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Almost everyone got 2023 wrong…why should we even care about the macro outlook?
As we enter a new year and start a new journey, it is worth looking back at the past year to see which market predictions were correct and which were wrong. It is fair to say that most of the market's predictions for 2023 are far from the actual situation.
As the Federal Reserve takes unprecedented action to raise interest rates, bond yields face the risk of "taper tantrum" and asset prices are widely expected to plummet. In the first half of 2023, the Federal Reserve led by Powell firmly maintains its advocacy of fighting inflation and has no intention of confronting the FOMC. For asset markets, every step poses a challenge.
Unwavering interest rate hikes have led to significant losses in interest-rate sensitive assets such as mortgage-backed bonds and their underlying real estate, with the entire commercial real estate (CRE) sector in particular experiencing a sharp valuation correction, with transaction activity entering a deep freeze and office prices in many US gateway cities falling by more than 50% in 2023.
While the problems facing high-value, institutionally held commercial real estate may only affect professional investors, the pain of interest rate tightening has also spread rapidly to the regional banking system and has the potential to spill over to other areas of the economy; the surge in discount rates has led to a significant impairment of the net value of banks' "held-to-maturity" book assets, which has become the fuse for the regional banking system to fall into a serious panic, ultimately leading to the rapid collapse of Silicon Valley Bank (SVB) in the first quarter of last year.
Inflation remains above trend, the U.S. banking system faces Lehman-like contagion risks, the commercial real estate and private equity industries have stalled, and the Fed remains aggressive in fighting inflation. The combination of these factors should give U.S. risk markets a It’s a heavy blow and the stock market is due for its long-awaited correction, right?
If you think so, you may end up being the laughing stock; instead, the S&P returned 26.3% in 2023 and the Nasdaq returned 54%, and despite a 100 basis point surge in overnight rates, the 10-year Treasury yield remained essentially unchanged at 3.8% in 2023; active fund managers once again significantly underperformed the index (again), and the US stock market once again outperformed all other markets in the world.
The situation in 2023 is so good that you can enjoy high returns without speculating in cryptocurrencies. Even if you blindly choose investment categories, you can get a 10-15% return rate. Even the most cautious investors can get a 5% return from holding cash. 2023 is undoubtedly a year worth recording in history.
Why will 2023 be so strong?
1. After a tough 2022, investors are generally underweight
The traditional 60/40 portfolio set a new record for losses in 2022. Investors naturally showed a risk-averse attitude at the beginning of 2023, and generally held a negative view on the macro outlook. Risk exposure was low at the beginning of the year, and there was an overall lack of positive investment sentiment.
2. The U.S. economy is still far from a recession
Even though the market is flooded with pessimistic forecasts of a global economic slowdown, and the inversion of the yield curve is constantly regarded as a "conclusive" signal of an imminent economic recession, in fact the U.S. economy is still far from a recession, and consumption performance throughout the year is particularly outstanding.
3. Pessimism
Investors have chosen to remain pessimistic even as economic data have shown otherwise, with sentiment surveys based on soft data lagging behind hard data all year, as if it were more glorious to be bearish against the trend.
It is certainly commendable to be cautious, but we should also remember that developed economies and professionally managed businesses tend to be self-correcting, while humans typically learn from their mistakes, which is why market observers who are good at macro analysis may not necessarily make good operators.
4. The American consumer remains resilient
American consumers have long been criticized for overspending, arguing that this situation cannot continue, but by 2023, the net wealth of American households (after taking into account debt) remained near historical highs, continuing the upward trend of the past 40 years with little impact.
Although consumers' absolute debt levels have increased, the debt is insignificant compared to the dramatic growth in housing values, stock investments, pensions and other financial investments. The balance sheet of U.S. consumers reached $171 trillion, while liabilities in the third quarter of 2023 were only $20 trillion; in addition, 66% of the debt is mortgages, which is a more reasonable type of debt compared to borrowing for consumption purposes.
Even more impressive is that even as borrowing costs have risen rapidly, causing problems for regional banks (like SVB), commercial real estate, real estate funds (Blackstone has set redemption limits), and Chinese developers (Evergrande), the U.S. consumer has been remarkably stable, with their debt service ratio holding steady at a 40-year low of 10% and household debt as a percentage of GDP at its lowest level in decades.
