The 12 Predictions of 2024
December 21, 2023
Dow: 37,404
Loosely modeled on the 12 days of Christmas.
The labor market will remain strong.
Real wage growth will accelerate.
Household wealth will continue to grow at a healthy clip.
Interest rates will continue to fall.
Inflation will be below 2% in 2024.
Private credit will be a problem.
FOMO
You will hear less about Artificial Intelligence.
GLP-1 will be the AI of 2024.
The stock market will broaden in 2024.
The S&P 500 will gain more than 10% in 2024.
Either Biden or Trump will not make it to the general election.
Everyone at Dana sends their best wishes for a healthy, happy, peaceful, and prosperous 2024.
Thankfulness
November 28, 2023
Dow: 35,417
It should not be cliché to say that we have much to be thankful for. We live in the democracy that has led the world for most of the past one hundred years. Our economy has continued to thrive on innovation. All of our largest technology companies were founded in the last fifty years; three of them have been around less than 25 years. They have been a key to the continued growth and prosperity in this country and around the world, and are supported by thousands of smaller companies, many of them also entrepreneurial success stories. There are many investment opportunities outside of the largest tech companies, as valuations outside of tech are currently below average, and the economy is continuing to expand.
Regarding the economy and markets, we are most thankful that the economy has endured the Fed rate hiking cycle and seems to have thrived in spite of the flurry of rate increases. Real GDP rose 5.2% in the third quarter, the strongest quarter of growth since 2014, aside from the post-Covid bounce. We have also experienced a productivity bump, with real GDP expanding more than 7% since the end of 2019, while unemployment has only increased 1.5%. This productivity increase is positive and has helped the economy deal with the bump in inflation. The S&P 500 Index has almost fully recovered from its recent July-October correction. The landscape looks very different today from the beginning of the year when the end was not in sight for rate increases, trailing inflation was still above 6%, and earnings declines were widely expected.
Unemployment is going up for the right reasons, as more people join the labor force. The elasticity of labor supply will help mitigate fears of a resurgence of inflation driven by demand increases and a more limited supply of labor. This is one case where unemployment increases due to growth in the labor force are a good thing as long as overall job growth continues to expand, and it has.
While the rebound in stocks can be attributed to the end of rate increases and the resilience of the economy, we can also be thankful for the recent decline in longer term interest rates. Over the last five weeks, longer rates have declined about 70 basis points, offering some relief from impending borrowing cost increases. Even the red hot housing market shows signs of leveling off, as existing home sales have dropped significantly.
With employment growth remaining strong, consumer confidence should also remain strong, or even strengthen, into 2024. Much of our economy is driven by confidence. It drives financial transactions of all types, including driving individuals and companies to spend and invest. If we do not experience disinflation next year, we should enter an environment where real wage growth should strengthen and families will recoup some of the purchasing power they lost in 2021 and 2022.
We are also thankful to announce that three of our investment strategies were named to PSN’s Top Guns List of best performing separate accounts, managed accounts, and managed ETF strategies for 3Q 2023.
We are proud of these three equity strategies’ notable 3Q rankings and are already hard at work with the goal of achieving similarly strong rankings and results for our investors in 4Q. Published quarterly by Zephyr, the highly anticipated PSN Top Guns list is one of the most important references for investors and asset managers. Rankings are tabulated for thousands of strategies across 75 peer groups subdivided by increasingly rigorous screens and reported in ascending classes from 1-6 stars.
At Dana, we are thankful for a challenging work experience that supports personal growth, excellent colleagues with which to share our career journey, and clients that we are fortunate to serve and with whom we have built beneficial and lasting relationships
Random Thought: “Showing gratitude is one of the simplest yet most powerful things humans can do for each other.” – Randy Pausch, author of The Last Lecture
[2-Star Category:] had one of the top ten returns for the one-year period in their respective strategy.
[3-Star Category:] had one of the top ten returns for the three-year period in their respective strategy.
[5-Star Category:] had an r-squared of 0.80 or greater relative to the style benchmark for the recent five-year period. Moreover, the strategy’s returns exceeded the style benchmark for the three latest three-year rolling periods. Products are then selected which have a standard deviation for the five-year period equal or less than the median standard deviation for the peer group. The top ten returns for the latest three-year period then become the 5 Star Top Guns.
