QVMS - Q4 2023 CIO Overview And Outlook

2023-12-25 08:15:00 ET

Summary

• We have experienced a sequence of rapid and forceful rate hikes as the Covid exit occurred, to a multi-month “no change in rates” period, to the beginning of a sequence of rate cuts. The debate among market agents is now focused on how low rates will go, when, and at what pace.
• The US economy is slowing but not in recession. The stock market has exhibited a strong rally that has spread more widely. Earnings of most companies have exceeded earlier expectations, and those expectations are being revised upward for 2024.
• Politics and war are the dominant themes for the markets to address in 2024. The issue of the Fed and inflation is secondary as we start the year.

The year-end 2023 outlook starts with a Federal Reserve on hold. The financial markets have witnessed a dramatic “pivot” in policy. The outlook for interest rates went from “higher for longer” to “high for a while” to an expectation of rate cuts in 2024. All this happened in less than a half year and since the Cumberland mid-year outlook was published in the summer of 2023. So, we have now experienced a sequence of rapid and forceful rate hikes as the Covid exit occurred, to a multi-month “no change in rates” period, to the beginning of a sequence of rate cuts. The debate among market agents is now focused on how low rates will go, when, and at what pace.

The changes since mid-year 2023 include a Fed on hold while inflation is receding but still above the Fed’s targeted 2%. The American economy is slowing but not in recession. The US stock market has exhibited a strong rally that has spread more widely. Earnings of most companies have exceeded earlier expectations, and those expectations are being revised upward for 2024. More and more estimates are placing the S&P 500 above 5000 by year-end 2024, with an estimated annualized earnings rate close to $250. The stock market strength is broadening from the “FANG” or “Magnificent 7” or other metaphorical metrics to the entire market, and small-caps are exhibiting strength, as are most sectors.

Geopolitics have had a marked influence on the stock market. We continued to witness an expanding war in Europe; it is now entering its third year. Yet, funding for US defense and assistance to Ukraine is caught up in the political culture war politics within the United States Congress.

There is a marked difference between chambers. The Senate seems able to reach some compromises, while the House has an extraordinary record of dysfunction and failure in 2023. The House voted out the Speaker after taking 15 ballots to elect him. The House threatened a debt ceiling default. It has failed to offer any meaningful budget actions. And then it decided to go home for the holidays, leaving a full plate of unfinished business.

The Senate remained in session longer than expected and resolved the confirmation of the military appointments held up by Senator Tuberville. It passed the defense funding bill, along with others. The border issues are unresolved, and the divide between House and Senate and among the members in each chamber is acute and appears intractable. As we write this commentary, the outcome is unknown and unpredictable.

In 2023, we faced the launch of a new war when Hamas brutally attacked Israel on October 7. Evidence including Hamas’ own videos is coming out and shows how brutal Hamas is. Hamas leaders admit they don’t care about Gazan casualties. They admit they use innocent Palestinians, including women and children, as human shields. They were caught on their own videos mutilating captives with torture and murdering them. And the Hamas-Houthi-Hezbollah nexus of Iran-backed terrorists has now expanded actions to the Israel/Lebanon border and to the Red Sea-Suez Canal shipping zone.

The Houthi attacks have disrupted worldwide shipping, raised maritime insurance rates markedly, and altered the geopolitical balance. Example: Egypt needs Suez Canal revenues for its budget. The Suez Canal-Red Sea transit carries between 12% and 14% of the world’s shipping. That choke point damage is worsened by the water level deficiency in the Panama Canal. So, both major global shipping canals are impaired. That means longer shipping times, higher costs, and rising inflationary pressures of potentially huge proportions. Note that this has nothing to do with the Federal Reserve’s policy of fighting inflation. The Fed has no power to resolve any geopolitical issues. It can, and does, try to alleviate US dollar funding pressures that might upset financial stability.

Israel’s counterattack in Gaza and the intensification on the northern Israel frontier as it confronts Hezbollah are ongoing as this commentary is written. We expect both fronts to intensify. Israel faces an existential threat. Now the bad actors in Hamas do as well. And Hezbollah is an unknown. The Houthi missile attacks on shipping are inviting a multinational military response in Yemen. As we have written in other missives, we enter 2024 on a growing war footing. It is global.

As we enter the political year of 2024, the issues are incredibly complex. A former president has been barred from a state election. That now goes to the US Supreme Court for resolution. A congressman was expelled from the House. His seat is vacant, and the special election will feature two Democrats running against each other, with one of them endorsed by the Republican Party. American politics are simply extraordinarily unpredictable in their current incarnation.

Politics and war are the dominant themes for the markets to address in 2024. The issue of the Fed and inflation is secondary as we start the year.

Meanwhile, markets are sanguine and bond yields have dropped by over 100 basis points from their peaks, with stocks making new recovery highs.

The US Equity ETF portfolio is fully invested. The aerospace-defense sector has been, and continues to be, an emphasized overweight position. Another specific overweight position is in the small-cap arena. And we are overweight US domestic energy. This is fertile ground, as the small-caps have lagged for a long time. By many valuation metrics, small-caps may be poised for an extended period on a positive performance trajectory.

We haven’t seen much stock market reaction to the early primary political outcomes in the run-up to the 2024 elections. Market agents seem to be ignoring the theatrics and rhetorical displays. We expect those to intensify as the election cycle progresses from narrowing primaries to the general election in November.

We wish all readers safe travels during the holiday season and good health in the new year.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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