So far in 2024 markets have continued their strong run from last year as inflation has trended down, GDP has surprised to the upside, and the advent of artificial intelligence has given optimism for future productivity gains. This has culminated in one of the strongest market rallies of the cycle, led almost entirely by large-cap technology and growth.

Today's chart is probably our most commonly used one, showing the 20 year performance of the S&P 500 overlaid with the ‘Wall of Worry’- reasons for investors to sell stocks and get out of the market. But as can be seen, US stocks have had incredible resilience at powering through these apprehensions. So much so that looking back some of them seem incredibly insignificant in the rearview mirror or are even hard to remember.  ..

Almost like the dog catching the car it appears we have finally reached the end of the Federal Reserve's tightening cycle as inflation has rolled over and the labor market has remained exceedingly strong. We think inflation remains sticky around 2.5%-3% and a resurgence cannot be ruled out which might keep the Fed on pause for longer than the market is expecting, but nevertheless the next significant move in rates will likely be lower. Markets have celebrated this with stocks staging a sharp rally to cap off 2023 and have carried that momentum into the beginning of this year. What's more is that the consensus view of an impending recession has yet to materialize.

In mid-2021 when inflation first took off and the Fed began signaling it would start raising rates markets went through a stretch of anxiety. Around that time we wrote a piece outlining how historically markets remained strong in the initial phase of hiking cycles with the caveat of increased volatility (that piece can be found here). However, even in the context of historical precedents the ensuing annual market swings exceeding 20% both up & down were exceptionally volatile. Such moves are usually associated with a recession.  ..

It's that time of the year again. Time to get together with family and reflect, but also to think about what's in store for the year ahead. Topics at your family gathering may be wide ranging but none are as exciting as the economy and markets. So in case these topics come up, we are here to help with 5 questions that we think are most likely to arise or you have yourself. For each question we suggest both a short and long answer - depending on if the topic comes up over dinner or dessert, and how lively the discussion is.  

1. Last year everyone was talking about a recession. Now economic growth is showing 5% percent. What happened?

 ..

Quite the turnaround from last year, markets have clocked a strong first half of 2023 with the S&P 500 and NASDAQ both up double digits. What's more is that this overall reversal in market performance applies to sub sectors with many of the worst performing pockets of 2022 being the best performers in 2023. Of course the leader this year has been large-cap tech which got pummeled in 2022 but has roared back accounting for almost all of the broader index’s return in 2023. We wrote about this recently in a note which can be found here. Fixed income markets have also stabilized and now offer pretty attractive yields across the curve...

The first half of 2023 has felt very similar to the tumultuous years of 2020 and 2021 which saw the market dominated by mega-cap tech stocks. The average YTD return on Amazon, Apple, Google, Meta (Facebook), Microsoft, Nvidia, and Tesla is 84%. The average YTD return for the rest of the S&P 500 is just 3.7%. In fact, when breaking down the contribution to the index’s total year-to-date returns this chasm becomes even more apparent – ten stocks contribute all but 1.4% of the returns which is shown in today's chart above. This is the most narrow breadth in the market since the tech bubble in the early 2000’s.

What's driving this? A lot of it is optimism over the proliferation of artificial intelligence (AI) and multiple expansion for the previously listed top ten stocks. Many of these are now priced at or near the top end of their historical valuation range which is puzzling considering those previous highs were when interest rates were near 0%. For Meta and Nvidia, sharply increased earnings expectations are also part of the explanation for their meteoric rise this year. For the other five stocks mentioned in the first paragraph of this note, earnings expectations are either flat, or in the case of Tesla projected to fall due to $2k-$10k price cuts for the Model Y, S, and X vehicles (which hasn't prevented Tesla from rising by over 90% in 2023)...

Not a barcode… Today's chart plots the frequency and duration of every post-Civil War recession in the United States. If the year has a blue bar that indicates the US economy was in a recession or decline in business activity for the period.

As the Fed embarks on their capital tightening cycle to tame inflation we are likely nearing the end of this expansion pointing to perhaps one of these blue bars appearing in the next 6-12 months. In past notes we have hinted at the likelihood of this occurring and what it would mean for asset prices and long term investment portfolios. See here, and here...

I am sure by now you have seen the headlines of the failure of Silicon Valley Bank (SIVB). Our President wrote a letter on Monday (here) touching on the situation but also outlining what we are prepared for as we progress through this broader economic cycle. In this note I want to expand on that letter and give a more specific commentary on what took place at Silicon Valley Bank and how it reached the point of collapse. In this note I focus on SIVB but the same characteristics are shared by Signature Bank (SBNY) and First Republic (FRC) which have also gone under or are under significant stress.