The Pause That Refreshes
September 27, 2023
Dow: 33,550
We all know market corrections are normal. Look at a long-term chart of almost any stock or market index – they invariably look like some sort of a serrated knife held at an upwardly sloping angle. The ones with problems look like a knife held at a downwardly sloping angle. On many, the serrations look more severe and haphazard than normal. If the slope trends upward over time, things are going well and the company is executing its business plan properly. If the long-term trend is down, obviously there are business problems that need to be fixed.
The S&P 500 Index is down more than 5% since July 31st. The Index gained almost 20% in the prior four and one half months. Is this an ominous sign of problems to come? There is no indication that storm clouds are on the horizon. The slowdown in earnings appears to have turned, and the S&P 500 Index companies should show meaningful earnings growth for the year.
Nevertheless, there are hurdles for the markets to overcome. Treasury yields are at or near multi-decade highs, consumer purchasing power is still feeling the pinch from past inflation, and housing costs have increased, both in terms of housing prices and borrowing costs, a double whammy.
The current key driver of worry in the markets is interest rates, especially on the longer end of the curve. The ten year treasury has moved up to 4.50%, a sixteen year high. Paradoxically, treasury yields are rising while inflation is falling. Annualized inflation has fallen to below 4% from a high of 9% last summer, and it should continue to trend towards 3% or lower over the next few quarters. Higher treasury yields push borrowing costs higher across the economy. Credit card rates trend up, mortgage rates increase, and borrowing costs for companies go higher. This creates a drag on the economy, and the fact that it is happening now, more than a year after the Federal Reserve began increasing the Fed Funds rate, is evidence of the lagged effect of monetary policy. Part of the problem with Fed policy is they do not know if they have done too little, or too much, for months or years after they have made a change in monetary policy.
Government spending has played a part in this bout of inflation. The Federal deficit, or the amount spent minus total government receipts, will exceed eight trillion dollars for the past three fiscal years. When the real rate of interest is negative, i.e., treasury borrowing costs are below the rate of inflation, borrowing is a form of free lunch for the government. That has now changed as the rate of inflation moves below the cost of borrowing for the government. Decisions in Washington will be much more difficult without the low borrowing cost tailwind. We are not optimistic that most of the representatives in Washington are willing, or qualified, to make these difficult decisions. Politicians are well known for taking the path of least resistance. Federal borrowing costs will now be a drag on the economy that is greater than the stimulus benefit of Federal spending.
Who benefits from positive real interest rates? Bond investors. Bond investors will now receive an income return on their investment that is higher than the rate of inflation. As longer rates move up, there is less of an income disadvantage for choosing to lock in current yields for a longer period of time. Our portfolio managers are taking advantage of these opportunities in the market every day in every one of our fixed income strategies. For example, high-quality, short-term bonds now offer yields near 6%, the highest returns since 2007. Municipal bonds also offer excellent value for savers or entities in higher tax brackets.
Back to the stock market, it is difficult to see this move downward in equities as anything other than a garden variety market correction. Companies have proven they have varying degrees of pricing power, revenues have been resilient, and larger numbers of participants are rejoining the labor market. Earnings have rebounded, and the layoffs in the tech sector of the market have seemed to run their course. We will continue to be vigilant regarding the effect of higher interest rates. A Fed near the end of its tightening cycle and inflation trending lower are two key positives that we expect to provide support to equity prices.
Random Thought: “Theory is when you know everything and nothing works; practice is when everything works and nobody knows why.” – Albert Einstein
Almost There
August 3, 2023
Dow: 35,216
Are we there yet? Ok maybe we are there. The “there” being the end of the Federal Reserve interest rate increases. Inflation is coming down, the economy is still growing, unemployment has not increased meaningfully, and the consumer may still have purchasing power to spare. So, what is the next challenge for the market? There are always possible threats on the horizon, but here are a few of the current headwinds and tailwinds.
Jerome Powell overdoing the rate increases has been our primary concern, as most of you know from past Viewpoints. The Fed Funds rate has been increased 10 times, for a total of five percentage points, in the last 15 months. The speed and magnitude of the increases has slowed, but that has been no less worrisome, as monetary policy works with a lag. On the plus side, S&P 500 corporate earnings fell during 2022 but are showing a recovery in the first two quarters of 2023. The unemployment rate has remained below 4% for the last 17 months, even as rates have increased significantly. This certainly demonstrates economic resiliency.
