The Times Are Still A-Changin’ -

The Times Are Still A-Changin’

Jan 06, 2025Jeremy ParkinsonFinance0

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At the beginning of every year, investment firms around the world publish their year-ahead outlook for markets and the economy. These prognostications can be interesting but not for the targets they place on various market or economic metrics. It is difficult to predict the long-term return of the stock market in advance but it is impossible to predict the short-term return. And make no mistake, a year is short term. It is also impossible to predict the course of the economy over the next 12 months. All most of these “outlook” pieces do is extrapolate the existing short-term trends into the near future. Sometimes it works, most of the time it doesn’t. The only useful information in these think pieces is the narrative, how these firms and their clients are thinking about the economy and markets. That can give us clues about how they are positioned and how they might have to change if their expectations are not met.This year is especially difficult because we have a new government about to be installed in a couple of weeks. We all know what policies Donald Trump talked about on the campaign trail but we have no idea which ones were conveniently adopted for the campaign and which ones are serious proposals. We also don’t know which ones Mike Johnson can get through the House and John Thune can get through the Senate and actually to the President’s desk. Even if we knew exactly what policies will get enacted this year, we don’t know in what order they might come. Will mass deportations start happening by February? Given the potential cost, will Congress be willing to fund the effort? Will the tax cuts from the first Trump administration be extended? Made permanent? When? Will tariffs be imposed unilaterally by the President or will Congress need to pass legislation? Will the tariff levels be the ones repeatedly talked about on the campaign trail or will they be lower or higher? Will they be imposed all at once or gradually over time? No one has the answers to these questions and the course of the economy over the next year will certainly be affected by the answers.As most of you know, I take the month of December off to think. I don’t spend a lot of time thinking about what might happen over the next year. I spend my time thinking about the really big picture, how things might develop over the next five to ten years. As I said, it is impossible to predict market returns over the short term and it isn’t much easier over the long term. But we can make observations about the starting conditions and predict generally how markets will perform over the next decade. For example, one of the simplest methods of predicting future returns for stocks is the Bogle method:Expected Return (nominal, annualized, 10 years) = Starting dividend yield + Earnings growth rate + annualized percent change in the P/E multipleObviously there are variables here we have to guess at but we can come up with a range of potential outcomes:
Historical earnings growth, by the way, has been about 6.7%; corporate profits for the economy as a whole will grow at about the same rate as Nominal GDP. The S&P 500, representing 502 of the biggest and best companies in the US can do a little better. If you are thinking about the next 10 years, I think it is reasonable to assume historical earnings growth and a P/E that falls to the mean. If you think inflation and interest rates will trend higher over the next 10 years – and we do – you should probably choose a lower P/E. The repeat of the 1970s scenario is probably too extreme but historical earnings growth and a P/E that falls to 15 is probably a reasonable expectation. As you can see that produces an expected annual return of just 2.54% over the next 10 years which should explain why we aren’t very enamored of the S&P 500.What I spent the last month thinking about is what is likely to happen to the global economy over the next 10 years. I am not so naive that I think I can actually predict that far ahead but I do think there are some things that are essentially inevitable and have known economic consequences. We know, for instance, that the US population will continue to age over the next 10 years and there isn’t much we can do about it unless we raise immigration significantly. I see no reason to expect that outcome today although I suppose that could change. So, I can pretty safely incorporate that into my expectations for the next 10 years. I wrote a long paper two years ago called The Dawn of A New Era and a follow-up called The Times They Are A-Changin’ in 2023. I laid out my expectations for the long term in those two articles. I’m working on final edits to the next update right now and it will be available for download later this week. The trends I wrote about in those two papers – demographics, deglobalization, trade frictions – are still in place. The deglobalization trend and the trade wars are set to accelerate with Donald Trump’s re-election. We have had a moderation in inflation since the first paper was published but that is consistent with the expectations I laid out back then; I expected inflation to fall back during the Fed’s rate hiking cycle. The real test of my thesis is now as the Fed has embarked on an easing cycle; so far the market is reacting exactly as we would expect if inflation is not as dead as the Fed thinks.Here’s an excerpt from the new update:

The Fed is now in easing mode, having cut the Fed Funds rate by 100 basis points since September. The market has not reacted to these cuts as many expected with only very short term rates falling after the Fed cuts. Longer term Treasury yields have risen and the longer the maturity the greater the rise.

