June 2024 | Quarterly Letter

Charles Kindleberger was a prominent economic historian of the mid-20th century, who, among other things, was a leading architect of the Marshall Plan after the completion of World War II. He authored over 30 books, the most famous of which was Manias, Panics, and Crashes, a classic that may have relevance for today. As a historian, he knew the facts of history, but he also knew the stories. We use his quote below as the basis for discussion of what we call the Covid economic cycle and its implications for investment.

“In economics what everyone wants is a number, but what they really need is a story.”

- Charles Kindleberger

Everyone wants a number and right now that number is 2%. It is the number that the Federal Reserve (Fed) has targeted in its pursuit of lower inflation, and it is the number that investors in stocks and bonds want. We believe the 2% inflation target is the critical element in the Covid cycle story, and success or failure in achieving that target will largely define the story of this cycle. In that sense, the Covid story is still developing; it does not yet have an ending. 

Stories are narratives that convey experience, ideas, or messages through a structured sequence of events. As such, they can be educational. Looking back, there have been many episodes in the economy and financial markets that we know the story of, and importantly, how they concluded. From these stories we have learned. There was the long buildup in the “nifty fifty” bubble that finally burst in 1973, leading to one of the worst bear markets of the century. We know how the great inflation of the late 70’s ended under the weight of Paul Volker’s incredibly high interest rates, setting the stage for decades of disinflation. In the next decade there was the dot-com bubble that also ended badly, followed by a short recession. More recently, the Great Financial Crisis was a cataclysmic event that led to the great deleveraging and ten years of expansion in the economy and consistently above-average returns from stocks and bonds. 

The latest cycle and its story is the Covid one. We all know its contours: economic shutdown, skyrocketing unemployment, extreme supply disruptions, almost immediate massive fiscal and monetary relief, and finally, 9% inflation that ushered in the latest phase of monetary restriction which established 2% as its inflation target. Covid as a disease is largely gone, but its economic and market influence lingers. We do not know how the story will end, but we do know that the 2% number will be critically important to its ending. And like all cycles, when we can look back on this one, we will learn something from the story.

A happy ending to the story would be the attainment of the 2% inflation target in a benign fashion. That is, the economy slows enough for inflation to continue its descent toward 2%, allowing the Fed to reduce interest rates and maintain sufficient demand to avoid a recession. This is the soft-landing scenario, the one that the Fed is projecting and the one that the stock market seems to accept as most likely. A less salutary ending to the cycle is also a possibility. This is the recession scenario that continues to be forewarned by an inverted yield curve, leading economic indicators, and gradually rising unemployment. Although it is becoming a minority position, we believe it is prudent not to dismiss totally the possibility of a recession, and to keep in mind just how difficult it is to guide to a smooth landing such a large and complex economy as ours.

Regarding the 2% target, many are skeptical that it can be achieved and maintained. History would suggest that it can, and we are taking the Fed at their word that they will steadfastly pursue the goal. The importance of achieving the goal cannot be overstated, for low and sustained inflation brings with it the prospect of an economy in proper balance and capable of periods of extended expansion. The only question is, how do we get to the 2% target that everyone wants? If it is by way of a soft landing, it will be favorable for stocks and bonds as both asset classes should benefit from lower interest rates. If it is by recession, it will be painful for stocks as earnings contract, but favorable for bonds as interest rates in a recession would likely fall more than in a soft landing. Either way, the story will only end constructively if the 2% target is reached. The soft landing will be the easiest on all constituents, but on the other hand, a recession would probably enable a quicker attainment of the target and improves the likelihood of its sustainability. 

There is another element in the story that requires discussion. It has to do with the nature of the stock market today. Consider the following: Just this year the S&P 500 is up some 15%, a spectacular return for 6 months. Contrast this to only a 5% return by the Dow Jones Industrials and 7% for the Russell Value index. Small capitalization returns are also anemic as the Russell 2000 is up roughly 2%. Size and concentration are ruling the day as an equal-weighted S&P 500 has returned only 5%. Something is not right in this picture. We have written before of the concentration in the market and how, in the past, it has not been a harbinger of future strength for stocks. While the comparison is not exact, this period bears more than faint resemblance to the “nifty fifty” era when about 50 large capitalization stocks led the market, only to see their share prices collapse in the bear market of 1973-74. Also, who can forget the dot-com bubble of the late 90’s when exuberance for the internet then was eerily like the enthusiasm for artificial intelligence now. We all remember how that bubble ended. 

Our discussion of these stock market trends is not a prediction of coming doom for the leading stocks or for the market in general. But it is a reminder that the healthiest and more enduring markets rely on balance and widespread participation. Often such characteristics develop in the aftermath of a recession and bear market when excesses in concentration are corrected. We don’t hope for a bear market, but we do long for a period of greater market breadth, one that reflects solid economic fundamentals undergirding the market.

The outcome for stocks and bonds as the Covid cycle seeks its end is one thing. There are also other questions that, at this point, are left unanswered. For instance, after the attainment of 2% inflation, will other parts of the economic environment be different from before? Bond investors will be especially interested in what level of long-term interest rates investors will demand in a 2% inflation world. Will economic growth be higher than pre-Covid levels and what will be the reasons? Will fiscal policy moderate, thus lowering the potential for a government debt crisis? The end of the Covid cycle will bring answers to some of these questions, but not all. 

The fact that future uncertainty is always with us is a key starting point in our way of investing at Crawford. It leads us directly to quality and our effort to reduce the range of potential outcomes for an investment. We acknowledge that quality and its identification through dividend consistency has not received full investor appreciation so far this year. There is nothing unusual about this as investor infatuation waxes and wanes over time. Regardless, our faith in our approach remains firm. We have the benefit of almost 44 years of experience, a time during which we have lived through a number of economic and market stories and, we hope, learned from them. Markets have a way of evening things out over time. Critically, we have learned that regardless of the story and its temporary twists and turns, the most important thing is to remain steadfastly consistent in our approach. This we will do, and we believe it will continue to yield satisfying results over the long run. 

Disclosures:

The opinions expressed are those of Crawford Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward looking statements cannot be guaranteed.

Crawford is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Crawford’s investment advisory services can be found in its Form ADV Part 2, which is available upon request.

Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.

Crawford reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

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