Written by: David Waddell | Waddell and Associates
2023 delivered investors far greater joy than broadly anticipated. Our optimism entering the year relied on two theses. One, we saw investor pessimism as overblown. Two, we believed inflation would fall without a corresponding rise in unemployment. Classical economics teaches otherwise, asserting that inflation and unemployment maintain a stable and inverse relationship, scripting recession as the only cure for sizable inflation. We believed that the threat of recession would produce the same disinflationary results, negating the need for one. This became our #1 thing, informing our optimistic allocations and positioning. Fortunately, the textbooks failed as inflation fell without unemployment rising, leading investment indices back to record highs. We close the books grateful that our optimism… and more modern economics… profitably prevailed in 2023. See you for more in 2024!
The Full Story:
As this year closes, I am particularly grateful that our optimistic outlook for 2023 came to pass. Our primary investment thesis contained two components: first, that people were far too pessimistic exiting 2022, and second, that inflation would fall without an increase in unemployment. We expected that the two together would power surprising gains for investors, and so they have, with the S&P 500 inches away from hitting an all-time high. While we have written extensively about the impact of rising sentiment on markets this year (here is one final chart comparing the change in bullish sentiment in purple vs. the change in the S&P 500 in orange),
sentiment doesn’t change on its own. Sentiment changes require catalysts. For 2023, our belief that the expected relationship between inflation and unemployment would invert and provide a steady stream of positive surprises became our #1 thing. Economic surprises would drive sentiment surprises, which would drive investor surprises. Needless to say, our forecast placed us among the anxious minority.
Classic economics textbooks teach us that disinflation and tight labor markets cannot coexist. In 2023, they did. As this chart shows, the Fed’s preferred inflation measure, the core PCE, dropped from 5% to 3% (purple line) over the year while the US unemployment rate remained unchanged (orange line):
According to economic orthodoxy, this chart shouldn’t exist. An economy at or near “full employment” with more job openings than jobs available should experience wage inflation that metastasizes into overall price inflation. Econ nerds will recognize this as the Phillips Curve theory which states that inflation and unemployment have a stable and inverse relationship. Apparently not, says 2023. But why? We believed that the most anticipated recession of all time would compel companies to restructure and reduce bloated bureaucratic structures rather than fire hard to find frontline workers, more typical of the kneejerk recessionary response that drives unemployment rates higher. Furthermore, transformational technology investments relieve payroll demands and increase profit margins, placing less pressure on price escalations to power profits. In short, companies used the threat of recession to perform the surgery required to streamline businesses and enhance operating margins, rather than rely on layoffs. Note the change in profit margins despite the disinflation:
Overall, S&P 500 companies increased profit margins from 11.9% to 12.2%, with 55% of companies showing gains. This happened despite record unemployment levels, surging interest rates, and fading stimulus support. While earnings didn’t grow much in 2023, operating structures right-sized, corporations managed to disinflate pricing, and front-line employees maintained their employment. In the 1970’s, corporate managements used inflation as cover to chest thump over revenue gains and justify bloated operating structures. Economists called this perversion the “money illusion.” In the 2020s, corporate management recognized that unabated inflation would bait the Fed into triggering a recession. As such they did the hard things to fortify their businesses and enhance margins. Should 2024 deliver the long-anticipated recession, they stand ready. Should it not, they stand primed:
Today, analysts expect S&P 500 earnings will rise 11.5% next year. The Federal Reserve expects inflation to exit the year at 2.4%, and economists anticipate six interest rate cuts. Any of those alone would stoke investor enthusiasm. The prospect of all three explains this rapid and resolute rally into year-end. What 2024 will hold depends on correctly identifying the #1 thing again and positioning accordingly.