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Market Outlook – Q1, 2024

- February 6, 2024

Balancing Act

You have to be working in this business more than 43 years, before 1980, to have ever seen anything other than declining interest rates and ultra-low interest rates. So it’s only natural to conclude that declining and ultra-low interest rates are normal. But maybe they’re not. You have to understand history and understand where the current period fits into history and understand how it’s different from normal, and what it is that shaped those differences.

Howard Marks, Co-Chairman of Oaktree Capital Management

The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function. One should, for example, be able to see that things are hopeless yet be determined to make them otherwise.

F. Scott Fitzgerald

Cartoon: Balancing Act

Summary

4Q, 2023 Market Review

2023 was a ‘snap-back’ year with strong relative returns from midstream energy and U.S. large cap stocks, while commodities and real estate underperformed

Asset Allocation Views

Diversification crucial in a year where investors will need to balance a very wide range of potential outcomes

If we don’t maintain sufficiently tight financial conditions, there is a risk that inflation will pick back up and reverse the progress we’ve made. In light of the easing in financial conditions in recent months, we shouldn’t take the possibility of another rate increase off the table just yet. Restrictive financial conditions have played an important role in bringing demand into line with supply and keeping inflation expectations well-anchored… So, given the rapid decline of the overnight RRP, I think it’s appropriate to consider the parameters that will guide a decision to slow the runoff of our assets. In my view, we should slow the pace of runoff as overnight RRP balances approach a low level.

Lorie Logan, President of the Federal Reserve Bank of Dallas

A common theme is that, while inflation is coming down, and that’s very good news, the price level is not coming down…So people are still living with high prices. And that’s not—that is something that people don’t like.

Jerome Powell, Federal Reserve Chairman (December 13 FOMC press conference)

Growth Inflation & Policy

U.S. Inflation

The consensus view that inflation will be back at the Fed’s 2% target by June is reasonable; however, there are upside and downside risks

Seasonals

While election years are known for easy monetary and fiscal policy, markets aren’t immune to stress during these years

2024 Elections

Heading into an election year, the percentage of Americans identifying as traditional partisan voters is at its lowest in at least 20 years

In a potential rematch, betting markets now favor Trump over Biden for the first time since late 2022; consensus seems to be building that Democrats must field another candidate

Biden’s approval rating has dropped to new lows even as inflation has eased

Key issues voters consider highly important for the 2024 presidential election include the economy, government spending, and border security

Implied Fed Funds

In response to Powell’s pivot comments on Dec. 13, speculation about rate cuts swelled; markets were pricing in the equivalent of seven cuts in 2024…

…Until Christopher Waller’s Brookings Institution speech on Tuesday (the probability of a 25bps cut in March dropped to a 50/50 coin toss on Wednesday)

Central Bank Balance Sheets

Divergence between central bank balance sheets and stocks potentially due to RRP liquidity stopgap; if the Fed continues with QT, liquidity will dry up as the year progresses

Other Sources of Liquidity

The Fed’s reverse repo facility (which has dampened the effects of QT) may run out by March; Treasury cash balance is currently at $750bn but may be worked down depending on policy and growth

Leading Economic Index

Downside risks if the Fed doesn’t cut: Conference Board LEI still signals “short and shallow” recession in 1H24 and weaker future economic activity, creating a volatile backdrop for stocks

PMIs

Downside risks: ISM Manufacturing contracting for 14 consecutive months (surpassing GFC downturn) and services sector activity, which tends to lag manufacturing in downturns, has also softened

Downside risks if they don’t cut: December saw a notable downturn in services sector employment

Consumer Credit

Downside risks: revolving credit balances continue to climb even with credit card rates at an all-time high; delinquency rates across all banks are starting to tick up

Commercial Real Estate

Downside risks for small banks: non-performing commercial real estate loans are approaching troubling levels

Small Banks

Downside risks for small banks: CRE loans account for 30% of small bank assets and only 6% of large bank assets; big bank performance since Jan 2022 emphasizes their strength

Financial Conditions

Upside risks: ease too much and you risk a reacceleration in the economy; not unlike what has happened since December 12; asset markets pricing in dramatic future easing and potential reacceleration

Upside risks: ease too much and you risk a reacceleration in the economy, not unlike what has happened since December 13; mortgage applications and inflation expectations are picking up

When the time is right to begin lowering rates, I believe it can and should be lowered methodically and carefully. In many previous cycles, which began after shocks to the economy either threatened or caused a recession, the FOMC cut rates reactively and did so quickly and often by large amounts.
This cycle, however, with economic activity and labor markets in good shape and inflation coming down gradually to 2 percent, I see no reason to move as quickly or cut as rapidly as in the past.