While the rate and size of households’ excess savings (which peaked at $2.3 trillion) have fallen from their pandemic highs, they remain very healthy by historical standards, and much of the money withdrawn has been used to pay down debt, invest in stocks, and stimulate consumption.
In addition, WTI crude oil prices have fallen by about 40% from their highs in March 2022, providing strong support for consumers' spending budgets. At the same time, the correlation between oil prices and inflation expectations remains at a high level.
5. Hungry for talent
The U.S. job market is currently in one of the strongest cycles in history. The layoff rate has reached a new low, the number of job vacancies remains high, and wage growth has reached a 40-year high and is much higher than GDP growth. In this growth cycle , the bargaining power of employees has also increased, and many unions (such as the United Auto Workers) have obtained unprecedented concessions from employers in labor conflicts.
In short, life for the American worker has been better than it has been in a long time, which has led to strong consumer spending and confidence growth.
6. The U.S. housing market is back to a rising trend
Normally, when mortgage costs surge from a low of 3% to nearly 8% in just two years, you would expect to see a collapse in home prices, negative home equity and an increase in foreclosures.
However, the current economic cycle is anything but normal. Strong economic performance, a good job market, healthy immigration inflows, and soaring construction costs have left housing in short supply, with home prices rising in 2023 as the inventory of homes for sale has fallen to a 20-year low. It continued to rise throughout the year and hit a record high at the end of the year.
While interest rates may affect overleveraged borrowers and housing prices in the short term, in the long run, the prices of hard assets are ultimately driven by supply and demand fundamentals.
7. Large companies continue to make profits
In 2023, EPS of S&P 500 companies continued to rebound, returning to near post-pandemic historical highs at the end of the year, with EPS increasing by 0.4% compared to 2022, which is an outstanding performance considering the high benchmark and the massive liquidity withdrawal by global central banks last year.
In addition, because companies were able to pass on cost increases to consumers without affecting sales, profit margins were maintained at 12%, close to a 20-year high and well above the 9% average over the past 20 years, proving that corporate management has sufficient wisdom and strategy in dealing with the impact of the severe macro environment.
While the SPX's P/E multiples have increased, they have not reached extreme levels and are concentrated in large-cap tech stocks (the 7 big tech giants). In addition, valuations have never reached "bubble" levels, and the year-to-date retracement in 2023 was only 10%, which was a relatively mild year compared to the average of the past 40 years.
8. New Fed Tools
While we may be somewhat dissatisfied with the way the Fed handled quantitative easing and zero interest rate policy in the past, it must be acknowledged that the Fed (and the FDIC) responded to the regional banking crisis quite quickly and accurately, and they effectively controlled the spread of risks before anyone raised concerns about "Lehman 2.0"; in addition, this aid program is different from previous comprehensive bailouts (that is, it is not quantitative easing). Equity holders and subordinated creditors (such as AT 1 holders) have suffered actual losses, and the cost of using borrowing is quite high (OIS + 10 basis points). The main purpose of the entire program is to protect the interests of depositors.
The BTFP program, which successfully helped banks weather a period of deposit flight and eventually stabilized bank deposit balances, is likely to be withdrawn from the market in March as banks no longer require emergency liquidity support. In recent months, as OIS rates have fallen, banks have gained another arbitrage opportunity, causing BTFP usage to surge to record highs.
Regardless, this is a textbook case study of how to design and implement a good aid program, and it also shows that policymakers are constantly learning from past experience, just as CEOs of U.S. public companies are learning how to respond to a changing macro environment.
9. The Wealth Effect of Generative AI
While traditional macro watchers worry about borrowing costs and inflation, the rise of generative AI makes almost all of those concerns seem insignificant. Here are some statistics and charts from Accel’s annual Euroscape report:
In 2023, generative AI added more than $2 trillion in market value to the U.S. stock market, of which Nvidia accounted for nearly $1 trillion due to surging demand for its chips, and its market value added in one year was almost 70% of the total market value of cryptocurrencies.
It took the Nasdaq just 18 months to recover 80% of its decline from its 2021 high, compared to the 14 years it took the market to recover its decline from its 2000 high.
Nvidia’s weighting in the S&P 500 is now nearly as large as the entire energy sector.
About 60% of unicorns are related to generative AI, while traditional SaaS and cloud companies are more affected.