We must chuckle as Jerome Powell takes credit for lowering inflation as he as much as told us all that the economy and the job market had to be slowed in order to conquer inflation. Yet inflation has slowed while the job market has remained robust and economic growth has turned positive. Better update your rulebook, Jerome.
Although the news has been good so far, we must keep an eye on economic indicators, as rate increases affect the economy over time. So far, some slight slowing in employment cost indexes and payroll growth should give the Fed some pause, and manufacturing has definitely slowed this year. We need some slowing to rein in the Fed, but not so much that it slows profit growth and dampens consumer confidence. So far, the economy seems to be settling in that Goldilocks sweet spot.
The Goldilocks soft landing scenario is reflected in earnings. Company reports beat analyst estimates by a fair margin in the first quarter and are doing the same in the second quarter. This is driving the market. You can almost feel the bears and the underinvested participants being pulled in and forced to buy over the last few weeks. This is what drives bull markets. Prices go up faster than earnings as price to earnings ratios expand. A number of popular bearish strategists are being forced to concede to the market’s strength. Many of these analysts had a following because they were bearish last year and correct, but the perma bear approach doesn’t work with a dynamic economy that is continually evolving and adapting.
Once the market moved up 20% off the October 2022 low, the S&P 500 Index was officially declared to be in a bull market. The average increase from that point, before another bear market, is 100%. Sure, there can be corrections or unforeseen events that can drive a new bear market, but another 100% gain without a 20% pullback is the historical baseline.
The bond market is also behaving as if economic growth has legs. The ten-year Treasury yield has begun to move up, seemingly signaling decreased chances of a recession near term. Corporate yield spreads to Treasuries have also stayed in a narrow range, reflecting the perception that companies can afford to repay their debt, even if they have to borrow at higher current rates. It certainly is rewarding to invest client bond allocations in quality securities yielding 5-6% now that rates are higher.
So, if the Fed is able to complete this rate increase cycle without pushing the economy into recession, we are willing to concede mission accomplished, and we would be happy to let another actor other than Jerome Powell take center stage. Maybe someone will step-up and address the concerns raised by Fitch in their latest downgrade of US debt.
Random Thought: “I did not succeed in life by intelligence. I succeeded because I have a long attention span” – Charlie Munger, Vice Chairman of Berkshire Hathaway
Stuck in the Middle With You
May 30, 2023
Dow: 33,042
We refer to the title of a 1973 hit song by Stealers Wheel. This has to be the way Jerome Powell, or any Federal Reserve Chair, feels at turning points in the rate cycle. “Clowns to the left of me, jokers to my right, here I am, stuck in the middle with you.” Catchy lyrics; and at the beginning and ends of rate cycles, it is usually most difficult to build consensus. Powell is truly stuck in the middle, or he has to stake out a position that becomes the middle in order to develop consensus.
For the last few weeks, it felt as if a pause was the clear consensus, but the equity market has moved to new highs and economic reports have been somewhat resilient. There may well be a pause at the June meeting, but markets are now expecting another increase at the late July meeting. We hope this isn’t so as the M2 measure of money supply is shrinking at an unprecedented rate. Supply and demand governs many market relationships and is a key source of market discipline. From 2020 through 2022, the economy was flooded with cash through many government programs designed to support the economy. These programs worked, but there was no return to normal. Many stimulative government programs continued into 2023. The money supply ballooned during this period, and inflation followed. We don’t disagree with the implementation of these large stimulus programs, but it now seems unusual to believe that the inflation would be temporary if the stimulus that caused it isn’t promptly removed from the system when the economic danger passes.
As we have pointed out before, over the next seven weeks, we will get two more inflation reports that should move the trailing year inflation numbers into the mid 3% range. If the Fed truly believes that their policy operates with a lag, they should pause. Inflation rates dropped to the mid 3’s in the third quarter of 2022, and they have maintained those levels as the Fed has continued to increase their policy rate. The economy has remained resilient as the Fed has raised rates and moved nearer the end of their tightening cycle. Last year we talked about this being our best-case scenario, and so far, it has played out.
Although the Fed policy rate has increased three times this year, Treasury yields at two-year maturities and beyond have barely budged, resulting in positive year-to-date returns for fixed income investors. Long rates have moved off their lows, implying a reduced risk of an imminent recession. As first quarter earnings season has concluded, fear of an imminent downturn in profits has also receded, and total returns of most equity indices are soundly higher. While the S&P 500 Index is up over 10% for the year, 100% of the return can be attributed to just eight of the largest stocks with only 28% of stocks outperforming the Index return.