Christopher Waller, Governor of the Federal Reserve Bank

While equities are often viewed as inflation hedges, that argument weakens when costs exceed revenues. Throughout this cycle, it was hopes and dreams, not cash flows, that propelled the share prices of the expanding proportion of unprofitable Russell 2000 constituents. Before the credit crisis, 20% of Russell members didn’t make money. Today, it’s 40%. Median net income for small cap public companies is basically the same place it was 25 years ago, in nominal dollars.

Palm Valley Capital

Equity

Historical Fed

‘Soft landings’ are rare: while a rate cut seems to be on the horizon, history shows that the Fed cutting rates doesn’t stop the pain from prior hikes and their ‘long and variable’ lags

The historical probability of a decline is slightly higher than that of a rally after the first cut following a major hiking cycle

Historical Context

Are we underestimating a 1995-type outcome (i.e., a Fed cut will usher in a multi-year bull market)?

S&P 500 Cyclicals

“No better economist than the inside of the stock market” (i.e., market internals); recent bounce in cyclicals was not enough to send a definitive message re. a budding economic reacceleration

Global Valuations

Using a simple yield-to-earnings yield comparison (ERP), U.S. stocks are less attractively priced vis-à-vis bonds than at any point since the 1990s; valuations also appear rich from a Shiller PE perspective

Market Valuations

Emerging market stocks remain relatively cheap vs. developed markets

Emerging market stocks look cheap compared to U.S. large cap stocks; free cash flow yield of EM is ~2% higher than U.S. large caps, the widest margin in 15 years

Over the very long term, EM stocks have seen prolonged periods of over/underperformance vs U.S. large caps; the current 10-year performance divergence is among the widest in history

Chinese stocks have trailed the rest of the EM space, mostly due to recession/debt deflation concerns, but certainly not helped by geopolitical tensions (Taiwan)

Active management in small cap is key; profitable small cap companies have substantially outperformed the broader small cap universe

Small Cap vs Large Cap

There is a historic performance divergence between U.S. large cap and small cap stocks since Nov 5, 2021 (small cap peak)

Magnificent 7 vs S&P 500

‘Mag 7’ forward valuations have dropped substantially from peak levels, but still remain disconnected from the market; Apple is currently trading at 30x earnings, despite single-digit growth expectations

S&P 500 Sector Valuations

Most sectors within the S&P 500 are trading at premiums relative to their median valuations, with tech and financials reaching 10-year extremes; energy still offers value relative to its ranges

AI

Despite high valuations, the market is still at least trying to be discerning with AI ‘winners’ and ‘losers’

Magnificent 7 vs S&P 500

After failing to materialize in 2023, will earnings growth finally accelerate in 2024? If so, will the expected +10% be sufficient to grow into high valuations?

Market Valuations

Depending on the path of inflation and earnings growth, where might the S&P 500 trend to? Markets are currently pricing in 11.6% EPS growth over the next 12 months, implying a 19.6x P/E vs LT average of 17.2x

Secondaries Fundraising

While secondaries fundraising has been robust in 2023, it still represents just 4% of all private market fundraising over the last 7 years

Venture

VC fundraising is on pace for its worst year since 2016, driven by negative investor sentiment and a lack of viable exit opportunities

PE Buyout

PE buyout multiples continue to creep higher as elevated interest rates and looser covenants deter debt investors, causing equity share in new deals to climb above 60% for first time ever

We are spending like drunken sailors. Pre-COVID, the federal government was 20% of GDP in spending. Now it’s 25% of GDP… My father told me ‘if you’re in a hole, stop digging Stan’.

Stanley Druckenmiller, American Investor

Fixed Income & Credit

Treasury Market

We are in the biggest bond bear market of all time – the question is whether the future will look like the 2010s, or more in line with broader history

Yield Curve

While yields have come down considerably, the yield curve remains inverted; this time will have to be different to avoid a recession

Treasury Payoff

There’s always opportunity: the 2–3-year part of yield curve has an attractive risk-reward profile—yields could rise 1.5% in the next year and total returns would still be positive

High-Yield Spreads

Current credit spreads (at 3.6%) are significantly below 2022 highs and continue to suggest runway for the economy (i.e., a ‘soft landing’); spreads below 4% have historically resulted in below-average forward returns

Spreads by Sector

Credit spreads are near or below median across most sectors; while a recession still seems probable based on LEIs & manufacturing data, HYB spreads at current levels don’t corroborate that view

