September 2023 | Quarterly Letter

"The question is, is the glass half full or is it half empty"

-Anonymous

It is not clear who first posed this question, setting up a structure for defining one’s basic attitude as one of optimism or pessimism. Obviously, viewing the glass as half full is optimistic, half empty is pessimistic. With regard to the economy and the markets, the half-full/half-empty construct applies nicely since the outlook is never crystal clear, and one is forced to make judgments that are influenced by one’s basic way of looking at things. That is certainly the case today as there are conflicting ways to view many of the elements that make up the economic and market outlook. In this letter we review some of these in the context of the stock and bond markets.

STOCKS – HALF-FULL OR HALF-EMPTY? The half-full view is supported by the fact that parts of the U.S. economy are performing very well. Gross Domestic Product (GDP) is being reported at higher than expected growth rates, unemployment remains near record lows, and inflation has fallen dramatically in the last year. Stock markets need underlying economic strength, and they seem to be getting it today.

The positive view is further buttressed by the emergence of Artificial Intelligence (AI) as an available tool that may have the capability of enhancing productivity, which in turn would lead to higher GDP growth rates in the future. While AI is early in the development stages, investors have heartily endorsed any company that has a demonstrated potential in this area.

The half-full view is also taking a constructive view of the U.S. economy in terms of its ability to achieve a soft landing. This may be the argument that buoys investors’ spirits most, for if achieved, a recession with all of its negative consequences would be avoided. To achieve this soft landing, GDP would have to remain positive while inflation declines to near the 2% target and unemployment remains low. Upon achieving such a state the Federal Reserve (Fed) could begin easing interest rates toward a more neutral level. A soft landing would then have been achieved.

These are all positive items that reflect well for the half-full advocates. However, those on the other side, the ones who see the glass as half empty, have their doubts. They make the point that while a small group of stocks are performing quite well, the broader market is languishing. There is considerable dispersion among the various indices, and it is easy to conclude that the market lacks the broad upward sweep among most stocks that characterizes truly strong markets. That small group of stocks that is performing so well have reached an inordinate size within the indexes, and it should be remembered that concentration, while it is working is great, in the end represents a risk factor for the broader market.

Returning to the soft landing scenario, there is a sharp difference between the half-full and half-empty views. The half-empty view counters with the argument of history. Soft landings are very hard to pull off, and rarely do they occur. The need for a soft landing only occurs after a period of monetary tightening, the goal of which is to reduce overall demand in the economy. Reduce demand and you reduce growth. Reduce it too much, and you have a recession. It is very difficult to get it right.

What is our view of the stock market? We appreciate arguments on both half full and half empty. But, this market does not possess the kind of internal unity we prefer. To have only a few large stocks leading the parade while all the others lag behind is not a sign of health. We also note that all of the indices are still showing negative returns when measured from the end of 2021. It is easy to forget just how bad last year was. And, while we hope for a soft landing, realistically, the odds still favor recession. This is not a prediction of a recession, but because there are still a number of recessionary warning signs, we believe it is prudent to remain on recession watch.

Sustainable bull markets in stocks typically occur when the economic glass is more than half full. While we cite favorable economic numbers above, it would be a far more supportive environment if the economy and companies were not having to compete with restrictive monetary policy, something that the Fed is projecting to be in place for some time. Over the long run, however, there is no question where we stand. The stock market will have bull markets and bear markets, but in the end we believe the upward trajectory of stocks will be the prevailing trend.

INTEREST RATES – HALF-FULL OR HALF-EMPTY? The question of interest rates is always of critical importance. They define economic activity in so many ways. Credit is the grease that makes the economic wheels turn, interest rates provide a hurdle that companies and consumers must clear to effectively manage their affairs, and as noted above, they can be either stimulative or restrictive of economic growth. Also, interest rates bear directly on bond yields and total returns. All things considered, a half-full view assumes lower interest rates. After a decade of extremely low interest rates following the financial crisis of 2007-08, we now find ourselves in a higher interest rate environment. The Fed has federal funds at 5.5%, and the 10-year Treasury trades above 4.5% for the first time in many years. On a historical basis these levels are not extreme, but compared to what we had become accustomed to, they feel extreme. Are they here to stay?

The half-full view would start with the basic assumption that the economy possesses the ability to sustain a growth rate of around 1.8%, a number that is widely accepted as consensus. This number is based on population and immigration trends plus productivity. Many would argue that a growth rate that low is not compatible with high interest rates. Part of the interest rate equation is demand for funds, and high demand comes from high growth. Furthermore, a low growth rate is not normally associated with high inflation. If the economy grows at around 2% and inflation is 2% (we assume the Fed will be successful in achieving its target), the case for a federal funds target of 2.5% seems plausible, which is less than half the current rate, and implies lower long-term interest rates also.

The half-full view also maintains that the Covid period brought with it many economic distortions that are still being worked out and that the desirable state of pre-pandemic economic conditions can be regained after a lengthy transition. Among these conditions are interest rates which reflect sustainable real economic growth and inflation rates for the U.S. economy. Right now, the Fed’s primary objective is to reduce inflation to their target level, which, if successful, will likely result in lowering interest rates.

On the other hand, the half-empty view also has its basic assumptions about the interest rate environment. Essentially, this view holds that the decade after the financial crisis was abnormal, a long corrective phase when the excesses of the previous cycle were gradually wrung out. That all ended with the arrival of the pandemic when fiscal policy turned expansive and secular trends began to change. In essence, the half-empty view believes we are now back to conditions that would be considered more normal by longer historical comparison, and thus, higher interest rates are here to stay.

The half-empty view that rates are high for good reasons posits that secular trends are in fact changing. Higher interest rate advocates point to the fact that the economy seems to be defying the effect of higher interest rates. Its ability to keep growing in the face of restrictive policies must indicate that something is different. It may be that changing secular trends are pushing the neutral rate of interest (the theoretical interest rate at which growth is neither stimulated nor constrained) higher. If the neutral rate turns out to be higher, the terminal federal funds rate would also be higher.

Our view on this question of interest rates is nuanced. It is important to distinguish between the short term and the long term. The Fed is expecting interest rates to be elevated for the next couple of years, noting the economy’s strength in the face of restrictive monetary policy. Also, the fact that the neutral rate is theoretical makes for greater uncertainty. Our view starts with the assumption that the Fed will be successful in reaching its target of 2% inflation. That will imply lower interest rates. That said, we also believe that we are not likely to revisit zero interest rates, thus, rates are likely to be higher in coming years than they were in the post financial crisis years. Over the short-to-intermediate term the interest rate glass is definitely half empty. However, over the longer term we expect lower interest rates and see the glass as half full.

THE CRAWFORD VIEW. We have never claimed clairvoyance or prescience. We certainly don’t have it with regard to the two questions we have discussed. But we do have two foundational assumptions that we rely on when thinking about issues like those we have discussed. Our investment philosophy rests on the assumption that the future is unknown and the range of possible outcomes for investment is wide. We rely on the resiliency and adaptability of the U.S. economy as foundational reasons for optimism. And, we rely on the resilience and adaptability of high-quality companies as a foundation for optimism.

Our normally optimistic view, spiced with a dash of realism, becomes half full, or as one friend of the firm labels it “cautious optimism.” Whatever the appropriate term, we believe in the U.S. economy and its institutions, and we believe in high-quality securities. And we look forward to successful investment in the future based on these assumptions.

Thanks so much for reading, and we look forward to the next occasion.

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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