Economic & Investment Outlook: Perception Isn’t Reality
Feeling down about the economy and markets?
Paying high prices at the store while watching the S&P 500 hit all-time highs?
Often, how we feel about the market and our investments doesn't jive with what's really happening.
In our Q2 outlook, we look at the data to get a better picture of what's really happening in the economy and financial markets.
Watch the video or listen on the podcast feed to learn more about what’s really happening in markets!
Q2 2024 Economic and Investment Outlook
0:00 - Inflation Feels Different Than Reality
3:03 - What's Happened So Far This Year?
4:06 - Why Long-Term Perspective is So Important
6:00 - Job Market
8:36 - Layoffs
11:04 - Inflation
12:28 - How Are Companies Doing?
17:19 - Stock Prices and Valuation
20:46 - International Markets
24:13 - Bonds and Interest Rates
27:00 - Where Will Long-Term Interest Rates Land?
30:40 - Gold
31:54 - Conclusions & What Investors Should Consider
Transcript:
Hello, and welcome to this edition of the capital stewards podcast. It doesn't feel great out there. Right. And yet investment returns continue to be a positive. The economy keeps going along. So if you're like me trying to figure out why are we living in this sort of dichotomy where, man, it just feels worse than what we're seeing on paper.
And so that's what we're going to dive into in this episode of the podcast and in our outlook for the second quarter of 2024. Our theme going into this year was that the sugar high from global monetary and fiscal stimulus was over and that economies would have to stand on their own, sort of under the pressure of increased interest rates.
I mean, we expected that that would cause a continued deceleration in global growth. And so far that has been the case. But as bad as coming down off the sugar high might feel, that doesn't mean that we're in for an imminent downturn or a major recession.
, we'll start by looking at prices, , which seem high every time you go to the grocery store.
If you're like me, you feel like you're putting on Thanksgiving dinner for your entire family every single week., but the reality is that wages have kept up with inflation over time. You see, in this first chart, since the global financial crisis in 2008, , inflation is up 47%, but all of the three measures of income that we're showing are up.
So what does that mean? That means that while we may be frustrated as consumers,, you know, we're still able to spend and consumers are still able to spend because our incomes have been going up as well.
When we zoom in and we look just at that post COVID period, , the CPI, the broadest measure of inflation that we look at, that's up 20%.
That's a lot, , in a relatively short amount of time. But again, average hourly earnings, they're up slightly more than that., and it's important when we look at income, we kind of take a multifaceted view of income because average hourly earnings only look at the pay that comes out of payroll. So what people are making from employers doesn't include investment income, government benefits, , income coming in for business owners, all kinds of things like that.
So for that, we've got to use that broader personal income statistic that comes out of the GDP report. And when you look at that, you can see that it's even further ahead of inflation., I think that's especially important, in a world where lots of the baby boomers are retiring and they're spending their nest eggs, which are up significantly, by the way, , and all of that, you know, increased pay, increased hourly earnings for folks that are working, , those retirement nest eggs, all of that is driving consumption and that's the majority of gross domestic product.
That's the majority of GDP. And so we keep thinking there's a recession right around the corner. But the main driver of GDP, which is everybody's, everyone's income, their propensity to spend continues to go up.
So as we do in most of our outlooks, , and in this edition of the podcast, we're going to look at the data and what it really shows us about the economy and about markets.
We'll try to dispense with our feelings about how things feel. Sometimes those get us into trouble. If you're like me and how we feel about things gets in trouble sometimes. So we're gonna look at the data, see what that tells us, , about where things are going, , for, , the rest of 2024, so let's dive in.
So, so far this year, stock returns have been strong in the first quarter with the S and P 500 up just more than 10%, just north of 10%. Much of that performance was driven by growth stocks specifically the magnificent seven or the, you know, the, the fabulous four, whatever you want to call it.
The same stocks have been generating strong returns over the last couple of years. Other stocks were up but the returns were more muted golden commodities also posted strong returns. I, in the first quarter. Bonds and real estate were down slightly as interest rates rose over the quarter. We'll, we'll talk about that.
The narrative in the media has sort of shifted, right? That the expectation is the fed's going to cut rates. I think there's a lot of consensus that that's going to happen in the second half of this year. You say, well, why are rates up if everybody's expecting the fed to start cutting rates? Well, the market kind of got ahead of itself in the fourth quarter of last year, we saw a really strong decline in interest rates to close out last year.