In short, the wealth effect of the past decade was driven primarily by quantitative easing, zero interest rate policy, and loose monetary policy, but now the main force in maintaining FOMO sentiment has shifted to generative AI, at least in the short term. In addition, compared to cryptocurrencies, AI can distribute the wealth brought by FOMO to a wider group of people, thereby creating a higher "wealth circulation velocity" and thus driving the development of the overall economy.
10. "Turn"
Of course, the Federal Reserve and the Treasury Department cannot be ignored in macro discussions. The Federal Reserve and the Treasury Department, which had been firmly fighting the market and waiting for inflation to fall back to 2%, have successively given signals that the tightening cycle is about to end.
First, Yellen surprised investors by announcing in its November quarterly funding announcement that the Treasury planned to shorten the maturity of its fourth-quarter debt issuance, which was widely viewed as an attempt by the Treasury to ease supply pressure on long-dated bonds, although fundamentally it might have been wiser for the Treasury to lock in lower funding costs while the yield curve was severely inverted.
For those who have lived through previous cycles, Yellen’s pivot can be viewed as a mild form of “yield curve control (YCC)” or “Operation Twist.”
Soon after, Powell also made the Fed's own "dovish turn" at the December FOMC meeting, slashing the interest rate dot plot, pushing the federal funds forward rate down by about 100 basis points and raising expectations for rate cuts in 2024 to more than 150 basis points.
All of this is happening against the backdrop of core inflation, although falling, still well above the Fed’s 2% target, and whether this is done in response to the potential risk of an economic slowdown, because the Taylor Rule shows that the Fed is “behind the curve,” or to revive the frozen commercial real estate/IPO markets, the result is the same — a dramatic shift in market risk sentiment heading into year end.
11. Opportunities can be fleeting if you are not careful
As with so many things, timing is key. Despite all the factors at play, the bulk of last year’s market gains occurred in the final two months, coinciding with Secretary Yellen’s November pivot and further spurred by Powell’s dovish turn toward the end of the year.
Finally, we come back to the Federal Reserve. We still have to respect the ruler of monetary policy...
What should we be focusing on in 2024?
As mentioned at the beginning of the article, misjudging the situation is common, and the views we put forward may be proven to be (extremely) wrong in the future, but after all, life is short, so why not have your own opinions?
Here are some key developments we think investors should watch in the Year of the Dragon.
1. Has inflation really disappeared?
As mentioned earlier, the main narrative for the second half of 2023 is slowing inflation and the Fed's policy shift, while the massive rise in asset prices in 2024 is expected to be driven by global interest rate cuts. Although core inflation in both Europe and the United States remains well above policy targets, expectations for interest rate cuts in Europe and the United States this year have exceeded 150 basis points.
With PMIs continuing to weaken, headline inflation finally declining, and the job market showing tentative signs of softening in the fourth quarter, risk asset markets are getting signals to go full steam ahead.
However, a deeper analysis of the inflation data shows that the decline in overall prices was mainly driven by a slowdown in goods inflation, while the services CPI remained high and actually rebounded sharply from its low point in the first half of 2023.
Moreover, easing supply chain issues are the main reason for slower commodity inflation in 2023, however the benefits of base effects will disappear this year and recent conflict in the Red Sea has begun to lead to a sharp increase in transportation costs.
On the services sector, continued high wage growth, a prolonged tight U.S. labor market, and a recovery in consumer confidence are likely to combine to keep services and “super core” inflation well above the Fed’s target.
All this is happening at a time when investor sentiment on bonds has reached its most in 15 years, while also significantly reducing holdings of commodities, arguably leaving the market ill-prepared for any inflationary resurgence that could occur in 2024.
2. Treasury's refinancing and bond maturity structure
Every day, pessimistic predictions are made about the U.S. government’s debt problems, highlighting that the debt-to-GDP ratio is approaching post-war highs and that interest payments on the debt exceed $1 trillion per year.
However, from the perspective of debt service coverage ratio, the ratio of interest expenses to GDP is still at a controllable level of about -6%, which is far lower than the level during the epidemic (-13% to -15%), and even lower than the global financial crisis period (-8% to -10%); furthermore, as U.S. consumers struggle to pay off debt, the U.S. private sector's financial position is actually much better than most developed markets.
Having said that, the net marginal supply of government bonds does increase over time, and the central bank's quantitative tightening program will further pressure bonds in 2024, so the market is cautious about the Treasury's quarterly refinancing announcement ( QRA) is of increasing concern, with the last announcement last year triggering a noticeable rebound in market risk sentiment towards the end of the year.