The 3-month T-bill rate has fallen 78 basis points since the end of August.
The 2-year T-Note yield has risen 67 basis points since the Fed’s first rate cut on September 18th.
And the 10-year T-Note yield has risen by 96 basis points since the first Fed cut.
The result of these market-based changes in interest rates is a dramatic steepening of the yield curve. The 10-year/3-month curve has steepened by 150 basis points since the first Fed cut.
Contrary to those who have identified this steepening as a recession indicator, the circumstances of the steepening points to a different outcome. It is true that the yield curve has, in the past, tended to steepen just before recession. However, that type of steepening is known as a bull steepener and it occurs because while both short and long term rates fall, short term rates fall faster.The type of steepening we’ve seen since the Fed’s cut in September is known as a bear steepener and occurs because long term rates rise faster than short term rates. In this case, the 3-month rate fell while longer term rates (2-year and 10-year) rose. This type of steepening is generally associated with a rise in inflation expectations. Indeed, since the Fed’s first cut, 5-year inflation breakevens are up by 46 basis points while 10-year breakevens have risen by 25 basis points. The market can, of course, be wrong but right now it is pointing to the outcome we warned about 2 years ago.The New Era I referred to in that paper was one of higher inflation and rising interest rates, essentially the polar opposite of what we experienced from the early 1980s until COVID. Some big trends came out of that long 40-year period of disinflation and I expect them to reverse:

S&P 500 valuations rose during the long period of falling interest rates. When rates peaked in 1981 the Shiller P/E for the S&P 500 was 9. By the end of the decade it was 17 and it continued to rise until hitting its all time peak in 2000 at 43. Valuations compressed some during the rising rate/falling dollar period in the new century but expanded again after the 2008 crisis. Today, even after rates have risen from their lows, it stands at 38. If rates keep rising, valuations will fall. Will they fall all the way back to 9? It certainly can’t be ruled out but that isn’t my base case.

Growth stocks outperformed value stocks for most of the period of falling rates and inflation but especially over the last 10 years during the experimental monetary policy phase. But in a rising rate environment, as valuations compress, the highest valued equities – growth stocks – will be the most vulnerable. History says value should outperform in a rising rate environment.

Commodities have performed very poorly during the disinflationary period which, of course, makes perfect sense. But historically commodities move to the top of the performance rankings in a rising rate environment. Gold also performs well in that environment but is more sensitive to movements of the dollar.

International stocks have underperformed for much of the period of falling rates. They also tend to outperform US stocks in a rising rate environment.

Bonds perform well when rates are falling and for the last 40 years have offered diversification benefits for stock investors. When the economy approached recession, bonds provided offsetting positive returns to stocks. In a rising rate environment stocks and bonds will tend to be positively correlated; bonds don’t offer as much diversification benefit in rising rate periods. During the 40 years of falling rates, every spike in rates was an opportunity to buy long term bonds. Now every time rates fall it will offer an opportunity to sell bonds and buy shorter maturities.

Falling interest rates turbocharged the LBO/Private equity business as debt was swapped for equity. It was so successful that the number of publicly traded stocks fell from 8000 in the mid-90s to roughly 4500 today. A reduced supply of publicly traded stocks and steady demand from index investors is part of the reason stock valuations rose as much as they did. That should reverse with higher rates as adding debt becomes more onerous.

Falling interest rates also made it attractive to issue debt to buy back stock. That accumulated debt will eventually cost more and I would expect buybacks to wane. Rising rates may induce a surge in secondary stock offerings to retire the previously issued debt.