And probably to, to a level that was, was not in line with reality. And so we've given some of that back a little bit in the quarter
so, all of that led to kind of flattish to slightly down performance for fixed income and the same thing for, for real estate in in the 1st quarter.
All right. So when we do these outlooks and our annual updates, we always take a step back and we look at long term returns. And that's because most of our clients are long term investors. Most of your goals are long term. They're not this quarter next quarter, even next year. The year after that they're long term.
If you're investing on behalf of your family, or for an endowment or foundation, you're looking at 5, years down the road. And so we don't want to get lost in sort of short term feelings and short term. Expectations around the market. We want to make good decisions over long periods of time. And so when we look at what's happened to returns over long periods of time, you can see the stock market is growing compounding 9.4 percent a year still averaging every single year over time. Right. And you would have been a really happy investor in the stock market. If you had invested before the crash after 2000, right before the global financial crisis, right before COVID, if you look all of those points on that red line are significantly below where we are today.
Then you see that bonds of average 4. 2% over time, still significantly beating inflation at 2. 5%. And then you see gold there in the middle with with 7 percent returns over, over the long term
when we zoom in a little bit, and we look over the past 10 years. You see the stock market doing a little bit better, 12.96%, bonds have done a little bit worse as rates have risen over the last a couple of years. 1.5%. You see gold at 5.34%. And then you see CPI up a little bit to averaging 2.7% percent over the last 10 years instead of 2.5% percent over the longer time period. So. What's important is just understanding that staying invested , , there's been a lot of discussion the last couple of years of, next year is going to be the recession.
The recession's right around the corner. We should, you know, we should get out of the market, all those kinds of things. It's really important to stay invested over long periods of time, if you get in and get out and you miss you know, the, the ups in the markets, and it's going to be really difficult for your portfolio to perform close to those annual averages.
All right, so let's look at what's going on in the employment market.
This year, we'll talk a little bit about the economy, where things are, why we don't see a recession happening this year, what the actual data says about how consumers are doing, how the economy is doing, and then we'll dive into specific investment markets around stocks, bonds. And then I want to talk a little bit about gold this time since it's done so well in the 1st quarter as we, as we closed out this episode.
In prior outlooks, we've discussed the health of the consumer and how that's the most important factor in keeping the economy growing. And the health of the consumer is largely determined by their ability to work, grow incomes, and ultimately spend. If you have a job and you're a U S consumer, ultimately you're going to spend a lot of what you make, even if you're saving, you're still going to spend a lot of it.
So we've looked at this chart for a while and we noted specifically the switch that sort of happened around the covert time period where we saw the available jobs exceeding the available workers for the 1st time , since the jolt survey came out Since that switch happened and the labor market was really hot, that drove some of that initial inflation that we saw coming out of COVID, the labor market has been cooling off.
We continue to see the number of open jobs in the red line coming down, and we only see slight increases in the number of unemployed workers. And further, we, we kind of also see the ancillary data that's around this. So average hours worked every week declining slightly. So it's not just that the headline unemployment numbers that, that we're looking at everything that we see indicates that the labor market still really strong, but it's cooling off a little bit and that's going to help keep a lid on inflation.
I also, I, I do think that migration is having an impact. I think they're taking some of those jobs that were available and bringing them down. And so I do think that's having an impact. I think it's worth like an entire sort of podcast episode to dive into the impact that immigration is having or not having.
So we'll do a deeper dive on that maybe later in the quarter. But it's worth noting that that certainly is having an impact, I think, on the, on the labor market.
Another way to look at the job market is of course, the unemployment rate, which stands at 3. 9%. And there's been a lot of discussion about the unemployment rate recently and how, man, if it goes just a tick up to 4%, we're going to have a recession.
We're going to trigger the SOM rule. Lots of bad things are going to happen. When you look at it in context over history you can see that we are much closer to all time lows in unemployment than we are to the level of of job losses that we typically see in recessions. And typically in recessions, you see unemployment rise well above 5%.
We're not going to be there anytime soon. And and so I, I think overall, again, the labor market looks really good. And the reason, the primary reason that we're not going to see really high levels of unemployment anytime soon. Is because layoffs remain low in historical context.
So layoffs have been in the news a lot.
And this is our next chart and it makes headlines. Every time you hear a big company laying off a few thousand folks, but layoffs happen throughout the economy for a variety of reasons as companies change their businesses layoff since 2000 have averaged about 1. 9Million a month. In major recessions, you see layoffs spike well over two and a half million workers every single month.
