“Well, isn’t that Special?” The famous line from Saturday Night Live certainly describes the November/December everything rally. The fourth quarter can only be described as spectacular. Like Waiting for Godot, a play about two vagrants waiting for Godot who never comes, this market has been waiting for a recession for the better part of the last year and a half. No one expected that the US could beat inflation without causing unemployment to rise and an economic recession. This could be the calm before the storm, but the market is convinced that the US economy has stuck the landing.
What do we have to credit for this good fortune? It wasn’t earnings; fourth-quarter earnings estimates declined almost 8% throughout the quarter as topline pressures (due to less inflation) caused margin headwinds.
Interest rate declines powered markets higher, causing the “everything rally.” Two months ago, the 10-year US bond was at 5%, and Jamie Dimon and many other experts debated whether 6-7% would be the next stop. However, interest rates quickly reversed and returned to sub-4% in a vicious about-face, sparking one of the best bond rallies in history. Inflation declined to the upper 3% range, overstated as rent inflation is still listed at 6% in the November CPI report.
Rent inflation does not measure the current month’s leases, but rather the last 12 months’ average, as rents typically are for one year. This inflation measure lags reality by about 12 months. I believe CPI should be close to 2% by the end of the first quarter of 2024, perhaps even lower. Markets have sniffed this out and decided that maybe inflation was transitory after all. How could we avoid a recession after such a dramatic increase in interest rates and so many floating geopolitical icebergs suddenly rising without warning?
One possible explanation is that Artificial Intelligence (AI) may be the salve for the market’s wounds. Certainly, it would explain why technology was really the only game in town for the stock market last year.
The only other time the Federal Reserve (Fed) achieved a perfect landing after raising interest rates more than four times occurred in the mid-1990s. In 1994 and 1995, the markets were unsteady due to interest rate increases as Fed Chairman Alan Greenspan was concerned about the reemergence of inflation. The economy powered through those rate increases led by another technological leap that accelerated productivity, this time the ubiquity of client-server technology to allow networking. A small company named Cisco became very big, linking companies’ employees together. Documents and projects could be shared for the first time, improving time to market and eliminating many secretarial roles.
This allowed local jobs to become global jobs at a fraction of the cost. Trade was a good word back then, as politicians actually ran on Free Trade agreements. At the end of the decade, the internet was introduced. The 1990s was arguably the greatest period for low inflation but strong economic growth in the post-World War II period. At the end of the era, the US government had a budget surplus, low inflation, and booming growth. All of this was led by the productivity explosion from networking and the internet that benefited both top-line and margins.
We feel AI has a similar promise. Much of the spending on AI is occurring at big tech companies for large language models. Given the price of entry, it will be hard to replace big techs as the pipes of AI, just as we saw with Cisco’s routers, which were the pipes of the internet. Once these models reduce mistakes, which we expect in 2024, many white-collar jobs will become much more efficient. For example, Google recently advanced after a report that AI sales tools in the advertising department allowed them to reduce sales professionals. If Google can write the same number of ads with fewer people, margins will potentially increase. While the big tech giants are the nearest-term beneficiaries, every sector in the S&P 500 Index will be able to use AI in the years ahead to enhance efficiency.
Just think – estate lawyers can potentially produce more wills with AI writing most of it and a person just checking specific details. Further, think how many fewer writers will be needed to script a television show. This was one of the major issues during last summer’s Hollywood strike. Recently, I asked Google’s Bard to write a script like Aaron Sorkin, arguably a much better-than-average writer. Sounded close to me.
One possible trapdoor for the markets in 2024 could be that inflation is picking up in the second half of 2024 due to energy, consumer goods, and rent deflation becoming lapped. As they seem to do annually, healthcare and insurance rates will increase next year. If the economy doesn’t receive the productivity boom from AI that we anticipate, this could cause inflation to start increasing. The US has very low unemployment and an immigration policy that will most likely be stricter no matter which party wins in 2024.
Part of the 1990s economic miracle was fueled by globalism. During the 1990s, China began its long march to First World prosperity, and Eastern Europe joined the Western world economically as workers and consumers. This part of the 1990s playbook looks like a wonderful dream in 2024. In the 1990s, one needed Cisco and the internet to enable a global workforce and to scale global manufacturing. Importantly, there was also political will to allow free trade. Currently, one world is being divided into two blocks, and few leaders on either side seem to understand the downside.
This will put even more pressure on AI to fuel output productivity as baby boomers retire and fewer younger people enter the workforce. No political party in any democratic country is running on free trade and more immigration. “Davos” has become a dirty word.
The great thing about AI is it can increase workers’ productivity, which is needed as most government policies are hurting productivity and barriers rising worldwide. With AI’s power, we think the market is likelier to go parabolic on the upside than parabolic on the downside. Just like Prince, AI may allow the market to party like it’s 1999.
Rhys Williams, CFA
Chief Strategist, CIO, All Cap Equity & SMID Core Equity
Chief Strategist, CIO, All Cap Equity & SMID Core Equity
Rhys Williams joined Spouting Rock Asset Management (SRAM) in 2019 and is the chief investment officer for the All Cap Equity and SMID Core Equity strategies.
Prior to SRAM, Rhys held various roles at Columbia Partners including principal and acting chief investment officer. He also served as a member of the management committee, equity management team, team leader for the small cap portfolios, and managed the firm’s single-strategy hedge fund endeavor. Before Columbia Partners, Rhys was a senior vice president at Prudential Securities where he successfully managed small and mid-capitalization stock portfolios. He was also a journalist in the Moscow office of The London Sunday Times before joining Prudential.
Rhys earned a BA from Duke University (magna cum laude) and an MA in International Economics from Johns Hopkins University. He also holds a CFA® designation.
The views expressed are those of the Spouting Rock Asset Management (“SRAM”) platform, as of January 18, 2024, and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. There can be no assurance that any SRAM strategy or investment will achieve its objectives or avoid substantial losses. There can be no assurances that any of the trends described will continue or will not reverse. Past events and trends do not imply, predict, or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.
