Bridge Perspective – January 2024

A Year in Review – 2023

Summary:

Markets have a unique way of compelling even the most intelligent individuals to embrace humility. The year 2023 was remarkable, featuring unexpected drama across various sectors. It is appropriate to divide the year into three distinct yet interconnected segments: technology, macroeconomics, and geopolitics.

In the realm of technology, we made significant strides towards singularity, notably through the rapid advancements in large language models like ChatGPT and Bard. These developments propelled certain technology stocks to remarkable heights, defying the headwinds of rising interest rates. The macroeconomic landscape was primarily shaped by inflation, interest rates, and a banking crisis reminiscent of the 1907 financial turmoil. Notably, Jerome Powell’s intervention in 2023 mirrored John Pierpont Morgan’s actions in 1907, averting a similar crisis. Although inflation receded and the Federal Reserve claimed credit, this was significantly aided by the alleviation of supply chain pressures. Towards the year’s end, a surge in long-term interest rates was observed, as the supply of treasuries exceeded demand due to various factors, seamlessly connecting to geopolitical issues.

Geopolitically, China shifted its focus from purchasing U.S. treasuries to accumulating gold, a response to the U.S. freezing Russia’s treasury holdings following its invasion of Ukraine. Additionally, the Middle East emerged as a focal point due to escalating risks of regional conflict in the fourth quarter.

As we enter 2024, forecasts mirror those made for 2023; however, they are likely to be equally inaccurate. The future, inherently unpredictable, demands our attention, nonetheless. For investors, the primary objective is not perpetual accuracy – though that would be ideal – but rather, tilting the probabilities in our favor. Consistently aligning the odds on our side over an extended period allows us to benefit from the law of large numbers, ultimately leading to success. This can only be achieved through diligent research.

Technology:

  • Artificial Intelligence:

In 2023, the landscape of technology investing underwent a significant transformation, largely attributed to the groundbreaking advancements in large language models (LLMs). [1] This phenomenon, spearheaded by innovations in AI such as ChatGPT and Bard, has catalyzed a substantial shift in the valuation and performance of tech stocks, defying the conventional headwinds of rising interest rates.

The impact of these LLMs on the market cannot be overstated. They represent a leap forward in technological capability, offering unparalleled efficiencies and applications across various industries. This has not only attracted substantial investor interest but also prompted a reevaluation of the potential growth trajectory of companies involved in AI development. In an environment where interest rates were expected to dampen investment enthusiasm, the allure of AI and its applications proved irresistible. Investors, recognizing the transformative potential of these technologies, were willing to overlook the immediate challenges posed by the economic climate.  As a result, technology stocks, which were coined as the Magnificent 7 experienced a remarkable surge in value, setting them apart from the broader market trends. [2]

This phenomenon underscores a broader theme in investment circles: the ability of disruptive technologies to reshape market dynamics. While rising interest rates typically signal a cautionary environment for equity investors, particularly in growth-oriented sectors like technology, the emergence of LLMs has provided a counter-narrative. Investors have shown a willingness to invest in innovation-driven growth, even in the face of macroeconomic headwinds. This trend not only highlights the enduring appeal of technological innovation but also suggests a more nuanced relationship between interest rates and equity valuations in sectors at the forefront of groundbreaking advancements. As we progress, the influence of large language models and similar innovations is likely to remain a pivotal factor in the investment landscape, continually reshaping the boundaries of technology investing.

Economics:

  • Interest Rates & Inflation:

 

 

The Federal Reserve continued its interest rate hikes in 2023 to combat inflationary pressures in the United States. At the beginning of 2023, the Federal Funds rate was between 4.25% and 4.50%, and by the end of the year, it had been raised a full percentage point. [3] Overall, this led to a slowing of the rate of increase in inflation and economic growth, but not as much as forecasters had predicted at the beginning of the year.  The Survey of Professional Forecasters projected inflation to hit 2.9% in 2023. [4]

Inflation decreased from a high of 9.1% in July 2022, down to 3.4% in December 2023. This decline was due to the combination of increased interest rates and the normalization of supply chains. [5] Inflation occurs when there is a mismatch between supply and demand, with supply encompassing labor markets, supply chains, and the general inputs into products, and demand being money in all its various forms. During the Covid-19 lockdowns, the United States printed trillions of dollars through omnibus stimulus packages and kept interest rates near 0%, even as inflation began to creep past 2%. This was coupled with global supply chains having difficulties restarting, which caused prices to spike, and a lack of workers reentering the labor force as many people in the 55 and older demographic decided to retire with their increased net worths. [6]

The increases in interest rates were designed to reduce the wealth effect that caused people to retire early, increase unemployment to reduce consumer spending, decrease business investment which lowers the demand for goods, and generally slow the pace of the economy. This process generally worked but it was much slower than expected due to the number of corporations and homeowners who had locked in long-term debt at very low interest rates, thereby making them more resistant to the effects of interest rate changes. [7] The real win on inflation in 2023 came from supply chains normalizing and China exporting deflated goods to the United States as they dealt with a quasi-debt crisis. [8]

The longer interest rates stay high, the more those businesses that were insulated from the rate increases will have to refinance their debt at higher rates, which will cause an economic slowdown. Therefore, it has become a timing situation: which will occur first, a crack in inflation or the economy, or both?