Muni vs Treasuries

Shorter duration muni yields are unattractive relative to Treasuries; while longer duration muni’s offer better tax-adjusted yields, spreads remains below median

GDP & Treasury Yields

The fiscal balancing act: Historically, long-term yields tend to follow GDP; but what will happen in 2024 depends largely on policy

Treasury Issuance

2023 Treasury issuance was the highest after 2020, and 2024 is gearing up for another big year—Q1 estimates alone outpace several historic FY issuances; the cost of outstanding debt continues to climb, now above 3.1%

Government Debt

Nearly $9 trillion in government debt matures within the next year, and will need to be rolled at much higher rates; bills comprise over 21% of total debt and are expected to continue to rise, yet eventually, the Treasury will need to extend durations

Net Interest Outlays

Treasury net interest outlays climbed to $730bn in 2023, nearly matching the CBO’s 2024 projection; tax receipts aren’t keeping pace and will need to play catch-up if the fiscal situation is to be kept under control

Foreign Holders

Foreign ownership of Treasuries has waned significantly since 2015 (while foreigners are still buying, they’re buying much less proportionally)

Private Credit

Private credit AUM surpassed $1.5 trillion in 2023, now roughly 5x bigger since the GFC

[Red Sea disruptions] could potentially have quite significant consequences on global growth… At this time when inflation is a big issue, it’s putting inflationary pressure on our costs, on our consumers, and ultimately on consumers in the U.S. and Europe.

Vincent Clerc, Maersk CEO

Having been in this industry for decades, I’ve never seen such strong support for nuclear power… A number of private companies are taking action now with plans to support the expansion of clean nuclear energy today and in the years to come.

Timothy Gitzel, Cameco CEO

Real Assets

Relative Yields

Midstream distribution yields trended lower as the sector broke out to upside but remains stabilized around an attractive 7.5%; free cash flow yields of the energy sector have declined

Geopolitical Risk

Heightened geopolitical risk from key global oil producers could increase volatility in the oil market if conflict escalates or spreads further in the Middle East

Geopolitical Risk

Commodities and gold tend to perform relatively well during wars and periods of general geopolitical stress

Long-Term Returns

While not useful for timing the market, it is useful to keep in mind longer-term cycles that are not observable on a day-to-day basis

Oil

Gasoline inventories saw the largest build in history during the last week of 2023; speculative crude positioning is back at pessimistic levels

Gas Prices & Crack Spreads

Gasoline crack spreads are up to $17/barrel from to $9/barrel in Q3, while diesel remains elevated at ~$33/barrel; despite crack spreads being ~30% lower y/y, gasoline inventories continue to build ( = lower prices at the pump)

Gold vs Fed Funds

The end of hiking cycles has tended to be positive for gold as the prospects of rate cuts reduce opportunity cost and the Fed tends to cut into a deteriorating deficit

Gold Miners

Gold producers remain disconnected from the underlying metal, partially for good reasons (rising costs, country risks etc.), but should provide leveraged upside if gold decisively breaks out

REITs

After a strong Q4, U.S. REITs have rallied 22% off 2022 lows; however, they still look wholly unattractive on a relative yield basis, despite looking more attractive on an absolute basis

Real Estate Valuations

Implied cap rates still suggest muted returns, but the opportunity set is improving from a valuation perspective

Private Real Estate Performance

Private real estate funds have not sufficiently marked down properties

Uranium

At COP28, 20 countries pledged to triple their nuclear energy by 2050, recognizing its role in achieving netzero emissions; long-term forecast point to uranium demand outpacing supply over the next two decades

Uranium stocks hit new highs following a spike in prices due to supply shortfalls from the world's largest producer; effects on demand should be minor, as uranium prices contribute little to total nuclear costs

There is no better teacher than history in determining the future. There are answers worth billions of dollars in a history book.

Charlie Munger (1924 – 2023)

Opportunistic

Yield Spreads

Despite yields falling ~80bps over the past two months, the attractiveness of most asset classes hasn’t materially improved relative to the 2-year Treasury yield

CEF Discounts

Median CEF discounts remain wide at -11.7%; U.S. Muni CEFs are trading at a compelling 12.7% discount to NAV, but relative muni yields are less enticing

Bitcoin

Historically, major bitcoin product launches have ended in ‘sell the news’—a trend that seems to be repeating with the recent launch of bitcoin spot ETFs

The price of bitcoin tends to increase after each halving event, the next which is likely to happen in mid-2024

MOVE vs VIX

The implied bond market volatility (MOVE) still isn’t showing the same level of composure as equities (VIX) and it’s unlikely that both markets are correct; 2s10s spread has historically lead equity volatility by 30 months

The shock of the rate increase recently has put a damper on banking deals and capital market deals. And that is because everybody doesn’t really know what their cost of financing is. The minute the Federal Reserve has concretely signalled that they’ve stopped raising rates, let alone the point at which they first do a rate cut, these markets will take off.