These trends are set to reverse because the conditions that created that long period of disinflation are ending. A good part of the disinflation of the last 30 years was driven by China’s entry to the global trading system in the mid-1990s. The US and other developed countries have finally decided that the imbalances created by China’s mercantilist policies need to be corrected. The political backlash to the economic consequences of China’s policies is what elected Donald Trump in 2016 and it is what re-elected him last year. But now it isn’t just Trump who is looking to reverse China’s gains. Populism and economic nationalism are a global phenomenon and the policies that are coming will be intended to correct the imbalances that have developed over 30 years of neglect. Counteracting China’s mercantilist policies by enacting our own mercantilist policies does not seem the right path to me but that doesn’t meant it won’t be tried. That is Donald Trump’s stated playbook and I expect him to do everything in his power to enact it. The consequences of that seem likely to make inflation great again but there are a lot of variables and it is impossible to predict the rest of the world’s response. History says though that protectionism will produce higher prices and lower quality because it will reduce competition. Think Ford Pinto or Maverick or the AMC Pacer or Gremlin or any number of awful 70s American cars. Another wild card is the debt we accumulated during that period of falling and low interest rates. The Trump administration’s goal of reducing the trade deficit is likely unrealistic unless they can also reduce the deficit and debt as a % of GDP. How will that be done? To reduce the debt/GDP ratio, the rate of debt accumulation will have to fall below the rate of NGDP growth. Right now the deficit is 6% of GDP and NGDP grew 5% over the last year. To get the deficit down to, say, 3% of GDP while maintaining that 5% NGDP growth rate is not going to be easy. Right now, cutting the deficit in half would require a combination of more revenue and less spending that adds up to about $1 trillion/year. Doing that while also keeping NGDP growing at 5% isn’t impossible but it sure isn’t easy either. I don’t know how the next year will turn out. Every year is different and history can only act as a guide. Almost none of the historical outcomes we expect in a rising rate environment worked last year. Rates were up but growth outperformed value, commodities performed poorly and international stocks continued to underperform their US counterparts. None of those conform with what history tells us to expect. But as I said at the top, what happens in a year is impossible to predict. If our blueprint for the next 10 years is close to accurate, I expect the historical norms to reassert themselves.With Trump returning to the White House, one thing I’m confident about is that the world is going to be less predictable, more chaotic. That’s his style and we shouldn’t expect him to change. It’s going to be an interesting 4 years.

Environment

Interest rates and the dollar both rose last year. The dollar is now in a short-term uptrend while rates are still in a trading range.

Markets
Over the last year the big winner, as everyone knows, was the S&P 500. More specifically, it was the growth stocks that ran away with things last year. The returns of value stocks were good – mid-double digits – but paled in comparison. Commodities have had a decent run over the last year but, again, way less than stocks. Interest-sensitive assets like REITs and bonds underperformed. While we expect that to continue for bonds, we are more positive on REITs, assuming that rates don’t run away to the upside. REITs have historically outperformed in a rising dollar environment. Small and midcap stocks performed well but, as with value, underperformed on a relative basis versus large company stocks.

Sectors
Only three sectors outperformed the S&P 500 last year, further confirmation of the narrowness of the rally. We are looking at some of the laggards from last year as potential investments. We are particularly interested in energy.

Economy/Market Indicators
Credit spreads continue to trade a very tight levels, although they have risen over the last month. For the full year, though, spreads narrowed by nearly 19%.

Economic Data
I’ve included in the chart below some of the more interesting economic data changes over the last year. For the overall economy, the CFNAI shows growth as just a little below trend. Most surprising stat on the list is, in my opinion, the 6.1% rise in existing home sales, even in the face of rising interest rates. It appears that people are getting accustomed to mortgage rates at these levels. Also of note was the 6.7% rise in auto sales, another surprising result in a rising rate environment. More By This Author:Weekly Market Pulse: Questions For The New Year
Weekly Market Pulse: Don’t Be A Sheep
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