During the first quarter of 2024, the S&P 500 Index delivered a robust return of 10.6%, with investors directing their attention toward the brighter near-term economic prospects. Notably, both growth and value stocks saw positive returns, with the S&P 500 Growth Index achieving a return of 12.8%, while the S&P Value Index yielded 8.1%. Furthermore, large capitalization stocks outperformed small capitalization stocks, continuing a longstanding trend. The S&P SmallCap Index, in contrast, posted a modest return of 2.5% for the quarter, trailing the broader market by more than 8 percentage points.
As the quarter drew to a close, signs emerged suggesting that market participants anticipated a continued favorable economic landscape, with anticipated growth in corporate profits. The price-to-earnings ratio for the S&P 500 Index, based on trailing twelve months earnings, hovered around 27, surpassing the long-term average of 16 for this valuation metric. Additionally, the VIX, a gauge of expected market volatility, settled close to 16 by the end of the quarter, aligning closely with its long-term average.
In the fourth quarter of 2023, corporate profits increased at an estimated 8.7% on a year-over-year basis. The consensus forecast for corporate profits in 2024 centers on 12%. The consensus economic forecast indicates that real growth is projected to gradually increase throughout 2024. For the year, growth is anticipated to range between 2.0% and 2.5%. Underlying these forecasts is the assumption that the Fed will declare victory in its fight against inflation and begin to lower short-term interest rates in 2024.
There is some evidence the Fed has begun increasing liquidity and the fight against inflation is over, for now. The Monetary Base, a measure of high-powered money, began increasing on a year-over-year basis in September of 2023. Investors may be adjusting their expectations to reflect the increase in liquidity. While the yield curve remains inverted, the entire curve has drifted upward over the last three years. The upward move in rates at the long end of the curve indicates that investors have raised the consensus forecasts for inflation and real growth.
The nature of the current economic environment is ambiguous. While unemployment is low at 3.8%, the rate of growth of job creation over the last four years has been approximately 1.1% at an annual rate, well below average. Moreover, full-time jobs as a percentage of all jobs is at its lowest level since 2020. While job growth in the private sector has been disappointing, public-sector employment has been growing at a much higher rate. The number of government employees as a percentage of the total workforce has been increasing at an approximately 2.9% annual rate in the most recent quarter. Real GDP growth in 2023 was estimated at 2.5%, with the consensus forecasting a slightly lower rate of growth for 2024. The Index of Industrial Production has dropped in the most recent period, an indication that economic growth might be slowing.
Investors have shown a tendency to prioritize short-term shifts in Fed policies and the latest economic data when forming their stock outlook. They are eagerly anticipating the Fed's projected three rate cuts for the year, alongside fresh economic data indicating subdued inflation and moderate real growth.
However, there's evidence suggesting that the optimistic economic and profit outlook, which currently bolsters high market valuations, may not endure as economic policy changes unfold in the coming years.
The two most destabilizing policies lie in the continuation of substantial budget deficits and the anticipated hikes in tax rates. The Congressional Budget Office (CBO) has evaluated the latest budget proposed by the Biden Administration, forecasting that over the next ten years—the specified forecast horizon—the Biden budget will contribute roughly $18 trillion to the total outstanding debt. Throughout this period, servicing the debt is expected to reach approximately 3.9% of GDP, surpassing the current expenditure on national defense. Projections indicate that the annual deficit will swell from $1.6 trillion to $2.6 trillion over this timeframe, resulting in the outstanding debt reaching a record high of 116% of GDP by the end of the period. The primary drivers behind the spending increases are Social Security and Medicare, with no politically viable proposals available to curb the rate of growth for either program.
Last year marked only the second time in history that the credit rating for US debt was downgraded. The initial downgrade took place in 2011 during the Obama Administration when Congress and the President failed to reach a budget agreement. This deadlock ensued after the 2010 off-year election, during which the Democrats lost control of both the House and Senate following their decision to raise tax rates.
A similar scenario unfolded after the 1994 election, which saw the Democrats endure their most significant off-year election defeat since 1938. President Clinton, who had raised tax rates in the first two years of his administration, faced a Republican victory in the House for the first time since 1954. However, unlike President Obama, President Clinton successfully devised a budget that garnered bipartisan support in Congress. Ultimately, both parties managed to reach consensus on a balanced budget, leading to the elimination of the deficit.
President Biden is proposing an increase in tax rates to help reduce the budget deficit. Among The President’s proposals is a 33% increase in the corporate tax rate. The CBO scoring cited above includes the proposed increase in tax rates. The outcomes of past increases in tax rates suggest that the CBO estimate of tax receipts is optimistic. In the past increases in tax rates have produced a slowdown in economic activity and tax receipts that are far below expectations.
If a permanent reduction in the budget deficit is the desired outcome of any change in tax rates, then tax rates should be cut now. As President Kennedy observed in a presentation to the economics Club of NY on December 14, 1962:
“…, it is a paradoxical truth that tax rates are too high today and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now. The experience of a number of European countries and Japan have borne this out. This country's own experience with tax reduction in 1954 has borne this out. … The purpose of cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus “
President Kennedy proposed a significant reduction in tax rates to increase tax receipts. His plan was adopted as part of The Revenue Act of 1964. Tax rates were cut, and tax receipts increased. Similar tax policies were enacted during the Reagan Administration, with comparable results, tax rates were cut, and tax receipts increased as economic activity increased.
The most recent tax receipt data indicates a year-over-year decline. History suggests that raising tax rates would exacerbate this decline. Consequently, the Federal Reserve may find itself compelled to monetize the debt by purchasing Treasury obligations. Should the Fed assume the role of "lender of last resort," monetary aggregates will expand, potentially reigniting inflation as a significant concern.
The Fed retains the option to refrain from increasing liquidity; however, since President Nixon's closure of the gold window in 1971, the Fed has consistently opted for the path of least resistance by augmenting liquidity. Consequently, over the span of more than fifty years since 1971, the Consumer Price Index has surged from approximately 42 to 311. Additionally, the price of oil has soared from around $7 per barrel to $86 per barrel, while the price of gold has skyrocketed from $35 per ounce to nearly $2,360 per ounce. In contrast, from 1913, the year of the Fed's establishment, until 1971, the price of gold experienced a modest increase, rising from $22 per ounce to over $35 per ounce. Given this historical trajectory, it seems unlikely that the current leadership at the Fed will veer away from entrenched policies.
In the post-World War II era, Winston Churchill penned a six-volume history of the war, offering his unique perspective. This monumental work eventually earned him a Nobel Prize for Literature, largely owing to its depth and insight. Titled "The Gathering Storm," the first volume delves into the period preceding World War II, starting with the aftermath of the Treaty of Versailles. Despite the ominous signs, few paid heed as the storm brewed on the horizon. Investors would do well to broaden their perspective beyond the minutiae of the Open Market Committee's meetings. There are indications that a storm is brewing, and foresight beyond immediate events is crucial.
Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis
The information contained in this commentary represents the opinion of Affinity Investment Advisors, LLC and should not be construed as personalized or individualized investment advice. The analysis and opinions expressed in this report are subject to change without notice. The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations of economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.
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