Stuck in the middle with you is also an apt description of the current relationship between the Speaker of the House Kevin McCarthy and President Biden. They have spent a good deal of time together over the last few weeks – how can that not be a good thing? Most of the reporting on the debt ceiling has been incorrect and borderline dangerous. Treasury Secretary Janet Yellen recently said that in the event the debt ceiling isn’t raised, “We have to default on some obligation, whether it’s Treasuries or payments to Social Security recipients” – this is irresponsible. A late payment made by the government to anyone or any entity other than a debtholder is not a default, it is a late payment. If a company pays a supplier late, it is not a default. Government officials know that interest and principal on Treasury debt will be paid first, above all else, but stating that does not help them increase their political leverage.
Sad Random Fact: In the fiscal year ended September 30, 2022, the deficit was $1.4 trillion dollars, or approximately $160 million per hour.
Show Me the Money
April 11, 2023
Dow: 33,684
The depositors in many regional banks seemed to echo Cuba Gooding Jr’s famous line from the movie Jerry Maguire, “Show me the money.” The bankers’ response seemed to echo Jimmy Stewart’s from It’s a Wonderful Life, “The money’s not here, it’s in Joe’s house” and other income producing investments. A great example of how a bank is a collection of assets and liabilities, loans, and deposits. That little thing called leverage also usually plays a role in fast moving liquidity crises. No bank can sustain a short-term demand for the return of a majority of its deposits – a bank run. It is the job of the banks individually, and the government and regulators as a whole, to ensure that there is confidence in the system. The failure lies both with the management of the banks, and with the regulators and government officials tasked with both limiting the risk that there will be a bank run and reacting appropriately to stop it when it happens.
The stock market is up since its recent low of March 13, which was higher than its December low, which was higher than its October low. So far, markets and the economy are holding up in the battle against the Fed’s effort to slow the economy and raise unemployment. The battle is not won. There are unforeseen fragilities in the system, as the struggles in the banking system demonstrated last month. First quarter earnings will provide a barometer of how the economy is holding up through the most recent rate increases. We expect that the news will be largely positive. Companies have discovered a new focus on controlling costs and focusing on profit. Consumers are largely optimistic as they have seen inflation roll over in the second half of 2022. The immediate shock of higher mortgage rates is working its way through the housing market. Supply chain issues have continued to abate, which helps businesses plan better and optimize their operations.
The Treasury market has shown significantly increased volatility as banks became more stressed. Even as the Fed raised rates at their March meeting by 25 basis points, Treasury yields fell across the yield curve. The two-year Treasury fell 80 basis points in March, and the ten-year Treasury fell 45 basis points. Instead of expecting Fed Funds above 5% by year end, the market now expects rates to be cut at least three times by year end.
There have been three Fed rate hiking cycles since the late 1990’s, and we are now in the fourth. In every case where the two-year Treasury yield dropped below the Fed Funds rate, the next Fed rate move has been a cut. The two-year Treasury dropped below the Fed Funds rate in June of 2000, and the Fed cut rates six months later. It happened again in July of 2006, and the Fed did not cut rates until 15 months later. The Great Financial Crisis followed, and the S&P 500 Index did not bottom until eighteen months after the first rate cut. In the third instance, the two-year Treasury dropped below Fed Funds in March of 2019, and the Fed cut rates four months later. The ten-year Treasury yield moving below the three-month Bill yield may be an even better indicator of imminent Fed rate cuts, and that spread has been negative for five months.
Some indicators of economic activity are slowing without an abrupt reversal, and the labor market seems to be softening ever so slightly. These are both excellent signs because they demonstrate that the economy may remain healthy as we approach the end of the Fed tightening cycle – the proverbial ”soft landing.” Corporate earnings and company outlooks will be insightful as they begin to be reported for the first quarter.
Market returns have been respectable in the first quarter in both the stock and bond markets, representing a partial recovery from 2022 returns and recognition that we may navigate this Fed tightening cycle without material damage to the economy. If we had to pick one economic indicator to use to navigate the markets, it would be the unemployment rate. As long as we do not see a material rise in unemployment, the economy should be able to navigate higher short-term rates without a slowdown.
There seems to be a significant amount of pessimism present among market participants, evidenced by declining long-term Treasury rates and expected Fed rate cuts in the back half of the year. Higher than normal pessimism is usually accompanied by market opportunities, and we seek to take advantage of these opportunities.