Silicon Valley Bank is a chartered bank in Santa Clara California. In many ways SIVB operated like any normal bank. A classic bank has short-term deposits and long-term assets. Depositors loan their money to the bank for an interest rate payment. That bank then loans that money to fund useful projects that earn a higher interest rate payment (typically in bonds, stocks, loans, mortgage backed securities, etc). As long as the depositors do not withdraw their funds, the bank earns a profit. The deposits are liabilities to the bank and the loans are assets to the bank. All banks also use a fractional reserve system where they only hold a fraction of their deposits in liquid “cash”. The fractional reserve system is often characterized as a sinister system but it’s the main vessel of money creation in our modern economy. The drawback is if enough depositors rush to the bank to withdraw their money at the same time you get a “run on the bank” leading to a collapse of that bank. The FDIC tries to mitigate the risk of this by guaranteeing up to $250k of a depositor's money so as to provide confidence to depositors that their savings will not just vanish. Since Friday the federal government announced protections for depositors at SIVB above the $250K limit. But as can be inferred from this whole dynamic, a bank run can be a self-fulfilling prophecy where if key depositors withdraw their funds from the bank, that can scare other depositors into withdrawing their money ultimately resulting in a state regulator to call in the bank and dissolve it.

So SIVB pretty much followed this typical bank failure model but with some nuance which gives hints as to what is happening to the broader economy. SIVB saw a huge inflow of deposits in the last 3 years as their client base of speculative tech companies have been perhaps the main beneficiary of the fiscal and government stimulus policies. SIVB received this huge inflow of deposits from their technology/VC/crypto clients and they could not figure out how to invest all those funds into high yield assets since rates were so low. Thus, SVB ended up purchasing low-yield, long duration, but relatively safe mortgage backed securities and long term bonds that were intended to be held to maturity (HTM)...

Not quite as salient in markets as inflation, but certainly occupying the headlines has been the pending battle on raising the debt ceiling. Congress has always placed restrictions on federal debt. These limitations have helped Congress assert its constitutional powers of the purse, of taxation, and of the initiation of war. Since WWII, Congress has raised the debt limit 78 times and suspended it another five times. For most of the post-war period debt limit increases were considered routine legislative chores that never engendered much debate or public scrutiny. The current debt limit of roughly $31.4 trillion was reached this quarter prompting the discussion to begin on raising the debt limit in order to maintain the country's spending habits. You'll remember we went through a similar episode in 2021 when the debt limit was reached and subsequently raised but only by enough to prevent a default until the beginning of this year -  Thus here we are now having the current debate.

A deeply divided congress still has five or six months to reach a deal on raising the limit and avoiding a default or funding delay in the US treasury market, which is an integral component in the global financial system. Both sides are dug in early with Republicans saying they won't agree to a debt limit increase unless it accompanies spending cuts (although most spending appears to be off the table). Democrats say they will only support a debt limit increase without cuts or other changes. You'll remember in the 2021 episode which we wrote about at the time (here), both sides of congress used the element of political brinkmanship which rattled investors. This involves waiting until the very possible last moment, but ultimately hammering out a deal because they realize the consequences of not doing so would be catastrophic. We never like to assume, but feel that the situation this time around will play out similarly. For politicians there is no reason not to take things right down to the wire like they did in 2021. A government shutdown might even take place which does not affect markets much if it only lasts a few weeks...

Deflation in 2020/21. Inflation in 2022 … Stagnation in 2023?

During the covid lockdowns starting in 2020 deflation dominated markets as economic velocity and prices plummeted. US treasury yields fell to an all-time low bumping under 0.5%, growth stocks soared, and speculative phenomena such as NFTs and crypto went mainstream. During this time the US tech sector market cap rose to over $7 trillion...

As we reflect back on a tumultuous 2022 and begin to look forward to 2023 we are not only preparing for our new year outlook but also what topics are on everyone's minds, including our own, over the holidays. We have listed the notable questions and what our take is on each one, both a short answer and a more nuanced view. So if the economy comes up in those lively holiday conversations hopefully these provide some interesting discussion material.

1. “Are we in a recession? We have had two consecutive quarters of negative GDP growth this year, isn't that a recession?”

Short answer:Not yet. 

Long Answer:  Although two quarters of falling GDP meets the definition of a “technical recession”, from an economic perspective weakness has to broaden out to a wider range before it meets the criteria for an official recession. The National Bureau of economic research (NBER) makes the official call on whether the economy is in a recession. To do this they use 6 economic indicators which are more expansive than just GDP which can be impacted by large swings in trade and inventory data (which we have seen this year). ..

Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.

So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets...