And the covert recession obviously led to the largest spike on history as sort of business closed people, furloughed workers, all kinds of things happened with the business closures that happened around coven. So, but when we look at. The pre covid economy, and we compare that to the post covid economy.
We see that layoffs today are running at or even below the long term averages that we saw in this sort of pre covid world. So we have slow. We've we've slowed growth down. Companies are restructuring businesses. As a result of that. We've seen layoffs. We saw some. In 2021, we saw more 2022 more 2023, but I think the fact that they've been sort of occurring under the surface over the last couple of years has kept that number from spiking a lot.
It's kept most people employed over time. People are able to reskill, find new jobs, et cetera. And so, on balance, that's kept the labor market relatively strong, even while companies sort of retool for the, for the postcode world.
As a result of the strong labor market, consumers have continued to spend over the past year. You see retail sales, especially in the non store services sectors, growing more than 7 percent over the last 12 months. We have seen some slow down. That's notable.
You see that on the year to date chart on the right hand side so far in 2024. The first quarter typically is a weaker quarter for sales. And so it wouldn't surprise me if we saw that normalized as we go through the rest of the year, and we ended up in something like 3 to 4 percent the 7 percent growth that we saw last year.
That's probably not normal. That's part of the sugar high that we saw. So again, it would be normal for for a cooling off of sorts of of retail sales, both for goods and for services, but but still sort of growing or low single digit growth. And that's what the numbers so far in the first quarter seem to support.
Inflation is trending down despite sort of being a, on a sort of rocky journey down prices are still higher than they were a few years ago, and this is the, you know, the argument I always hear with, from folks around inflation say, Hey man, but prices are still really high when you go to the grocery store and they're still really high and that's true.
But the rate of change in prices is coming down. It's down sharply from its peak. We're not all the way back to the 2 percent target for the Fed, but in our view, we're going to move closer to that 2 percent inflation target as we go throughout the year. Inflation measures that exclude shelter are already close to 2 percent and that's really important because the statistical measures that we use to track the cost of housing, they lag the market by about a year.
But we know that in real time, housing and rental rates they're increasing at levels that are more consistent with a 2 percent inflation rate in real time. So I would expect the official inflation numbers to continue to normalize throughout the rest of the year and to get closer and closer and closer to that 2 percent level.
That doesn't mean that we won't take 2 steps forward and 1 step back, right? None of this economic data moves down sequentially perfectly every single month and then up sequentially. As we go through the cycle, it has bumps along the way but I expected the overall trend will remain down shockingly enough.
So does the fed we'll talk about this more when we move on to rates and bonds, but regardless of what you think about fed chair Powell they've been telegraphing their thoughts on the market pretty well last year. They said, Hey, we think there's going to be a couple of rate cuts in the back half of the year.
And the market said, no, it's going to be way worse. They're. Definitely going to be lots of rate cuts earlier this year. And then the, the path of inflation going down has been fairly slow. And so I think it's wise to heed the advice of the fed on, on on interest rates, don't fight the fed. That's that moniker has been around for a long time.
And I think you know, I think there is some truth to that, certainly in this market.
Let's turn to businesses a little bit. The ISM surveys that we're showing here measure business activity, things like new orders production and delivery to give us a sense of how the economy is doing before we see the results start to show up in in company financials that kind of happened on a lag a quarter or two quarters later.
And I couldn't come up with a better word for business activity than blah activity, manufacturing and services. They're below long term trends, but they're holding steady. Importantly, the way that the ISM statistics are calculated. If you're not familiar with that data, a number above 50 means that activity is growing, so more orders, more production, more deliveries, those kinds of things.
A number below 50 means that the particular sector that they're measuring is declining or not growing. So the services sector is still growing at low levels. That's consistent with the slow growth economy. That's what we want to see in manufacturing and goods. They're still sort of struggling. You saw this huge pop in manufacturing right around right for COVID as people were ordering lots of hard goods, and then they're sort of getting the payback for that, for that now.
So is it a great report? No. But again, I think it's consistent with coming down off the sugar high, the economy normalizing, returning to returning to slow growth. I think we can hang in here just fine and not have. A recession. If that services number starts to drop below 50 for an extended period of time, I think that's where you got to worry about potentially seeing a recession.