  • Bank Failures:

On Thursday, March 9th, there were $42 billion in investor withdrawals, causing Silicon Valley Bank (SVB) to become insolvent.[9] The run on the bank was initiated the day before with a letter to shareholders from then CEO Greg Becker, stating that the bank had suffered a $1.8 billion loss on the sale of US Treasury and mortgage-backed securities. [10] This letter came as a shock to many investors and depositors because up to 97% of SVB’s depositor base was not covered by the $250,000 FDIC insurance coverage limit. [11]

The fundamental issue began with the influx of cash from Venture Capital firms, buoyed by the easy monetary policy that the Fed conducted throughout the 2010s and into the 2020s. This influx caused SVB’s depositor base to triple since the fourth quarter of 2019. [12] Since banks borrow short-term and lend or invest long-term to profit from the difference in interest rates, they invested this deposited cash in long-dated Treasury and Mortgage-Backed Securities, presuming that the Fed would not raise interest rates. However, the Federal Reserve, in its bid to combat inflation, raised interest rates by 450 basis points in 12 months, causing significant depreciation in the value of these long-dated bonds.

However, this was not immediately considered an issue due to an accounting rule that obscured the true losses on the securities. Held-to-maturity (HTM) and available-for-sale securities (AFS) are categorized differently on bank balance sheets. HTM securities do not reflect the unrealized change in the value of long-term bonds, whereas AFS securities do. However, HTM securities reveal the actual losses if the bank is forced to sell them, which is precisely what occurred as redemption requests began pouring in from depositors. As depositors withdrew money, SVB was compelled to sell these securities at a substantial loss, exposing the true extent of the realized losses on these bonds. This created a self-reinforcing cycle that further panicked depositors, leading to more redemption requests and culminating in SVB being declared insolvent.

Ultimately, three major banks failed in this manner in 2023: Silicon Valley Bank on March 10th, 2023, Signature Bank on March 12th, 2023, and First Republic Bank on May 1st, 2023.[13] These banks all faced similar issues as described above, and they each had unique depositor bases that were generally not covered by the $250,000 FDIC insurance, making them vulnerable to potential problems. This issue did not spread further, largely because banks were generally flush with cash from over a decade of quantitative easing and due to the Federal Reserve creating the Bank Term Funding Program (BTFP). The BTFP was designed to value long-term securities, which had incurred substantial losses due to rising interest rates, at par value instead of their discounted market value.[14]

Geopolitics:

  • China & Gold:

In February 2022, the global geopolitical and financial landscapes were profoundly altered by Russia’s invasion of Ukraine. This event triggered a series of punitive measures from the international community, notably led by the United States. Among the most significant of these were the exclusion of Russia from the SWIFT payment system and the freezing of Russian assets, including U.S. Treasury securities held by their central bank. [15] These actions, designed to isolate Russia economically, underscored the United States’ formidable influence over the global financial system.

The repercussions of these sanctions resonated deeply, particularly with China, a major geopolitical challenger to the United States. Observing the ramifications of the U.S.’s financial countermeasures against Russia, China embarked on a strategic reassessment of its financial policies. The Chinese government recognized the potential risks associated with its substantial holdings of U.S. Treasuries. In a geopolitical climate where interests can shift rapidly, the dependence on U.S. financial instruments became a significant concern, especially in light of China’s interests in Taiwan and other sensitive areas. [16]

In response, China initiated a significant shift in its central bank’s asset allocation, moving away from U.S. Treasuries and increasingly accumulating gold. This move was a clear strategy to reduce China’s financial vulnerability to U.S. policy actions and enhance its economic sovereignty. By bolstering its gold reserves, China aimed to create a more robust and diversified financial foundation, less susceptible to external geopolitical pressures. [17]

This strategic pivot by China in 2023 was not just an isolated financial decision; it reflected a broader, potentially transformative trend in international finance. Other nations, particularly those whose geopolitical interests do not always align with those of the United States, began to consider similar diversification strategies. This trend pointed towards a gradual shift in the dynamics of international finance, with potentially reduced reliance on U.S. Treasuries and a growing interest in alternative assets such as gold.