Economic growth spiked coming out of the pandemic trough in 2021 with the aid of aggressive fiscal & monetary support. Late in 2021 that growth began to cyclically slow down leading to volatility in the first half of this year followed by sizable rallies and selloffs. The selloffs have been exacerbated by geopolitical shocks, tightening monetary policy, and inflation. The rallies have been characterized by optimism that these sources of contention are showing signs of dissipating amid record low sentiment in equity pricing. At the center of these contentions is inflation. High inflation is typically an offshoot of strong economic activity and loose monetary policy. Symmetry implies that a slowdown in economic growth should coincide with a peak in inflation which would be a welcomed respite for investors allowing the Fed to lighten up on rate hikes. This “dovish pivot” was the root of the 17% rally in the S&P 500 in mid-June through mid-august, but the crux of this optimism is that slowing economic growth risks a recession and the inflation we are experiencing now is unique in many ways. In response to this Fed chairman Powell’s recent comments at Jackson hole sent equity markets lower after this dovish pivot never materialized. On the contrary Powell's speech was short, but explicit in relaying the central bank’s commitment to fighting inflation even at the risk of recession...

Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.

So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets...

Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.

So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets...

More Pain To Endure

There is no doubt that this has been one of the most difficult years in recent memory for many investors. Nearly every equity index has fallen below the definition of a traditional bear market, a decline of 20% or more. Equally difficult has been the performance of the bond market which is supposed to insulate portfolios from market volatility. Even commodities, which started the year strong with heightened geopolitical activity, have begun to roll over. Crude oil has fallen -25% during the third quarter of 2022 and -35.7% since its March peak. Under restrictive Fed policy to mitigate heightened inflation, we will have to endure the pain until the Fed completes their mandate of price stability.

What has been behind the weakness in the market is above average inflation and a major shift in Fed policy. Nominal GDP has been very strong, up 8.5% in the first quarter and up 6.6% in the second quarter. After inflation though, real GDP is trending negative. Inflation, as measured by the Consumer Price Index, has come down from its peak of 9.1% in June of 2022 but still remains up over 8%, well above what the Fed considers its “neutral” rate of around 2.5%. In response to stubbornly high inflation, the Fed Funds rate has been increased five times so far in 2022 to a range of 3.00% to 3.25%. We anticipate two more hikes before year end which will leave the Fed Funds rate at a target of around 4.5%. We anticipate Fed policy may be able to transition sometime in early 2023 depending on the inflation data...

With the dramatic compression in valuation multiples this year we can now start to plot the current positioning of the market versus historical averages to gauge whether or not equities are attractive. On the graph above I have the forward 12 month P/E ratio of the S&P500 which currently stands at 17.6x and represents a level of 4,029. Overlapped on the chart I have 5, 10, and 15 year average multiples along with corresponding S&P 500 prices...

The situation with Russia/Ukraine remains fluid but we wanted to follow up our note on the ‘Turmoil on the Eastern Front’ from the beginning of the invasion. In that note we showed the historical playbook for geopolitical events, and looking back the market has behaved remarkably in line with those precedents up to this point. But we don't think the situation is completely behind us and want to reiterate that historically what happens after the initial recovery mostly depends on what conditions were like going into the crisis. In today's case that was inflation and changing central bank policy. We continue to think that will be the dominant theme as we go into the second half of 2022.

For more on the geopolitical situation please see Schwab’s latest market perspective below:..

Geopolitical tensions continue to boil with the Russian invasion of Ukraine shocking an already inflationary global commodities market. Rumors of progression in ceasefire negotiations have boosted markets today but regardless, the economic fallout from the sweeping sanctions will likely last for some time. In our last note we outlined from a high level what the market behavior was during past episodes of similar geopolitical turmoil. We also reiterated why having operating cash set aside and being able to ride out volatility is essential to long term investing. But just as important is understanding what you own and making sure the assets are fundamentally strong...

After 18 months of very little volatility a cascading series of events including the escalation between Russia and Ukraine have reverberated throughout markets causing our first 10% percent drawdown in large cap stocks since March 2020. I'm not going to try to predict the path of military actions in Europe but I can try to put into perspective what the economic impact might be from what's taking place in the region.

Geopolitical events by their nature are difficult to predict and tend to be short lived, although there are certainly exceptions.Outside of the commodities sector, Russia is a marginal player in the world economy accounting for only 1.3% of global GDP, and Ukraine makes up an even smaller portion. US exposure to Russia in terms of total trade is a very low 0.1% of GDP. The EU on the other hand sources roughly 1.5% of their total goods trade with Russia. The main exposure is that commodities are a global market with Russia accounting for about 10% of global oil production and the EU has become ever more dependent on imports for energy. EU imports have long represented over 90% of its oil consumption, while the natural gas import share has increased from roughly 50% in 1990 to also over 90% today. By contrast, the US has moved from importing over 50% of its oil & petroleum during the 2000s to being a net exporter today. So in theory the first order effect from rising energy prices should be modest to the overall US economy. Still, the second order effects of a shock to the already tight global energy market is what could be disruptive...