Random thought: FDIC Insurance historically had limits, until it recently seemingly didn’t:
Good News is Good News
February 22, 2023
Dow: 32,875
In the markets, sometimes good news is bad news and bad news is good news. Stick with us here. Market movements always factor in expectations, or more specifically, changes in expectations. When a company announces good news, sometimes its stock will go down if the news was not good enough relative to expectations. Or a stock may go up even if the company announces bad news, if the news is still better than expectations. For a number of months, the stock and bond markets have shown many instances where they have sold off on stronger economic news and rallied on weaker economic news. Why? It has to do with expectations, specifically expectations of future moves in the Fed Funds target rate.
Market participants fear a Fed-induced recession. The Fed has stated that they want slower economic growth and higher unemployment, so recent stronger than expected economic news has led to higher expected Fed Funds rates and lower stock and bond prices. Conversely, weaker economic news has led to expectations for a lower terminal Fed Funds rate.
It’s time to reframe this tradeoff; good news is good news. As the Fed nears the end of its tightening cycle, economic growth has stayed strong. Recall where we were at June 30, 2022: the Fed had just raised rates from 0.875% to 1.625%, GDP had declined in the first quarter of 2022 and would fall again in the second, trailing year CPI was 9.1% as of 6/30/22, and the S&P 500 Index fell 20% in the first six months of the year.
In the second half of 2022, the S&P 500 Index rose slightly. GDP rose slightly more than an annualized 3% ‒ not too hot, not too cold. CPI averaged less than an annualized 3% in the second half of the year, even with a revision that increased that rate. This economic rebound happened while the Fed raised rates from under 2% to over 4% by year end. In the bond markets, rates increased far more on the short end than the long end, as recession fears were pervasive.
So the question of whether the economy and the markets can outlast the Fed rate increase cycle is not settled, even as we undoubtedly move closer to reconciliation, with higher rates and decelerating inflation. The end game is near, but still not completely clear. Many of our equity strategies have shown solid performance versus their indexes through the second half of the year and into 2023. Fixed income and preferred strategies have shown strong rebounds at the beginning of 2023. The Fed has chosen to move more cautiously of late, with the last increase being 25 basis points. A resilient economy will keep the Fed active, so inflation needs to continue to decline in order to satisfy the Fed.
Generating positive income and providing relative outperformance is possible even in choppy, unclear environments, and that remains our primary goal.
Random thought: “What do most people say on their deathbed? They don’t say, ‘I wish I’d made more money.’ What they say is, ‘I wish I’d spent more time with my family and done more for society or my community.” – David Rubenstein
Playing to Our Strengths in a Fed-Dominated Fixed-Income World
We closed out 2022 with one of the biggest and best sporting events worldwide – the World Cup. While the game of soccer sometimes catches some flak for its lack of scoring and hard-hitting plays that we are accustomed to seeing in American football, the game of soccer is known throughout the world as “the beautiful game”. Yes, most of the typical game is spent with the ball being passed around the middle of the field, but it is those special few minutes when the action is confined near the goals where the magic happens. The last 18 yards on either side of the field or the “tails”, if you will, are the high impact areas that generally determine the outcome of the games. This analogy is similar to how investment managers create outperformance or alpha for their investment strategies. Think of the middle of field as the “market consensus” or average expectations as a lot of time and investment discussions are spent in the middle of the field among the majority of market participants. If you want market returns then play it safe and spend all your time passing the ball around in the middle of the field but if you want to outperform the market then you have to do something different than the market consensus. You must spend some time in the goal areas or the tails if you want to outperform the market. At Dana, we are not in the business of trying to predict macro events – stock market moves or interest rate forecasts. We construct portfolios based on assessing risks and opportunities. When opportunities arise, we send the ball into the goal areas with the expectation to capitalize on the opportunity in order to generate outperformance for our investment strategies. As we look at the bond market today, we have the excitement of playing in a World Cup match and see tremendous opportunities regardless of the next interest rate decision.
Gone are the days of Alan Greenspan’s Fed being somewhat hush-hush and opaque about policy. Can anyone forget his famously tongue-in-cheek quip, “If I seem unduly clear to you, you must have misunderstood what I said.” Today, nearly every day outside of Fed blackout periods, some Federal Reserve governor or regional Fed president is talking hawkishly about keeping rates ‘higher for longer’ or waiting for definitive signs that inflation is on the mend returning to the Fed’s target of 2% to 2.5%. The constant chatter is compounded by the financial media and broad macro strategists endlessly debating the issue. It may fill airtime on financial networks as the media needs a spin for daily market swings but it’s overwhelming and exhausting for what purpose?