Secretary Yellen’s strategic shortening of the maturity of debt was a shrewd move that effectively pushed down long-dated yields, however, was this just a one-time bluff or will she continue to use this new method to further manipulate investor sentiment?
The Treasury Borrowing Advisory Committee (TBAC) outlined three possible but divergent debt maturity outcomes, depending on the mix of long- and short-dated bonds to be issued, which would be supportive of risk assets if the shift to shorter maturities continues and auction sizes are lower than expected.
The next refinancing announcement will be released on January 31, 2024, next to the JOLTS data on the 30th, the ISM/FOMC on February 1 and the non-farm employment data on the 2nd, which constitutes the first macroeconomic note worthy of attention this year. Event week, be sure to be prepared.
3. Slow down the balance sheet reduction
The December FOMC minutes raised the idea of an early halt to balance sheet reduction (i.e., slowing the reduction), mainly based on some technical discussions on the shrinking reverse repurchase (RRP) balance. The key quotes from the minutes are as follows:
“Several participants noted that the Committee’s balance sheet plans suggest that it will slow and ultimately stop the reduction of the balance sheet when reserve balances rise moderately above the level of ample reserves, and these participants suggested that the Committee should begin discussing the technical factors that could lead to a decision to slow the reduction of the balance sheet well in advance of making such a decision in order to provide the public with appropriate advance notice.” — December 12-13, FOMC minutes released on January 3.
The president of the Dallas Fed went on to say a few days later on January 6 that it would be appropriate for the Fed to slow down the pace of balance sheet reduction when reverse repurchase (RRP) balances become "low" (however defined); while the New York Fed's Williams later mentioned on January 10 that the Fed did not seem to need to slow down its balance sheet reduction yet. Mester of the Cleveland Fed further echoed this point on January 11, saying that "we still have a lot of reserves in the system, and there is no There is an urgent need to do this immediately, and we still have time... I am sure that this year we will start discussing this issue and making plans." Finally, Director Waller expressed his opinion on this issue on January 16, believing that "we will start thinking about this issue sometime this year. is reasonable".
Whenever it finally happens, don't say they didn't give us advance warning; easing could come at any time.
4. Tracking the flow of funds
Regardless of the source and purpose of the funds, deposit rates of around 5% have attracted a record $9 trillion in inflows into money market funds and similar vehicles over the past two years.
With the S&P 500 back at all-time highs, bond yields falling significantly, cryptocurrency prices rebounding sharply, and even the IPO market showing signs of thawing, will money market investors return to risk markets as the Fed begins cutting interest rates? How will they reallocate assets? This will be one of the key questions that markets will actively seek answers to in 2024.
5. Commercial real estate is in a deep freeze
Unlike the "only-going-up-never-going-down" housing market, office buildings are the biggest collateral damage from the Fed's anti-inflation campaign, and the commercial real estate market has sunk to its lowest point.
Rising financing costs, reduced bank lending, soaring labor and input costs, and the rise of remote work after the epidemic have fundamentally changed the attractiveness of office buildings. Starwood Capital Group (AUM: $115 billion) CEO Barry Sternlicht described the current situation as a "Category 5 hurricane," while distressed debt investment firm Oaktree (AUM: $170 billion) said that the risks facing commercial real estate are the most severe at present due to the upcoming wave of debt maturities.
According to Trepp, more than $540 billion in commercial real estate loans are set to mature in 2023, the most in a single year, and the industry is already struggling, with another $2.2 trillion set to mature over the next four years. In the current interest rate environment, borrowers are unable to repay or extend their loans, and loan delinquencies are already climbing.
Data shows that about 50% of commercial real estate loans come from banks, and the balance sheets of these banks were hit as early as the first quarter of last year due to unrealized losses on their portfolios. Of course, we cannot expect banks to bear all the losses alone. In the next few quarters, borrowers and lenders should jointly negotiate solutions to share this pressure. If interest rate cuts actually occur, these pains may be alleviated, but we still need to pay close attention to this area that may pose risks to balance sheets.
6. Will China shine in the Year of the Dragon?
If we talk about the areas most misjudged by (foreign) macro-strategists, China is probably the one.
