2023: Now For the Harder Part

Michael Grant

• CPLIX reduced its net equity exposures in late July on the assumption that further improvement in inflation would be harder to come by due to the stickiness of labor incomes.
• There will be a time to acknowledge the heightened recession risks, but that is a storyline for 2024. For now, we are at the stage of the cycle where “good news is bad news.”
• We continue to emphasize a mix of select quality GARP opportunities and cyclicals that appear too cheap in the absence of a recession.

In last quarter’s review, we stated that the “Easy Part” of 2023 was behind us, and the third quarter confirmed this belief. Equities succumbed to a bearish mood in recent months, though the correction from the highs of early July has been orderly. The disinflation narrative that led markets higher from October 2022 into July has been suppressed by several less supportive narratives that imply equities could be stuck between a rock and a hard place (aka, the resilient economy).

CPLIX reduced its net equity exposures in late July on the assumption that further improvement in inflation would be harder to come by due to the stickiness of labor incomes. US consumers were never the source of the pandemic surge in prices but are now positioned to demand higher wages. This stubbornly energetic labor force is one reason the Federal Reserve will be slow to temper its restrictive policies and points to a “higher for longer” setting, which is weighing on equities and bonds alike.

This tightening of financial conditions is occurring in the context of an economy that seems well placed to absorb it, for now. The consumer is in good shape, employment markets are firm, corporate profit estimates are moving higher and fiscal policy is unusually pro-cyclical for this stage of the expansion. Higher yields thus appear well justified on the back of a resilient economy and a hawkish Fed. There will be a time to acknowledge the heightened recession risks, but that is a storyline for 2024. For now, markets are hostage to the direction of oil prices and the US 10-year Treasury yield—for better and for worse.

For much of the past 40 years, interest rates would be declining to new lows at this stage of the expansion, providing a liquidity impulse through refinancings and housing demand. Instead, investors are confronted by the gradual drain of liquidity that is apparent in the narrowing gains of almost all financial prices. Nominal economic growth is still healthy, but the persistent contraction of money and credit implies this has an expiry date. The soft-landing thesis will remain suspect in the eyes of investors until something changes here. And the longer the economy remains resilient today, the greater the likelihood of an eventual harder landing.

This higher level of real interest rates speaks to the time value of money and contrasts distinctly with the post-2008 era of “free money.” The important conclusion is that valuation should be imperative to investment selection after a long absence. In other words, it is becoming increasingly difficult to justify a growth-at-any-price mindset. For CPLIX, we have avoided the latter stocks and continue to emphasize a mix of select quality GARP opportunities and cyclicals that appear too cheap in the absence of any near-term recession.

CPLIX Positioning Outlook

We advise clients to prepare for a different kind of decade ahead and the evidence of this is rolling in fast. Today’s financial cycle is quite different from that underpinned by the era of low and stable inflation. Equity exposures will need to be tactical and able to navigate a rising flurry of cyclical inflections that are different from the experience of many investors.