As portfolio managers, we spend our time separating the noise from the signal to anticipate what is going to matter going forward as we begin our run to the goal areas. At Dana, within the fixed income market, we see attractive yields that have not been present for much of the last 15 years. We stay committed to our fundamental investment process by positioning portfolios based not only on understanding current market conditions but, more importantly, where the market is going. The financial markets are discounting machines as they anticipate future actions into today’s present value, and investors will miss taking a shot on goal if they wait for the FOMC to pivot or continue to spend time debating financial information that is already priced into the markets. To help separate the noise from the signal, it is important to recognize as well as clarify the roles of three different groups on the soccer field – the officials “the Federal Reserve”, the announcers “the media”, and the players “investment managers” such as Dana.
The Fed’s Job
The Fed has a dual mandate to maximize employment and keep inflation in check through stable prices and moderate long-term interest rates. Monetary policy actions such as raising or lowering the short-term interest rate known as the Federal Funds rate as well as adjusting the money supply are the primary tools the Fed uses to achieve their mandate. The Fed communicates their actions to the financial markets through “forward guidance” which informs the financial markets about expectations as well as effects of future monetary policy actions on financial conditions in order to achieve the dual mandate. Ultimately, forward guidance centers on controlling expectations and pricing volatility. If the Fed issues a hawkish statement on their expectations for the future path of the Federal Funds rate in order to promote price stability then, the bond market will immediately adjust interest rates higher as they anticipate a higher discount rate into security pricing. The challenge with controlling expectation and pricing volatility is Fed Chairman Powell and the other members must constantly appear in interviews, issue statements, and give speeches that are in alignment with where they want policy to be going forward. It’s quite the pageantry.
The Media’s Job
The Media’s role is quite simply to fill the stadium seats so we’ll keep this section quite brief. The recipe for filling the seats – provide insight or elicit an emotion. The financial media offers a great outlet for insightful guests and commentary; however, the media can spend way too much airtime debating issues just to fill a time slot. Case in point, what will the Fed do next? Endless hours and days spent on speculating on whether a 25-basis-point hike is in the cards at the next FOMC meeting or if a larger half-point increase is in the works? After the umpteeth time and the umpteeth day, you have to ask yourself does it matter? We do not see investment alpha coming from that back and forth.
Dana’s Job
Let’s start where we left off on debating Fed moves. If everyone knows that the Fed is going to move then ask yourself “where is your edge or competitive advantage?” You have none as the participants within the financial markets have already incorporated the information into security prices. Does Dana have a viewpoint on future Fed actions? Absolutely and, to outperform the market, we need to get ourselves into the goal area by breaking away from the market consensus. How do we do that? We have to act on opportunities that the market consensus has not yet incorporated into the prices of securities. After a lift of over 400 basis points in the Federal Funds rate in 2022 and more on the horizon for 2023, we are upbeat about the opportunities available in today’s fixed-income market. Consider that compared with 10-year historical ranges and averages illustrated below, yields across the bond space are offering compelling value. We have positioned portfolios to take advantage of elevated short-term rates that feature low duration. After 15 years of earning next to nothing on high-grade, short-maturity bonds, we can own such securities with yields near or even slightly above 5%. Additionally, our portfolio managers have been able to purchase individual bonds with unique characteristics that offer expected higher total holding period returns without taking on much additional interest rate or credit risk.
Current Yields Are Attractive Relative to History
Source: J.P. Morgan Asset Management
Bonds are Back: Investment Grade, Low Duration Credit Yields > 5%
Source: Reuters, Refinitiv
You Play to Win the Game
Calendar year 2022 certainty was a challenging period as the Federal Reserve spent the year re-normalizing the yield curve but, as we begin 2023, the fixed income opportunities give rise to optimism for investors. Bond market yields are back to attractive levels, the majority of monetary tightening is behind us, and inflation is likely to continue to soften. A portfolio of high-quality bonds consisting of U.S. Treasuries, U.S. Agencies, and investment-grade corporate bonds can yield close to 5% without high interest rate risk. Tax-exempt yields in municipal bonds are also attractive for investors in higher tax brackets. In these uncertain periods, investors need to maintain a well-diversified core fixed income portfolio in an active manner to continue compounding interest rates no matter what path interest rates may follow into the future. Whether the yield curve flattens, steepens, twists, or inverts investors need to maintain an allocation to fixed income. Fixed income investments provide important benefits, including income, diversification from equities, lower volatility and the predictability of an income stream. Granted, it is very uncomfortable and takes a disciplined mindset to break from the market consensus but if investors want to outperform then they need to play in the goal areas – where the magic happens.