Perhaps not surprising to a lot of you. I listened to a lot of earnings calls each quarter. And the reason I do that is because executives understand their business. They have their nose. To the grindstone, so to speak they know what's going on, have visibility about what's going on in the economy.
They see it in their businesses every day, every week. And so I pulled a few earnings quotes from the Q4 earnings calls that just happened over the last couple of months. But I think some of the expectations for the rest of 2024 well, for the broader corporate set, I tried to go beyond. Just the magnificence, the magnificent seven the, the names that you hear in the media all the time and figure out what, what are the rest of the companies doing?
How they're performing? What are they saying about what's going to happen in the remainder of 2024? And so here's, here's a few, just a few things that came out of. So Caterpillar, I think this is probably sums it up best overall demand remains healthy across most of our end markets for products and services.
We ended 2023 with a backlog of 27 and a half billion, which remains elevated as a percentage of revenues compared to historical levels, we currently anticipate 2024 sales and revenues to be broadly similar to the record 2023 level in North America, after a very strong 2023, we expect the region to remain healthy in 2024.
We expect non residential construction to remain at similar demand levels due to government related infrastructure investments. Residential construction is expected to remain healthy relative to historical levels. So Caterpillar, expecting a pretty good year in 2024. Target said consumers are balancing a lot.
They have to make a lot of trade offs to meet the needs of their families while sprinkling in the occasional luxuries, like how they said that. And yet their affinity for style and newness plus early signs of disinflation contributed to a sequential uptick in discretionary category performance over the last few quarters as something we aim to build on and accelerate.
Another retailer, Walmart, we're not immune to the whims of the economy, and certainly there are economic outcomes that could cause us to move to the high end of the range or the low end of the range. So I think in retail again, you see sort of some, you know, some concern for the rest of the year, right?
It's not all rosy, but certainly not not predicting a recession. Eli Lilly for our investors, 2024 should be another exciting year driven by expected revenue growth and our core business near or approaching 30 percent continued investments to drive future growth or outlook for top tier revenue growth and operating margin expansion remains on track.
Pretty healthy MasterCard. Let's start in the macroeconomic front where we see both tailwinds and headwinds. First, the labor market remains strong with low unemployment and rising wages. These remain key drivers of consumer spending. Some risk we're monitoring include credit availability and delinquency rates.
Second, while inflation continues to moderate, prices of many goods and services remain elevated. We're tracking the efforts of central banks who are actively managing interest rates to normalize inflation. And finally geopolitical uncertainty remains a concern in several markets on balance, we remain fairly positive about the growth outlook, but we're monitoring the environment closely and we'll manage the business accordingly.
I think, and there's a couple more on the page that you can read, but I think you just see executives believe that there's going to be growth in their business, perhaps not gangbusters growth but modest growth some call out risks for the deteriorating economy but that's their tail risk scenario.
That's the stuff they're watching for. It's not their base case as they head into the rest of the year. I think it's also worth noting that executives are incented to share a more negative outlook than they believe is going to be true. They want to set reasonable, but low expectations and then over deliver on those results, not the other way around.
So if they expected a really challenging earnings this year, I think we'd already be hearing that they'd already be alerting investors to lower expectations. And so we just don't see that.
So let's talk a little bit about stocks then and stock prices. As we've seen, you know, pretty strong return so far in In the first half. So stock prices are up earnings. Not so much over long periods of time. We expect that stock prices should increase as the underlying companies grow their earnings power, right?
We're owning shares of companies as they get better at what they do, and they make more money every single year. We should get better off as investors. And indeed, you, you sort of see that the earnings per share growth for the S and P 500 roughly tracks. The change in the index over time we see relatively strong positive correlation between the two and they should move together.
Over the course of the past quarter earnings and growth expectations declined from 5%, 3 percent for the year. In the stock market, of course. Did the opposite. It went up more than 10%. So that divergence to me, just like in the fourth quarter it means that investors are continuing to pay more for the same stream of earnings.
According to fact set, the S and P 500 is trading at 20. 9 times future earnings expectations for next year. That's that's above both the five and the 10 year averages. But it's not anywhere near the long term peak, which is closer to 23 times earnings. So it doesn't necessarily mean that the market's going to, going to go down from here.
So I think, again, based on what we've heard from management expectations and earnings, I think underlying growth expectations for earnings should be sort of in line with expectations solid, but not gangbusters. I think the market's pricing and pretty significant growth. So I think there's some risk there.