James Gorman, Morgan Stanley Outgoing CEO

Asset Allocation

Analogies

Even if not base case, returns during periods of stress (stagflation, bubble unwinds, banking crisis) contrast so starkly with the last 10-14 years that they should be considered

Treasury Market

Stocks and bonds have remained correlated despite volatility in bonds yields, but yields and correlations are at a key inflection point (~4%)

Stock & Bond Correlation

Fixed Income & Credit

The near record-high correlation between stocks and bonds means higher yields could hurt stocks and vice versa

Asset Allocation

Credit vs Equity

Credit tends to lead equities on the way out of bear markets; the rally in credit post Fed pivot continues to point to a more constructive outlook

Private vs. Public Market Returns

Outside of venture and debt, private market funds have disconnected from public market returns

CMEs (As of 12/31/2023)

Expected 10-year returns for both stocks and bonds fell as equities rallied and yields fell; muni bonds are no longer attractive on an after-tax basis

DISCLAIMER

Magnus Financial Group LLC (“Magnus”) did not produce and bears no responsibility for any part of this report whatsoever, including but not limited to any microeconomic views, inaccuracies or any errors or omissions. Research and data used in the presentation have come from third-party sources that Magnus has not independently verified presentation and the opinions expressed are not by Magnus or its employees and are current only as of the time made and are subject to change without notice.

This report may include estimates, projections or other forward-looking statements, however, due to numerous factors, actual events may differ substantially from those presented. The graphs and tables making up this report have been based on unaudited, third-party data and performance information provided to us by one or more commercial databases. Except for the historical information contained in this report, certain matters are forward looking statements or projections that are dependent upon risks and uncertainties, including but not limited to factors and considerations such as general market volatility, global economic risk, geopolitical risk, currency risk and other country-specific factors, fiscal and monetary policy, the level of interest rates, security-specific risks, and historical market segment or sector performance relationships as they relate to the business and economic cycle.

Additionally, please be aware that past performance is not a guide to the future performance of any manager or strategy, and that the performance results and historical information provided displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be inferred that these results are indicative of the future performance of any strategy, index, fund, manager or group of managers. Index benchmarks contained in this report are provided so that performance can be compared with the performance of well-known and widely recognized indices. Index results assume the re-investment of all dividends and interest and do not reflect any management fees, transaction costs or expenses.

The information provided is not intended to be, and should not be construed as, investment, legal or tax advice nor should such information contained herein be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation. An investor should consult with their financial advisor to determine the appropriate investment strategies and investment vehicles. Investment decisions should be made based on the investor’s specific financial needs and objectives, goals, time horizon and risk tolerance. This presentation makes no implied or express recommendations concerning the way any client’s accounts should or would be handled, as appropriate investment decisions depend upon the client’s specific investment objectives.

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DEFINITIONS

Asset class performance was measured using the following benchmarks: U.S. Large Cap Stocks: S&P 500 TR Index; U.S. Small & Micro Cap: Russell 2000 TR Index; Intl Dev Large Cap Stocks: MSCI EAFE GR Index; Emerging & Frontier Market Stocks: MSCI Emerging Markets GR Index; U.S. Intermediate-Term Muni Bonds: Bloomberg Barclays 1-10 (1-12 Yr) Muni Bond TR Index; U.S. Intermediate-Term Bonds: Bloomberg Barclays U.S. Aggregate Bond TR Index; U.S. High Yield Bonds: Bloomberg Barclays U.S. Corporate High Yield TR Index; U.S. Bank Loans: S&P/LSTA U.S. Leveraged Loan Index; Intl Developed Bonds: Bloomberg Barclays Global Aggregate ex-U.S. Index; Emerging & Frontier Market Bonds: JPMorgan EMBI Global Diversified TR Index; U.S. REITs: MSCI U.S. REIT GR Index, Ex U.S. Real Estate Securities: S&P Global Ex-U.S. Property TR Index; Commodity Futures: Bloomberg Commodity TR Index; Midstream Energy: Alerian MLP TR Index; Gold: LBMA Gold Price, U.S. 60/40: 60% S&P 500 TR Index; 40% Bloomberg Barclays U.S. Aggregate Bond TR Index; Global 60/40: 60% MSCI ACWI GR Index; 40% Bloomberg Barclays Global Aggregate Bond TR Index.