APPROVED FOR DISTRIBUTION TO CLIENTS. Dana Investment Advisors welcomes any comments to their newsletter and is more than willing to discuss or explain any aspect of the letter. This newsletter is provided for general information only and is not intended to provide specific advice or recommendations for any individual or entity. This is not an offer, solicitation, or recommendation to purchase any security or the services of any organization. The foregoing reflects the opinions of Dana Investment Advisors.
Demand is not the Problem
December 28, 2022
Dow: 32,875
We have heard a lot about the demand side of the economy from the Federal Reserve this year. However, we almost never hear about the other side – the supply side. Jerome Powell has said that we have to lower demand in order to bring the economy into balance and bring inflation under control. Powell wants to inhibit demand by slowing growth in employment. He has said economic growth is too high, and he wants the unemployment rate to be higher than it is now to help keep wage pressure low. He essentially wants more Americans to struggle in order to reduce inflation.
“We are tightening the stance of policy in order to slow growth in aggregate demand. Slowing demand growth should allow supply to catch up with demand and restore the balance that will yield stable prices over time. Restoring that balance is likely to require a sustained period of below-trend growth.” -Jerome Powell, 11/30/22
This is not the kind of help the U.S. economy needs.
Why not try and grow the economy by finding ways to help increase the supply of goods and services? Make it easier for businesses to hire, rather than more difficult. End the Covid emergency declaration at the Federal level, which will end the expansion of support programs that took place during Covid. These measures will increase the incentive to work, and decrease the disincentives to work. Those who are out of the workforce see their skills and habits erode over time, making it more difficult for them to reenter the workforce, at least at a job level that is equivalent to that which they had when they left the workforce. The goal should be to increase incentives to be in the labor force. Child tax credits should not be refundable, which means that you receive the payment even if you don’t have income and don’t pay Federal income taxes. Refundable credits are disincentives to work, they decrease the labor force, and increase inflation.
If businesses know that Powell is trying to slow the economy, they will try and front run the slowdown. Businesses will try and reduce costs and reduce output in anticipation of the reduction in demand. Companies will try and match supply to future expected demand in order to preserve profit margins. Some of this may have happened already, as it appeared that inventories rose to uncomfortably high levels during the summer at some companies, and they were forced to make adjustments. Powell assumes he can reduce demand and supply will stay the same as he says in the quote above; this is not true. Witness the layoffs announced by many large companies this fall. One ugly possible result of both supply and demand decreasing can be stagflation, a condition where the economy slows but prices do not come down. Less spending on the fiscal side can help avoid this outcome.
There is more evidence that the economy is bending, not breaking. Gasoline prices have moved down significantly, and the housing market has slowed towards more normal levels of price growth. Year over year home price growth has slowed from over 20% to below 10%, and may continue to slide due to higher mortgage rates. Existing home sales have slowed significantly, but new home sales have actually moved back up over the last two months to pre-pandemic levels. Auto sales have actually increased recently, as companies attempt to ramp up production to meet demand. Retail sales ex-gasoline have slowed.
Despite these signs of slowing, GDP for the third quarter was revised up to over a 3% annual rate, and may run stronger than that in the fourth quarter. For the last two months Core CPI has printed at the lowest levels in over a year. All of this is incrementally good news for the stock and bond markets over the intermediate term. Every month where inflation shows signs of slowing while the economy remains resilient looks more like a soft landing, and moves us closer to the end of the Fed rate hiking cycle. It also decreases the chances of a major Fed mistake. The Fed has already said that increases will slow, although they will not comment on any potential rate cuts. Fears of a recession and lower corporate profits in 2023 still run high, which is the main reason the S&P 500 is having a difficult time moving above the 4000 level. The Nasdaq index may be forming a stealthy bottom, as more than two thirds of the members of the index are outperforming the overall index.
