The questions that matter to markets in ‘24

Good morning. This is our first letter of 2024 and it would be traditional to devote it to some thoughts on what the year ahead will hold. But, having just received the news that we finished approximately last in the FT’s 2023 stock picking contest (see second item below), we are feeling a little jumpy about predictions. So, for now, we are going with questions rather than answers. Send us yours: robert.armstrong@ft.com and ethan.wu@ft.com.

Five questions for 2024

For risk assets in the US, 2022 was terrible and 2023 was great. We don’t know what’s next, but we do have some thoughts about what the determining factors are likely to be. We’ve stated these intimations in terms of five questions. Here goes:

What kind of rate cuts are we going to have? Consensus is that multiple cuts to the Federal Reserve’s policy rate are very likely. Equity markets are treating this as unambiguously good news. But rate cuts come in two flavours: disinflation-driven and downturn-driven. The latter kind are bad for stocks. The consensus bet seems to be for six 25 basis point rate cuts driven by pure disinflation, rather than concern over slowing or falling growth. Take a moment, however, to remember how the near-universal consensus of a year ago (recession) fared.

An interesting sub-question here is whether fiscal and monetary policy will be particularly supportive of economic growth this year, given that most democratic countries have elections coming up. Many pundits are arguing policymakers and office-holders will throw everything at markets to make sure voters enter the polls happy. But rates are still high; borrowing now costs something; and some governments are bent on fiscal tightening. How much stimulus can really be done this year?

What will long yields do? This is an evergreen point, of course, but particularly worth making now. We are consistently surprised by how much discussion of 10-year Treasury yields revolves around near-term policy expectations. But whatever happens to growth and inflation in 2024, there is a live debate about whether the 2-ish per cent yields that prevailed between the financial crisis and the pandemic are a historical anomaly or a normal state to which we are rapidly returning. If short rates keep falling and long rates stay around 4 per cent, we’re in a new world. 

What kind of stocks are the Magnificent Seven? Let’s imagine that economic growth disappoints badly this year (and, in answer to the first question, we get the bad kind of rate cuts). Do the Magnificent Seven Big Tech stocks outperform or underperform? We don’t know! In recent years, they have acted at some times like duration proxies, sometimes like growth stocks, sometimes like defensives. Which hat will the seven wear in 2023?

Was scary US bond-equity correlation just a bad dream? Stock-bond correlation spent an unsettling amount of 2023 in positive territory. Correlation tends to move in decades-long regimes, generally tracking inflation expectations. When inflation is tamed, downturns are all anyone thinks about, so stock and bond returns tend to hedge one another (ie, negative correlation). But when inflation is volatile and scary, such as in 2022-23, stocks and bonds fall and rally together, jerked around by changes in the inflation outlook. Charts like the one below, which we showed you in October, had some suspecting the dawn of a new regime:

Inflation today looks a lot less threatening than it once did. And correlation has started trending negative again. The chart below from Stuart Kaiser of Citi shows one-year rolling correlation approaching zero:

Maybe it was all a head fake? Either way, it’ll matter to markets in 2024.

Will global stocks stay resilient? US stocks, especially the Mag Seven, got all of the attention last year, but the rest of the world had winners, too. Investors warmed to the Japan bull case (we called that one right!) centred around corporate reform momentum and an end to deflation. As a result, an unhedged US dollar investor would have earned 19 per cent owning the Topix in 2023. Ex-China emerging markets posted a similarly strong year (total USD return: 20 per cent), helped by soaring Indian stocks and many EM central banks successfully steering through Fed tightening. Even in Europe, where stalling German and Dutch growth and sticky core inflation have hurt, stocks finished strong (total USD return: 20 per cent). All three — Japan, Europe and EM ex-China — enjoyed thumping year-end rallies.

What is remarkable about this is these markets achieved results close to those of the US, but without the US’s impressive economic growth. Are the results sustainable? And if global markets falter, can America keep rising?

Our nauseating 2023 stock picks

Writing up our 2023 entry in the FT’s stock picking contest, we said that 

We are not stockpickers. We don’t spend much time thinking about individual companies, and these picks were worked up under time pressure. We don’t have real skin in this game (under FT rules, we are not allowed to own individual stocks). So this ain’t investing advice!

That turned out to be almost the only sentences in the piece that were not catastrophically wrong. Though the final results of the contest are not yet tallied, we can say with confidence we came in last among FT journalists, and in the bottom few per cent of all entries. Our portfolio’s price return (from January 20 to December 29 2023) was minus 67 per cent.

We did not crash the car. We loaded it with dynamite, drove it off a ski jump and landed it in an active volcano. Hats off to those of you who went out and made the opposite bets:

We’d argue that our picks were actually worse than the raw numbers, horrific as they are, might suggest. Finishing last in a stock picking contest is not, in itself, a dishonourable result. Stock picking contests are not investing. Investing (as most people practise it) is a game of maximising expected returns over a wide range of possible outcomes, while trying to eliminate the very worst possibilities, all within parameters set by the investor’s risk tolerance and need for income. Stock picking contests are death or glory: the point is to win, and then strut around. Trying a high-risk strategy and coming in last is better than finishing in the mediocre middle. So, for example, in 2022, we went all short, and it worked really well.

And on the face of it, in 2023, we did take a high-risk, high-return bet and roll snake eyes. Our portfolio was basically an all-in wager on recession and collapsing liquidity: on the long side two very solid food stocks (Nestlé and Domino’s), and on the short side two high-flying tech stocks in troubled industries (Netflix in streaming and Coinbase in crypto) and one company that should suffer from high rates (the homebuilder Pulte). But we got the very opposite of the macro environment we were wagering on. The economy boomed and there was plenty of cash sloshing around. The most speculative assets, such as Coinbase, absolutely exploded. So: win some, lose some.

But that’s not what happened — or at least not the only thing that happened. We compounded our bad luck with three ugly mistakes.

First, and arguably ugliest, our short bet on Pulte betrayed a bad misunderstanding of how the housing market works, as we have discussed before. The idea was that higher rates would diminish housing demand by increasing the cost of ownership, hurting new home prices and Pulte’s share price. But what high rates did instead was simply freeze the market for existing homes: no one with a pre-pandemic mortgage sold their home unless they absolutely had to. That meant that all the demand from people who really need to buy a home was pushed into the new home market. New homes shot up from 10 per cent of for-sale housing inventory to a third, and Pulte had a great year.

The next mistake was thinking, as we did, that being long two staples stocks, in Nestlé and Domino’s, represented some sort of a hedge against the backdrop of our pessimistic outlook — a way of “protecting capital”, as we put it. But the two staples stocks were only going to outperform significantly in a recession; in a boom year, they were directionally the same as the three short bets.

Finally, we made an all-in bet on a macro outcome that was the market consensus, a recession. If you are going to make an all-in macro bet, and you bet with consensus, you open up the possibility of spectacularly bad returns, because you can be not only wrong about the macro picture, but also buying your portfolio companies at generally unattractive prices. Making a consensus bet means paying up at the outset.

Anyway, the whole thing is a crushing embarrassment, and we’re glad it’s finally over (we knew things had gone fantastically, irrevocably wrong six months ago, but in a stock picking contest there is no backtracking). Which brings us to next year: once again, we will be piling on the risk, but hope to do a slightly better job picking the risks. We are keen to hear your suggestions. (Armstrong & Wu)

One good read

Brian Potter on the unnecessary decline of US Steel.

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