Almost everyone predicts that after a severe epidemic lockdown, China will usher in a year of recovery with the support of macroeconomic policies.
However, worsening developer defaults, deepening youth unemployment, weak consumer spending, waning foreign interest, ongoing geopolitical tensions and tepid policy easing make China one of the worst performing markets in 2023.
Moreover, at a time when the world is worried about runaway inflation, China is experiencing its worst deflation in decades and its nominal GDP (measured in US dollars) has begun to stagnate.
Most Wall Street analysts are once again predicting a rebound in China, supported by loose monetary and fiscal policies and new measures to stabilize the real estate market. Will this year be a turning point in the fortunes of the world's second-largest economy, or will the situation remain unchanged? Only time will tell.
7. Investors’ positions and perfect market pricing
In stark contrast to the situation at the beginning of 2023, investors at the beginning of 2024 were actively holding long positions in almost all risky asset classes except commodities.
Investor optimism is not limited to stocks, with fixed income and corporate bond inflows also hitting record highs in 2023, and investors also actively holding long positions in the new year.
Additionally, short interest in ETFs like SPY and QQQ has fallen to one of its lowest levels in five years, while S&P 500 option implied volatility has fallen below the 20th percentile level over the past 30 years.
Options price distribution suggests there is a good chance the SPX could rise more than 10% in 2024, yet Citi’s POLLS index (Positioning, Optimism, Liquidity, Leverage, Stress) is flashing warning signs that investors may be too complacent.
Many wise investors often say, "You get what you pay for." The sharp rise in asset prices has raised the bar for expectations, and the stock market tends to be forward-looking, with forward P/E multiples often ahead of actual earnings growth. The US stock market will have to live up to the expanded valuation multiple expectations in 2024, and at the same time, investor complacency has reached its highest point in more than 5 years, and the margin for error has narrowed, which is indeed impeccable pricing.
With policymakers preparing to cut interest rates, we believe the macro outlook appears clearer than in recent years, however, we are also concerned that markets may be disappointed with the extent of policy easing as central banks appear more cautious in fully releasing liquidity in the wake of the pandemic.
We also have doubts about whether inflationary pressures have completely subsided and should be aware of various factors that could cause prices to rise again. The US economy could continue to outperform expectations, asset markets could pre-empt expectations of easing, escalating regional conflicts could cause supply chain disruptions again, and trade wars could return before the US election, to name just a few of the “known” risks.
In summary, while we remain more alert to risks, experience tells us never to be too pessimistic about the market, and patience will likely be our main guiding principle in the coming months.
8. The interest rate has been cut, then what?
There's an old trading adage: Markets tend to move in the direction that causes the most pain to most speculators, especially in the short term. The market has no emotions and certainly doesn't care how you think it should act.
Markets are the ultimate expectation discounting mechanism and they rarely move in the direction we most expect, which is why capital markets are the best casinos in the world and speculators love it.
Assuming the Fed does cut rates in 2024, what happens after that? Will a mere 0.25% or even 1.5% drop in borrowing rates instantly solve the world’s problems and drive prices up indefinitely? Is this really the answer to everything?
Goldman Sachs recently conducted a study that looked at the past ten interest rate cutting cycles and conducted a detailed cross-sectional analysis of the start and end scenarios and outcomes of each cycle.
The takeaway from this research is that while rate cuts generally help boost stock prices and bond prices are almost certain to rise, the long-term trajectory of asset prices actually depends on the ultimate direction of the economy. If the Fed's easing policy occurs during a period when the economy is not in recession and is still growing, the lower discount rate will further promote the growth of economic output, and asset prices will perform very well.
Conversely, if the rate cut is due to an impending recession, stock prices will likely fall because a downturn will lead to lower corporate profits and a contraction in price-to-earnings ratios.
Therefore, interest rates themselves are not a panacea for solving the world's problems, but rather a catalyst for reaction functions. We must consider the context of global overall output to fully understand the impact of interest rate easing. Macroeconomic analysis ultimately depends on the economy, and I hope to provide some valuable insights for friends who have read this far.
We would like to thank everyone who has supported SignalPlus since its inception. We are extremely excited about what SignalPlus and the crypto space can achieve in 2024, and can’t wait to share it with you when the time is right. Please continue to stay connected with us through our official X account, TG, and WeChat group. We look forward to your comments and feedback.
I wish you all smooth trading and profitable 2024!
