Three months ago, given unusually unsettled conditions, we expressed caution. Inflation had just turned up again (from 3.1% year-over-year in July to 3.7% in September), the credit rating of the US Government had just been downgraded, autoworkers were on strike, oil’s price had topped $100/bbl., student loan repayments were restarting, interest rates were at 16-year highs, bank credit was tightening, and war in Ukraine continued. And that was all before Middle East tensions exploded to multi-decade highs following the brutalities of October 7.
However, in these last three months, inflation cooled, the price of oil declined, economic growth strengthened, geopolitical tensions simmered rather than boiled over, and markets recovered. Perhaps the most important change for markets was that whereas three months ago, the Fed had recently reiterated that we should expect interest rates to remain “higher for longer”, today the Fed has telegraphed it has “paused” rate increases with interest rate cuts now expected as early as March. It is hard to overstate the importance such a shift in Fed posture has on markets.
One thing that hasn’t changed is that US stock market performance continued to remain unusually concentrated in the largest companies – specifically, in the so-called “Magnificent 7”: APPL, MSFT, GOOG, AMZN, NVDA, META, and TSLA, which now account for over 28% of the S&P 500 Index.
Over the full year, economic growth greatly exceeded consensus expectations and interest rate volatility remained higher than at any time since the financial crisis of 2008-9. For several years prior, interest rates had been so abnormally low that we took the unusual position of shifting bond portfolio average maturities shorter than those of the market indices. But in 2023, our decision to extend maturities back toward neutral (i.e., matching bond index average maturities) proved well-timed and was beneficial to bond portfolio performance (but not as beneficial as was our short maturity stance in the bond market’s horrible year of 2022.) At this point, interest rates that are high relative to recent years are just approaching normal from a longer perspective. This normalization improves prospective fixed-income returns.
2023 was a better-than-average year for our absolute performance overall as well as for stocks, bonds, REITs, and market risk hedges, but private real estate struggled. Our relative performance in US stocks lagged last year as should be no surprise in an environment in which just a few of the largest, most expensive stocks outperformed.
The overall stock market (including, by definition, those largest seven stocks) remains unattractive. But excluding those largest stocks, the market is somewhat more appealing. The outperformance of the largest stocks has been fueled more by speculation (that is, by market psychology) than by fundamentals and the extremity of that outperformance increasingly looks like an unusual opportunity to invest outside of that narrow group. This set of conditions calls for maximum diversification across stock market size, geography, sector, and across asset classes.
One of our most important roles is to get and keep investor portfolios diversified. That always sounds good in theory to investors. In practice, it’s one of the hardest things to do, because it always requires leaning away from what has recently done well and leaning into what has recently lagged. That is seldom comfortable, does not come naturally to most investors, and can often feel painful.
We certainly don’t know when the largest growth stocks will stop outperforming everything else. But uncertainty such as that is exactly why diversification is critically important. None of that implies performance implications over the short term (for example, for the coming year), but history is abundantly clear that the most popular and expensive stock groups are not the subsequent leaders over longer-term horizons of ten years and more.
Unfortunately, one thing that has not changed in the past three months is the outlook for the US deficit and debt. Total Federal bond debt topped $34 Trillion, having expanded 45% in just the last four years (a period in which control of Congress was not limited to either political party.)
In fiscal 2023, with a growing economy, Federal tax receipts were $4.44 trillion while Congress spent about $6.1 trillion, borrowing to fill the yawning gap of $1.7 trillion. Interest on the debt was $659 billion despite an average interest coupon of about 2%. As the interest rate for newly issued Treasury bonds is closer to 4% and the average maturity of Treasury debt is 6.25 years, that means that US government interest expense is set to nearly double in about the next 12-13 years even if the government were to suddenly balance its budget (which, of course, is not about to happen.) With rising geopolitical pressures from China, Iran, and Russia, defense spending at least is only likely to increase.
This has been building for a very long time and none of it creates problems for markets in the near term. But long term, there are only four options: 1) US bond default, 2) more government income (i.e., higher taxes), 3) less spending, or 4) inflation (i.e., devaluing the currency, and, therefore, the debt.) Default will not occur while lenders are to be found, and the dollar is the world's reserve currency, so lenders will be likely to continue to lend. In Congress, Republicans generally don’t want to burden the economy by raising taxes, while most Democrats and many Republicans don’t want to cut federal spending (even though it’s over 23% of GDP now.) So, neither is likely. That leaves inflation, which will probably be higher over the next 10-20 years than it was in the prior period.
That means lower real long-term economic growth, lower real (after-inflation) long-term stock and bond returns, and more reason to invest in inflation hedges like TIPs and real assets (such as pipelines and other infrastructure, natural resources, farmland, and eventually, real estate - though real estate is facing a severe credit crunch now). In bond portfolios, we’ve reduced traditional bonds in favor of a variety of forms of alternate credit that are less subject to interest rate risk. Broadly speaking, the prospect of higher long-term inflation is yet another reason to embrace significant diversification.
As we have entered a new tax year, we’ll use the new year’s additional tax flexibility to further reduce appreciated concentrations in stocks - especially in those high-flying seven that have become too popular - and we’ll redeploy the proceeds in ways that produce the most improvement in diversification in each unique portfolio.