The chart below shows the most intense global interest rate tightening cycle in over three decades is finally ending (blue-shaded region on the right).
Central banks embarked on a singular mission two years ago: to bring inflation down at all costs. The chart below confirms “mission accomplished,” as inflation in developed economies has fallen dramatically from their respective peaks.
It’s being called a “New Economic Order,” and in an extreme rarity, I grudgingly agree with this media-spun narrative. Because the world has yet to experience the full effect of that blue-shaded region in the chart above, and that’s fueling several crosscurrents that may stick around for a while.
On the one hand, the red arrow in the chart below shows that leading indicators point to a continued slowdown. The U.S. economy has not yet felt the true impact of interest rates at these levels, stimulus checks are mostly spent, and the jobs market is finally weakening.
On the other hand, the economy and financial markets are not the same. For example, the economy tends to bottom several months after the stock market. Hence, these leading indicators may already be priced into stocks, so getting too defensive this year may backfire.
Furthermore, even if a recession were to happen, more than any other cycle in recent history, consumers and businesses are ready. Both cohorts wisely locked in ultra-low financing years ago, which will almost certainly mitigate the depth and duration of any economic downturn.
Simply put, uncertainty in no way implies danger, but this New Economic Order does warrant a shift in strategy.
Regarding finance and investing, a year is little more than the time it takes for the Earth to circle a massive ball of gas. Markets don’t operate on calendars, where the start of a year somehow resets or adjusts the underlying drivers of asset prices. Instead, markets are event-driven. Something either must happen or be expected to happen for markets to move.
Coincidentally, something big happened at the end of 2023. Not only did the Fed stop raising interest rates, but they stated their intention to cut them over the next three years down to around 3%. The chart below shows that traders are even forecasting a 96% chance of at least one rate cut by as soon as May1.
The stock market loves the prospects of lower interest rates like nothing else. Lower rates incentivize investors to abandon “safer” asset classes like cash to seek higher returns. The chart below shows a record amount of cash on the sidelines in vehicles like money market funds2.
This cash may be enjoying high yields today relative to recent history, but back out taxes and inflation, and it’s lucky to break even. If these yields fall proportional to the Fed’s stated plan to cut rates, it could send a massive supply of cash into the stock market over the coming years.
Additionally, history may once again be on the bulls’ side. Ryan Detrick is a market analyst who recently published the table below. It shows that when stocks have dropped more than 10%, as they did in 2022, then jumped more than 10%, like last year, the following year has been up 100% of the time with an average gain of 11.7%3.
Lastly, let’s address the elephant in the room. There’s also a presidential election in November. While there may be the temptation to do the metaphorical “move to Canada” if your team loses, there’s a mound of data to suggest that may be unwise. Aside from the bad weather, the table below from First Trust Advisors shows how the stock market has performed during presidential election years since 1928.
Digging deeper, there have been 24 elections since the S&P 500 began. Twenty of these years, the index ended up (83% of the time). When a Democrat was in office and a Democrat was elected, the total return for the year averaged 15.0%. When a Democrat was in office and a Republican was elected, the total return for the year averaged 12.9%.
Said another way, the risk facing investors this year is not the election or an economic downturn but how one reacts to either. Fortunately, solutions exist today that may help temper the urge to get emotional.
The bottom line
Mark my words. Despite some of the challenges the economy may face over the coming months, the opportunity for long-term investors has never looked this exciting. I’m not just talking about artificial intelligence, either. Changing consumer habits, advances in healthcare, and new sustainable energy sources are merely a precursor to the innovation tsunami that’s about to hit the global economy.
But the media is right for a change. This is a New Economic Order, so the old playbook that worked when interest rates were artificially low is unlikely to be as effective. It could even cause more harm than good. That’s why we crafted a playbook designed to position for the future rather than copy and paste from the past.
This playbook aims to look for returns in uncorrelated assets and narrow the range of outcomes by taking advantage of higher interest rates before they’re gone. It’s meant to help navigate through all this uncertainty without introducing more risk.
The bottom line is while this may be a New Economic Order, we look forward to the challenge and see tremendous opportunity for long-term investors over the next several years. Thank you for your commitment, Happy New Year, and all the best in 2024!
1 CME Fed Watch Tool. As of 1/3/2024.
2 Goldman Sachs. As of 12/1/2023
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.