Some of that growth may be warranted as the expectations for interest rate cuts firm up a little bit in the 2nd, half of the year. But I think it's unlikely the S and P 500 continues to post double digit quarterly returns for the remainder of the year. While underlying. Um, So again, I, I do think you're going to see strong earnings growth, but I think probably and, and a good year for the stock market as we go forward, but, but I think probably a little bit more muted than what we've seen so far this year.
So, let's look at what's really been driving those multiples higher in the 1st part of this year. And that's really the Magnificent 7 we call this 1 in the Magnificent 7 lifting all the boats. You see so far a year to date. The Magnificent 7 are up almost 17 percent 16. 88 percent driving the S& P 500 up over 10 percent and then you see the equal weighted S& P 500 index trailing that at 17%.
7. 7%. So just as a reminder, the S& P 500 index is market cap weighted. So that means that the largest companies, as they grow, they have an even more outsized impact on the underlying index return. The equal weighted index just says, Hey, there's 500 companies. If I invest one 500, they're an absolutely equal amount of money in all those companies.
What would happen? And so the performance of the equal weighted index is more akin to what's happening to the average company, if you will, as opposed to, you know the, the market cap weighted index. And so you can see the average company is up 7%. That's a really good quarter for stock market returns.
But not quite as much as as what's happening in the magnificent seven. So. You know, can that sort of dichotomy continue? Can growth continue to outperform other areas of, of the market? We think so historically we've seen growth outperform in economies that are slowing down. We talked about this extensively in our outlook for this year.
And at points last year as well. So I do think growth can continue to outperform probably not at the level that we've seen. You know, that, that kind of dichotomy between the market just doesn't happen. Very much. But but I do think the growth can continue to outperform as we go through the rest of the year in the U.S.
In a continuation from 2023, the U. S. also continues to outperform most global economies except perhaps maybe India and Mexico. We'll talk about that in a 2nd in Europe, like the U. S. the increased interest rates. And that's slowed down the economy
the Eurozone economy is more sensitive to interest rates. And it's probably a feeling the pain of higher rates at the moment. More than in the U S a lot more bank debt. The idea of a 30 year mortgage doesn't really exist. A lot of things in the U S are, are less sensitive to interest rates than in other developed markets around the world.
So expectations in Europe are for pretty flattish GDP growth, not even low single digits, you're flat to down maybe even a little bit of a shallow recession the UK and Germany already have negative GDP. Couple of quarters. So when we look at Asia, it's, it's really a tale of 2 realities, Japan and India and other countries.
China are growing probably at the expense of China. The Chinese economy is dealing with the real estate, the real estate debt overhang from the last couple of years. And the government is keeping things afloat. They haven't announced anything yet. That's the massive stimulus that would sort of wipe the slate clean and devalue the yuan.
That's what we've seen in the past. So India and Mexico are both faring really well on the economic and investment front. And both of those are big beneficiaries of global diversification away from China. What's happening in China, by the way, is not really a disinvestment. Very few companies have sort of closed up shop and relocated.
Really what's happening is firms are choosing to not continue to investing there. They're not increasing their investment on the ground there. Instead they're diversifying into other markets. And I would expect that to be a theme for some time. Every time China invites us business leaders for show and tell is using ping came here.
Back in the fall, there was just a big convention in China a couple of weeks ago. The business community, they seem to leave those things pretty unimpressed by the approach that the government is taking towards the economy. I think it's going to take more friendly interactions in order to rebuild the trust that China has probably lost from a lot of leaders around the world over the last four or five years. So if you look at the stock market performance Europe and Asia are failing sort of similarly to us value stocks. Frankly, if not the majority of us stocks that aren't the magnificent seven the top end of the U S growth stock market is really what continues to drive out performance in the U S.
Versus other regions of the world. And that's kind of in line with our view that global economies are slowing interest rates are having an impact and that growth should outperform in this environment. We continue to be focused on the U S for that reason. When we think about allocating assets to markets around the world.
The Australian GDP was flat to in 2023 perhaps a recent rise in commodity prices will help there as we move into 2024. But the Aussie central bank is forecasting growth of less than 2%. By Q4 notably in Australia the Taylor Swift concert series just came through and it had enough of an economic impact to make the economic publications as a special one time event That drove spending in February.