In the fixed income markets, intermediate and longer rates have stabilized, providing positive returns for the quarter even as short rates have continued to move up. Most fixed income portfolios can now earn 4-5% annually, which supports total returns and provides a buffer against price volatility.
2022 has followed the uncertainty of the pandemic years of 2020 and 2021, but has been no easier to navigate. We continue to adjust portfolios to current market conditions and work to anticipate future potential scenarios. A 2022 highlight was Dana Investment Advisors once again being named the best place to work in investment management among companies with 50-99 employees. 2022 was our 11th straight year of receiving such National recognition and is a true reflection of the wonderful team and culture you’ve enabled us to build. This recognition and Firm environment have enabled us to attract and retain an amazingly talented and dedicated team here to serve you. It is our privilege to guide our clients’ assets, and it is a responsibility we take very seriously. We thank you for your business, and look forward to our continued partnership in 2023.
We wish peace on earth and a Happy New Year to everyone.
The Pension and Investments Best Place to Work article link is here:
https://www.danainvestment.com/wp-content/uploads/PI-2022_BPW_Dana.pdf
Faceoff
November 22, 2022
Dow: 34,098
The faceoff between Jerome Powell and the U.S. economy continues. At this point, just maybe the economy is gaining the upper hand. Despite four consecutive 75 basis point increases in the Fed Funds rate this year to almost 4%, the economy remains resilient. Treasury yields beyond five-year maturities have moved down aggressively after the most recent report on inflation, and the yield curve is as inverted as it has ever been in the current rate increase cycle. The economy was still able to swing to positive GDP of 2.6% in the third quarter. The monthly employment report has continued to show positive, albeit slowing, growth even as the unemployment rate ticked up slightly. Fed Chairman Powell has said he will not blink and vows continued aggressive rate hikes until the inflation rate reverses significantly and moves back towards 2%.
So, is it wise to cast your lot with Jerome Powell, and take him at his word regardless of what happens to the economy? That would probably mean investing in an intermediate or longer bond portfolio, with the expectation that he will continue to raise rates until inflation is vanquished, regardless of what happens to the stock market and the economy. Ultimately, a Powell win would manifest itself in lower long-term rates due to lower inflation, a much weaker economy, or some combination of both.
Or do you believe that the economy can weather the Powell rate hurricane and remain resilient until inflation begins to decline due to some combination of Fed tightening and marginal economic slowdown? This is often characterized as the “soft landing” scenario. Keep in mind that concurrent economic indicators are at a level consistent with GDP of 3% to 4% in the fourth quarter.
Over the last few weeks, we have had a rally in both the stock and the bond markets, as the S&P 500 Index has moved up almost 11% since October 12 and the ten-year Treasury yield has fallen over the same period. So far this year, the stock and bond markets have typically fallen at the same time, not risen, so let’s peel the onion.
The big move in both the equity and the fixed income markets took place on November 10th. On that day, the headline CPI report for October came in lower than expected, the S&P 500 increased 5.5%, and Treasury yields fell 25-30 basis points – huge moves for a single day. So far, that market gain has held up over the following trading days. Many said the market rally was unjustified by such a small move downward in a key inflation measure. Shouldn’t the market demand far more proof that the inflation dragon was slayed? It is important to note that this sign of moderating inflation was happening at a time when the economy was still rather robust. The housing market has certainly slowed, and there is news of layoffs in the tech sector, but consumer spending is still strong, and the employment market has shown resiliency. This combination of factors is the key. If inflation can turn down while the economy continues to grow, that is the goldilocks outcome where almost everyone wins.
It is also difficult to have a recession or a market correction when everyone anticipates it. Some large businesses are trimming employees, and many are managing their affairs in a conservative fashion, as if expecting a recession. Such anticipation can help avoid excesses caused by optimism that usually builds up before a recession. If companies are leaner, any unexpected pickup in economic activity should result in revenue that creates bottom line profits.
The Fed does not believe we can have a persistent cooling of inflation without weakness in the economy. The October inflation report hinted that just such a combination may be possible. It will take more subdued inflation readings to convince the Fed. With commodities prices, implied inflation in the TIPs market, and crude oil prices all stable to lower, there is reason to be optimistic. In the meantime, we can be thankful that the rally spurred by lower inflation has had staying power and that the increase in interest rates has given savers the ability to earn about 5% in short government and agency bonds.
Happy Thanksgiving to all.
Random thought: “We have two lives, and the second begins when we realize we only have one.” – Confucius