Seeing Around Corners?
Over the last few weeks, I have been speaking to a number of groups on the topic of “Ready for 2024?” The question mark is an obvious and cheap hook but there is substance behind it too.
You see, the human brain naturally goes to “2024 Predictions” and yes, the financial world is hooked on predictions. Rob Arnott and I wrote a fun piece back in 2020 in which we encouraged an active-reading practice that I had learned from a very senior colleague back in my NY days: the “Sharpie treatment.” If it’s objective information you’re reading (a fact), keep it. But if it’s just an opinion, then generously apply Sharpie over the words and move on.
As an aside, my wife has independently discovered the same “algorithm” when it comes to general press. Her rule is simple: “I don’t read op-eds.” View that as our household’s mental-health survival tip for 2024, given the amount of ink this year promises to spill as we reluctantly barrel toward the November election.
Seeing Around Corners.
In the world of investing, when someone is regarded as a skilled investor, people inevitably end up saying things like “Jane can see around corners.” That’s doubling down on the idea of predicting the future with the extra kicker of implausibility that comes with defying the laws of physics. The angle is the angle, and you can’t bend light beams when convenient. Good luck with that.
But think about the expression “seeing around corners.” It conjures up images of urban warfare. Now think about how professional military personnel trains for urban warfare. Soldiers go through extensive drills to anticipate the various scenarios they may face when they turn a building’s corner and they pre-condition rapid responses to these scenarios. With a mental map of what the future may look like and a slightly faster response time, odds of survival go up slightly at every turn, which compounds when your job is to turn a whole bunch of corners behind enemy lines. The analogy obviously has limits — starting with the inadequacy of comparing anything else to the courage of military personnel deployed to serve their country — but there is something fundamental to learn there.
Prediction jockeys had a particularly rough 2023. Instead of a recession, we ended up with a US economy that added roughly $650 billions of GDP (net of inflation) and created around 2 million jobs. What’s more, 2023 was supposed to be the year China showed us how to thrive after “re-opening” from their strict COVID policies. Instead, China is struggling economically, and Chinese stocks were a rare loser among main asset classes last year (How’s 6 trillion dollars of value erased for ya?).
Given that making one-and-done predictions doesn’t seem like the wisest way to operate in this world, here is a framework for making decisions when the future is unknown. It’s a simple model, which means it has “long shelf life,” as my former teacher, boss, and Nobel Prize winner Bob Merton would say. Simply put, for anything that matters to you, sort out three scenarios:
Very bad
“Another day at the office”
Very good
For each of these scenarios, work out what things may look like and what reasonable odds of each are. When that’s done, make decisions that:
Don’t look silly in the most likely scenario (Nobody wants to look silly when the “obvious” happens…)
Don’t look naïve in the second most likely scenario (That’s the basic difference between amateurs and professionals)
Don’t blow you up in the third scenario (That’s called risk management)
With that, let’s talk about 2024.
What about 2024?
I really enjoy Allison Schrager’s writing. She recently talked about 2024 as “the year the economy stops being weird.” That seems right. At this point, not being weird looks like the much-heralded “soft landing” that the Fed has been hoping for. Despite it being a rare feat (based on the historical record of modern central banking), it looks like the most probable scenario, and it happens to be the “another day at the office” scenario. How grand would that be, huh?
The economy would slow a little (It rose 2.5% in real terms for the whole of 2023)
Workers would get a little less comfortable (Wage growth would cool and, net-net, unemployment would go up)
We would avoid an outright blowup on commercial real estate (Time would be on the side of orderly workouts, though refinancing the 1 to 2 trillion dollars of CRE loans coming due would make for late nights and long weekends)
As far as residential real estate is concerned, we would see more activity, and get a better sense of what “true prices” are
Oh, and inflation would keep coming slowly, but with a good amount of volatility around the landing path
Given where interest rates are at this point, the soft-landing scenario is one that favors long rates staying roughly where they are and short rates coming down (but not as much as the market is hoping), allowing the yield curve to revert to something that looks more normal (read: “steepen,” in Wall Street talk).
The big one is volatility in equities and spreads on risky debt. Those have been recently low relative to history. We should hope that the soft landing comes with a relatively mild return to more normal conditions: somewhat higher equity volatility and wider spreads on risky bonds (Right now, it looks like the direction of travel on spreads is in the opposite direction, given the amount of money chasing a limited number of deals in debt-land, but that’s the point of laying out the scenarios, to know where the world conforms and where data points in a different direction).
Now let’s talk about the second most likely: a harder landing. It is distinctly possible that the fix is in, and that the economy could slow hard and in a hurry (Renewed Tech job cuts hint at this). If the cooling overshoots, jobs could be shed much faster, which would prompt the US consumer to choose between making mortgage/credit-card payments and going out for dinner. This is a world in which banks keep credit tight, commercial real estate trouble spills out “bigly,” and residential real estate prices finally start moving along the lines Jay Powell spelled out back in 2022 (read: down). In that world, short rates would come down hard as the economy dips, disinflation turns into temporary deflation, and the Fed aggressively stimulates the economy. We would see fire sales migrating from liquid assets to illiquid assets. The silver lining in all of this? Bargains would reveal themselves with big bright neon signs around them. This “land of opportunity” would come with a serious spike in market volatility (think VIX 40 or higher) and credit spreads (think 500 basis points or more). Buckle your seatbelt…
Obviously, there is a third scenario, one in which the economy re-accelerates on the back of more jobs, higher productivity, and fiscal stimulus from the usual suspects (China given their deep economic troubles; a politically motivated and strategically confused US Congress, for good measure). This scenario would be a good one for fundamentals, but it could very quickly turn darker on financing if the Fed pivoted back to tightening the screws. In the interim, equity prices could charge ahead of fundamentals, and we would need to worry about bubble-era behavior. In short, we should worry that the “very good” scenario would encourage non-economic “very bad” behavior.
Before we close, let's explore the dark corners where some of the scarier scenarios lay, just in case we find ourselves facing something yucky when we turn the next corner.
We have already discussed the possibility of commercial real estate causing trouble, particularly for regional banks. So far, time has allowed banks to make provisions for bad loans. But it’s difficult to ignore the lingering taste of the old Savings and Loans crisis of the 1980s and 1990s, where forbearance only worsened the eventual moment of righteousness. For what it's worth, if the Fed cuts rates more than the three cuts already advertised, it could easily be because of a train crash in commercial real estate and banking. The recent news that banks may be forced into tapping the Fed discount window as de-stigmatizing “a fire drill” does not bode well. On the other hand, the recent announcement that the Fed would close the arbitrage (read: subsidy) in the program put in place after the 2023 bank failures suggests that the Fed is frustrated (and under political pressure) after, once again, unwittingly making bankers fatter. It’s doubtful all this bad blood would reduce their willingness to jump in to “help” if things went sideways. The Fed is a little bit like Lassie, loyal and eager to rescue, even if silly Timmy keeps stumbling down the same well.
Finally, if geopolitics continue to deteriorate, we could reach a tipping point that resembles hot war on a global basis with the larger powers — the US and China — engaging in a more direct manner. Implications range from an easy return of inflation to a serious civilian economic contraction if Taiwan or the Middle East become wider military theaters (Bloomberg estimates a conflict over Taiwan could trim the world economy by 10 trillion dollars, though we may expect more rationality from China than Russia or Iran, say). Ready for 2024 or not, no one is prepared for that. May we avoid the worst-case scenarios facing us through a happy combination of luck and wisdom. May we get to review the record in a few months, to see if 2024 was indeed the year the economy stopped being weird.