As the world moves forward, it is becoming increasingly evident that geopolitical considerations are playing a more prominent role in shaping financial strategies and decisions. The diversification move by China and potentially other nations away from U.S. Treasuries in favor of gold or other assets signifies a deeper change in the global financial order. For investors and policymakers, understanding and adapting to these shifts is crucial. The financial landscape is evolving into one where decisions are intricately linked with international relations, requiring a nuanced approach that combines financial acumen with geopolitical insight. This evolving scenario underscores the importance of strategic foresight and adaptability in a world where finance and geopolitics are ever more intertwined.

  • Middle East:

On Saturday, October 7th, 2023, a series of heinous attacks perpetrated by Hamas terrorists against the people of Israel marked a significant escalation in regional tensions.[18] This event set off a chain of developments in the Middle East, signaling that this volatile situation will continue to be a major concern in 2024. In response, Israel initiated a military incursion into Gaza with the stated goal of dismantling Hamas. Alongside this, Hezbollah has been posing consistent threats to Israel’s northern border through rocket attacks. Additionally, the Houthis have disrupted key maritime routes in the Red Sea, employing drones and missiles to hinder shipping activities.[19]

Despite the gravity of these events, the conflicts did not significantly impact global markets in 2023, largely because of their localized nature. However, the situation is evolving, and the disruptions caused by the Houthis, particularly in critical maritime channels, pose an increasing threat to the stability of global supply chains. This disruption, primarily through the potential rerouting of shipping to avoid conflict areas, could have far-reaching implications for international trade. Such developments could complicate the Federal Reserve’s efforts to combat inflation, potentially affecting the trajectory of interest rate adjustments. The escalating involvement of Iran, the United States, and their respective allies adds a layer of complexity and unpredictability, with potential repercussions for global economic stability and the integrity of supply chains.

Looking to 2024:

As we venture into 2024, it’s clear that the year is set to be as dynamic and unpredictable as 2023, if not more so. With a range of critical factors at play, our market outlook remains vigilant and adaptive. Key among these factors is the upcoming U.S. presidential election. Current indications suggest a possible rematch between Joe Biden and Donald Trump, a scenario that promises significant political and geopolitical implications. A deeper analysis of this potential election battle will be provided later in the quarter, focusing on its potential impact on foreign policy direction and looking at the history of different presidents and market outcomes.

Another critical area of focus is the Federal Reserve’s ongoing battle with inflation. The Fed is steadfast in its mission to bring inflation back to its long-term target average of 2%, a goal that necessitates careful policy maneuvering. The central bank’s decisions in this regard will be pivotal; lowering interest rates too soon or too late could risk triggering a recession. We will be closely monitoring the Fed’s strategy and the accompanying economic indicators for insights into future rate adjustments.

The labor market is also expected to exhibit a continuing slowdown. This trend could have multifaceted effects on consumer spending, corporate earnings, and overall economic growth. Understanding the labor market dynamics will be crucial in assessing the broader economic health and investment opportunities.

Geopolitical tensions, as witnessed in the last months of 2023, are anticipated to remain at the forefront of global concerns. These tensions, whether in the form of trade disputes, regional conflicts, or international alliances, have the potential to significantly influence market dynamics. Our analysis will include a close watch on these developments, assessing their probable impact on global markets and investment strategies.

Perhaps the most important lesson from 2023, which remains pertinent for 2024, is to expect the unexpected. The unpredictability of market movements underscores the importance of portfolio diversification as a risk mitigation strategy. Our approach involves a continuous, thorough analysis of market conditions and trends to skew probabilities in our favor. However, as the past year has taught us, certainty in forecasting remains elusive. Therefore, our strategies are designed to be flexible and responsive, adapting to changing market conditions and emerging trends.

In conclusion, our market outlook for 2024 involves a comprehensive and dynamic approach, incorporating political, economic, and geopolitical analyses. While we strive to position our strategies advantageously, the inherent uncertainty of the markets calls for a cautious yet proactive approach, emphasizing diversification and adaptability.

Sources:

Bridge Advisory LLC Disclosures

Bridge Advisory, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. Investment Advisory Services offered through Bridge Advisory, LLC. Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type. Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Information herein has been obtained from sources believed to be reliable, but Bridge Advisory, LLC. does not warrant its completeness or accuracy; opinions and estimates constitute our judgment as of this date and are subject to change without notice. This newsletter expresses the views of the authors as of the date indicated and such views are subject to change without notice.

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