And as they said, may result in less spending for the remainder of the year as fans rebuild their savings. So I thought that was particularly interesting that Taylor Swift has caused a pull forward of demand in in Australia all in, I think developed markets around the world, they're exhibiting sort of low to no growth so far in 2024, hence our preference for the U S emerging market.
Stock performance globally is divergent. I think is the best way to say that MSCI China is the largest component of the emerging market index. And that's down a year to date. And MSCI India is up, you know, 5 percent year to date. So my view continues to be that as sort of active management matters.
In in global markets simply owning the index you know, around the world doesn't, doesn't work as well as it does in the U S
All right. So let's turn to the bond market. We saw interest rate.
Interest rates rise during the first quarter, as I mentioned earlier, that may have been a surprise given all the headline sort of news around the timing of eventual fed interest rate cuts this year. However, interest rates were down significantly in the fourth quarter of last year. The, the market was pricing in at the turn of the year, you know, 625 basis point fed rate cuts this year.
In our view, that was just not, that wasn't supported by the underlying data. We expect rates to trend down over time, but Not that quickly. And so now I think expectations have moved more back in line with a, sort of a reasonable two to three cuts this year. I think that's in that that is in line with the underlying economic data that we see.
So inflation declining a little bit rates coming down a little bit, but not this sort of like a quick sell off in rates that we saw in the, in the 4th quarter. As we mentioned earlier, inflation is moving lower and the economy, while still growing. It's not at risk of overheating. We see some slack in the labor markets.
We see muted corporate profit growth again, growth, but, but muted in a healthy way. So, my view, all of that adds up to a fed that will want to cut rates in the 2nd, half, sort of keep the soft landing on track and not risk pushing the economy into a recession by leaving short term interest rates. So high.
Above the inflation rate that that it starts to do do really negative things. I do think that path back down is going to be pretty slow and gradual. Not not a rush. That means that that rates while moving lower you know, they remain elevated versus recent levels for for quite some time for investors.
We think that means short term rates remain high. But now is the time to start to move out on the yield curve away from cash and the ultra short bonds, because once rates move lower the opportunity to lock in rates over the long term maybe maybe more challenging.
I think it's also helpful to look at bond investing And sort of understand what assets are working and what assets are not working in different markets. And we've had a great sort of view of this just in the 4th quarter of last year in the 1st quarter of this year, because we had rates going down primarily in the 4th quarter of last year and rates rising in the 1st quarter of this year.
So last year. In the fourth quarter with rates going down, we saw performance. The overall aggregate index was up almost 6 percent of the quarter and the longer term bonds performed fairly well. And then your sort of shorter term fixed income stuff that was floating, you know, up a couple of percentage points, but it lagged the, the longer term peers pretty significantly.
And then this, in this quarter, he sort of turned the page and you see the opposite. You see rates going up a little bit. And so you see slight underperformance from longer term fixed income securities. And then floating rate security, shorter term securities have done better in the first quarter of this year, but I think going forward, things are going to start to look a little bit more like the picture on the left hand side as rates go down over time, just perhaps not quite as extreme because I don't think you're going to see quite the sort of the, the level of rate declines in a short period of time that we saw in the, in, in the fourth quarter,
So the big question puzzling markets about rates is where will that 10 year yield eventually end up for the next decade or so before the financial crisis in 2008, we had a period of falling rates. But where rates were generally higher and the spreads were wider, then after the financial crisis, the federal reserve embarked on a decade of quantitative easing that pushed rates and spreads lower than they probably would have otherwise been.
And we've been experiencing that over the last decade or so before COVID. , we also continue to see technological innovation, which drives inflation lower naturally. And that's really, really important. That makes everything across the economy cheaper and cheaper over time after you adjust for inflation.
So, in my view, we're gonna continue to see innovation. We're not completely going back to the eighties or the nineties. , and, , we're also done with a quantitative easing that we saw from the fed after the global financial crisis. They've said as much their, their goal is to start to back off of that.
So, and we've seen them do that now a couple of times. , so we're, so we should land somewhere, I think, in the middle of those 2 scenarios, the sort of the 1990s, early 2000s, and the post GFC sort of financial, you know, , repression period of time. So the average spread on the 10 year over inflation as measured by core PCE, which is the measure of the fed uses for targeting.
It was 3.6 percent in the 1990s and it was 1.1 percent during that financial repression period that followed, , the global financial crisis. , so the average of those two is 2.35%. So if we assume that inflation runs a little hotter, , than the last decade. Which I think makes sense given the population dynamics and other things that are happening in the economy.
