Notes on the Week Ahead

This week, investors will be focused on the Fed’s second Federal Open Market Committee (FOMC) meeting of the year.  They are widely expected to make no change in interest rates.  However, Fed communications will provide guidance on two important subjects:  First, they will update their summary of economic projections and their “dot-plot” forecast for the federal funds rate.  Second, and particularly in Chairman Powell’s press conference, they will likely provide some further hints on when and how they could begin to phase out quantitative tightening.  While their messaging will likely continue to point towards monetary easing in the months ahead, the implied timing and extent of that easing could have major impact on markets.

Financial reporters and market strategists often argue about whether we are “early-cycle”, “mid-cycle” or “late-cycle”.  However, these perspectives are based on an outdated model of how the U.S. economy behaves.  In a pure “business-cycle” paradigm, the U.S. economy would, today, be in the late innings of an economic expansion that must naturally end rather soon.  However, a more realistic model of today’s economy suggests that this expansion could continue for some time more and that, when it ends, it will be because of some financial, environmental or geopolitical shock rather than the inevitable result of the age and stage of the expansion.  This doesn’t negate the need for diversification.  However, it does suggest that a portfolio should be stress-tested mostly against how it would react to a downturn triggered by non-economic shocks.

On Friday, December 29th, 1989, the Nikkei 225 stock index hit an all-time high of 38,957.  It then began to fall and it took until February 22nd of this year, more than a third of a century later, to reach this level again.  Today, for the first time, it closed above 40,000.

This ultra-long bear market in Japanese stocks was accompanied by the collapse of a colossal property bubble and was followed by decades of economic stagnation, rising government debt and periodic deflation.  While Japan still faces many challenges today, there are signs that it is turning a corner from both an economic and financial perspective.  However, decades of Japanese economic and financial malaise provide some powerful lessons for Japan itself and for governments, monetary authorities and investors around the world.

In last week’s article and podcast, I looked at the potential path for the U.S. economy over the next two years, noting that the outlook suggested a very tight labor market throughout.  This would be a generally healthy outcome for the country, boosting economic growth and productivity and supporting solid wage growth.  To the extent that it maintained pressure on profit margins and limited monetary easing, it would be less favorable for investors.  However, a number of readers asked the very reasonable question of whether my analysis took account of the recent migration surge at our southern border.

I spent most of last week fighting with a model. 

Before anyone starts googling “Nerdy Economist in Fashion Week Brawl”, I should clarify.  I was fighting with a macroeconomic model that insisted on telling me something I didn’t believe.  To be precise, it was projecting that, given the recent and projected pace of U.S. economic growth, the unemployment rate would slide to 3.0% by the end of 2025. 

This I don’t believe for reasons I’ll explain.  But the changes in assumptions necessary to produce a more reasonable answer can tell us a lot about the likely path of economic growth, inflation, interest rates, corporate profits and the dollar over the next two years with significant implications for financial markets and investing.

I think of myself as a pretty punctual person.  I get impatient when others are late and I don’t give myself much time to spare when catching a flight.  But sometimes, like when spending time with family, it’s OK to run a little behind schedule.

One month into 2024, the economic slowdown appears to be running behind schedule.  Growth is stronger than expected, the labor market is tighter and our forecast for inflation to hit 2% by the end of the year looks less certain.  But for investors, it should be all good.  Our 2.0.2.4. forecast of 2% growth, 0 recessions, inflation falling to 2% and unemployment at around 4% is now looking a little more like 2+.0.2+.4-.  But it still rounds to 2024, leaving plenty of opportunity for long-term investors.

This Friday, the groundhog will emerge unwillingly from his lair, examine the available evidence, that is to say, the presence or absence of his shadow, and, in all probability, reject any speculation about an early spring - at least for the next six weeks. According to USA Today, this has been the groundhog’s prediction in 107 of the last 127 years, or 84% of the time. That being said, the weather channel is forecasting “considerable cloudiness” over Punxsutawney, PA on February 2nd, so we might still get lucky.

Last Friday, as much of America was settling in for the coldest weekend of the year, the University of Michigan released its preliminary January reading on consumer sentiment.  The numbers were a pleasant surprise – the consumer sentiment index jumped 9.1 points to a reading of 78.8 – the best number seen since July 2021.  This confirmed other signs of a thaw in the public mood.  The Conference Board’s consumer confidence index rose 9.1 points in December to its second highest reading in two years while even the perennially negative Gallup survey on “satisfaction with the way things are going in the U.S.”, showed some improvement in December.

Every January, firms throughout the financial industry, including our own, hold annual training meetings or conferences.  One of the highlights of these meetings is an award for salesperson or sales team of the year.  These titles are hard-earned and well-deserved.  At least for our own firm, I can say that the winners are always those who, not only achieve impressive revenues for the firm, but do so through very hard work, understanding the investment environment and, most of all, understanding the needs of our clients.

Among the many comments on inflation in the minutes of the last FOMC meeting was the following, rather gloomy, prediction:

Several participants assessed that healing in supply chains and labor supply was largely complete, and therefore that continued progress on reducing inflation may need to come from further softening in product and labor demand with restrictive monetary policy continuing to play a central role.

Translating from Fedspeak: Several Fed officials worried that they might still have to trigger a recession to get inflation all the way down to their 2% target.

This perspective gained some support in Friday’s jobs report which showed a stalling out in a long trend of falling wage growth.  However, a broader analysis suggests that non-labor-market factors will continue to reduce inflation in 2024, giving the labor market time to normalize without the pain of recession.  While there are plenty of shocks or policy mistakes that could disrupt this path, the mostly likely scenario is a continued slide in inflation to the Fed’s 2% target without a near-term recession – an outcome that should support both U.S. bonds and stocks.