future performance.


Quarterly Letter Excerpt: Economy & Markets

What does it mean to have humility? Classically defined, it is “a feeling or attitude awarding no special standing that makes you better than others.” As we close out the year, there are many lessons 2023 can teach us. Perhaps most salient is the concept of humility, especially relating to financial markets. Sour moods festooned the investment landscape as the year began. Inflation was high, interest rates were rising, stocks (and bonds) had just closed out a tough year, and recession was expected by most. Fast forward twelve months, as the year closes inflation is lower, rates have peaked, stocks (and bonds) logged solid returns, and the US has so far avoided recession. On the latter, while our process is thorough, I got it wrong in 2023. But it’s fanciful to expect that we’ll get everything right. Rather the aim is simply to go to bed a little smarter than when we woke up. To be lifelong learners and compound our knowledge. Fortunately, our toil and tenets position us to do just that.

We lost the venerable Charlie Munger this year. For over six decades Charlie was Warren Buffett’s sage right-hand at Berkshire Hathaway. He used to say, “we try to arrange our affairs so that no matter what happens we’ll never be sent ‘back to go,’” [Monopoly board game reference]. At Albion, we manage money under a similar belief. We don’t speculate. We invest. We don’t bank on short run forecasts when building portfolios. We take a long-term view. Indeed, an investment strategy shouldn’t hang on getting macro and market calls correct, and any such projections must carry a sizable dollop of humility. In practice, this means portfolio execution is incremental as opposed to extensive. Again, avoiding ‘back to go.’ This conduct is core to our investment philosophy. Adhering to these principles, plus sound investment selection, work together to deliver laudable risk-adjusted returns over time. Knowing the future is impossible. Accepting this is the first step to becoming less fragile and more adaptable. Instead, we pursue strategies that can survive whatever may occur.

Now, let’s review the fourth quarter.

The October through December period saw a continuance of the post pandemic expansion. GDP was (very likely) somewhat higher, the labor market is healthy, and consumer demand endures. Meanwhile, as we’ve anticipated, inflation is now about 3% (sub-3% by some measures!) and the Fed has clearly communicated that they’re done hiking rates. On balance, economic and market conditions sit somewhere between favorable and improving. This sent equities bounding higher. Concurrently, business profits – the lifeblood of stock prices – have perhaps bottomed if we avoid recession. That last piece is critical; we’ll revisit in a moment. A
ding against the quarter was the awful Israel / Hamas war that broke out on October 7th. While markets, including energy, have taken the turmoil in stride, the human cost has been immense.

The overall good vibes sent valuations higher. The S&P 500 now goes for about 21.5x trailing earnings and 19.5x 2024 estimates. Not cheap, especially against yields that, despite the recent drop, are near multi-year highs. It’s also not wildly expensive. Profit growth for the whole of 2023 will settle in slightly better than flat (versus 2022) and growth expectations for 2024 infer an impressive +12% stride. And it’s here where the question of recession / no recession matters most. As for Wall Street’s big picture 2024 outlook? The consensus is now (unsurprisingly) cheerful. Economists and strategists expect a decent year for stocks (i.e., building on ’23 gains) and no recession. Our outlook? Unhappily we still see elevated risk of a mild recession. Yes, the economy has been resilient. But just because a slump hasn’t happened yet doesn’t mean it won’t. The business cycle always looks good just before it slides.

Generally, when you spike rates it has a negative impact that works with a lag. The idea that the Fed can take rates from 0% to nearly 5.5% with over a trillion in quantitative tightening (QT), over a short period of time, and that the economic pendulum will stop from strong growth to perfect growth without going negative doesn’t make sense to us. It would be ahistorical to expect that. There’s evidence of this in many of our preferred leading indicators, like LEI and the Treasury yield curve, as well as some early signs that strong employment and a robust consumer may be waning. Add to this those higher rates – plus the view that they may stay up here for a while (“higher for longer”) – and we still see heightened odds of recession near-term. We’re not out of the woods yet.

Despite this stance, with great humility and borrowing from Munger’s book of wisdom, we’re not betting the farm. Instead, the result of our uncharacteristically cautious macro outlook means we’ve added some “defense” to growth portfolios while, importantly, staying fully invested. We consider this approach to strike a functional balance between respecting short-term risks while staying true to our DNA as long-term investors. The big money is not in the buying and selling, but in the waiting. We will continue to manage your precious capital using a resolute investment philosophy, quality securities, and the best possible information. Many thanks for your trust in us. Happy New Year!

Albion Financial Group is an SEC registered investment advisor. The information provided is intended solely for educational purposes and should not be construed as an offer or solicitation for the purchase or sale of any particular securities product, service, or investment strategy. Past performance is not indicative of future performance.