So if we assume inflation runs about 2. 25%, , that leaves the 10 year treasury yield at 4. 6%. , today's yields are slightly under that level around 4. 3%.
The other way that we can look at the 10 year yield is the term premium for treasuries. And that's to look at the 10 year yield compared to the three month yield, which should track pretty closely.
The feds, the fed funds rate prior to the great financial crisis, , the spread between the 10 year and the three month yield was 1.65%. , and after the GFC, , the spread actually wind out a bit to 1.83%. So the average of those two would be 1.74%. So in a perfect world, the Fed would be able to reduce their short term interest rate back down to around two and a half percent, to track long term inflation.
If you add that spread on top of that, then you get a 10 year yield of 4.24%. So we have a number, I think, when you look at both of those 2 sets of analysis together, we have a number somewhere between 4.25 percent and 4.8 percent on the 10 year over a longer term period of time. And in my view, that seems like a fair way to look at rates going forward.
We'd look to add to longer term bond exposure when we've got positions and rates in those, in, in that range of 4.8%. 4 and a quarter to, you know, maybe 4 and 3 quarters, something like that. The pushback I hear on this a lot is what about the 1970s and the 1980s? We saw higher rates and spreads during that period of time.
My argument against using the 70s and 80s as a comparison period is that the economy and the, you know, the geopolitical situation, , are very different now than they were during that time period. Uh, technological innovation moves in a much, Yeah. Faster pace, which I mentioned earlier, that drives inflation lower naturally.
Additionally, inflation, the seventies was especially driven by oil supply shocks, , not the underlying economy. Geopolitical events are really difficult to predict. So could we have a war in the middle East that temporarily drives oil prices or inflation very high? We could have that. We saw that in Ukraine, over the last couple of years.
But I think geopolitical events are really difficult to predict, so I view that as sort of a risk, not as part of the base case when we think about where the sort of natural rate, , of, of, , of inflation and then the term premium on top of that, or the 10 year yield, should land.
So, so I think all in all, again, I think a 10 year, somewhere between four and a quarter to four point, , seven to five sort of makes sense given what we've seen historically.
So lastly, I thought we'd close on gold for all of you. Gold bugs that are out there. Gold's up an impressive six and a half percent so far at 2024. Despite that my long term view in gold and other commodities has not changed historically gold and other commodity prices increase rapidly right around unexpected spikes of inflation, which makes sense as the commodity prices are adjusting for the appropriate value of the U S dollar during those inflationary periods, but after those short spikes, prices tend to be stable to down for really long periods of time, mostly because inflation spikes in the U S are relatively rare.
We've seen gold rising this year. And while the inflation data has been a little hotter than we expected, that consists of few is still that inflation is going to trend down over the rest of the year. So I don't think that's really what's driving the price. I think the short term price increase is really just the investment dollars beginning to flow out of shorter term term money market funds out of ultra short bond funds that were paying historically high rates back into other stable assets that are associated with a little bit better long term return.
So I think as rates come down, that's going to sort of help the price of gold stay high. And I'm still, you know, I don't see gold outperforming other risk assets, stock market, things like that over, over the longterm. But, but a valuable part of portfolios, particularly in in the lower risk space to help maintain value and stay ahead of inflation and things like that in the conservative parts of portfolios.
So what should I actually do? As, as always at the end of this thing. We try to, to leave you with some practical things that you can think about and implement in your own portfolio. So our working theory for this year as sort of a good, but not great year continues, I think the economy continues to grow rates decline modestly.
Companies continue to figure out how to grow their earnings through a more challenging environment that isn't overstimulated by the Fed.
So a few practical things, I think, stick with it. I think 2024 may not feel great but financial markets may still generate positive returns. Despite that I think continuing to rebalance exposure to the Magnificent seven or the fab four, whatever it ends up being in any particular quarter, if they become.
Outsized positions in your portfolio is really, really important. Not letting the risk there build up. You can still generate really strong returns without, without having all of your portfolio invested in, in four or five stocks, which is great. And then, and the lastly, we had this with the end of last year, but I think it's still really important.
Reconsider your allocation to bonds. Higher rates should allow you to earn more returns. You know, in in your bond portfolio. And that means that you can have less exposure to risky assets like stock over the long term. And that's that's a really good thing. So it's really important to dial in on your bond exposure while rates are really high.
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