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  • Writer's pictureB C M

What We Just Don't Know

2023 in review


2023 was a broadly positive year for the financial markets. Other than crude oil, most markets saw gains for the year, from stocks and bonds to real estate and precious metals. Global stocks ended the year up +19.8% and U.S. bond prices were up +1.7%.

2023 Global Financial Markets


While markets ended 2023 on a decidedly bullish note, that was not the case throughout the year. There were two periods in 2023 when sentiment turned decidedly bearish.


Late in Q1, equity markets had a sharp pullback. U.S. stocks gave back most of their YTD gains and international markets even turned negative as a series of regional bank failures spooked investors.


Then, from Q3 into Q4 equity markets retreated again and international stocks turned negative again as rising interest rates caused investors to question the economy.


2023 Equity Market Pullbacks


But by year's end, the economy and the markets rebounded, proving more resilient than many expected. In some ways, we are a full 180 degrees from where we were a year ago. We take a look at what happened and what could happen in this letter.


180 degrees later


At the start of 2023, the consensus view among economists was for a global recession within the year. According to the World Economic Forum's Q1 2023 Chief Economists Outlook, most chief economists expected a global recession and 91% expected U.S. economic conditions to weaken in 2023.


Q1 2023 Chief Economists Survey


One of the most extreme calls was from the team at Bloomberg Economics which expected a 100% chance of a U.S. recession in 2023. In the defense of economists, hindsight is 20/20, but crystal balls are always blurry.


Recession Probability Models

I am not an economist, but as someone who regularly consumes economic content, the pessimism was not surprising. Many reliable leading economic indicators had been flashing recession for many months.


One example was the S&P Global U.S. Composite PMI, which is a closely watched leading economic indicator that measures business activity. The rationale is business activity typically leads employment, consumption, and other economic activity.


Historically, the PMI experienced sharp declines with readings falling below 50 before recessions. By year-end 2022, the PMI was in a 19-month downtrend and had been stuck under 50 for 6 months.


S&P Global U.S. Composite PMI

Another widely watched economic indicator in the U.S. was New Single Family Home Sales. The rationale is that new home construction and purchases are large, long-term commitments sensitive to changing economic expectations.


The chart below shows new home sales (blue line) experienced peaks and sharp declines (red circles) before every single U.S. recession (grey bars) in modern history. The peak and decline in 2021 was as convincing of a signal as any before it.


U.S. New Single Family Home Sales


There was also the Federal Reserve Bank of New York's widely followed recession probability model based on Treasury yields. The rationale behind the model is that interest rates are the grease that keeps the economy moving, and Treasury yields are benchmarks for other rates.


Historically, whenever the NY Fed's model rose above a 30% probability, a U.S. recession either followed or was already underway. The model reached 67% in 2023. For reference, it only reached 38% in the financial crisis and 42% in the dot-com bust.


NY Fed Recession Probability Model

We could keep providing examples of recessionary indicators, but the point is there was considerable and convincing data to support the consensus view. However, not only did a recession not happen, but real GDP expanded and the latest data show annualized growth accelerated to 4.8% (as of Q3 2023).


U.S. Gross Domestic Product


How did so many economists (and those who shared their views, myself included) get it so wrong? The simple explanation is the employment market remained stronger than expected.


Developed economies like the U.S. are primarily driven by consumer spending (i.e. people spending money on things and services). Americans who make money tend to spend it, so it is difficult for a recession to emerge when employment is strong.

Of course, we all knew that but the expectation was employment would deteriorate in 2023. I wrote several times in 2022 and 2023 that employment was the last and "only pillar" holding up the economy.


While there were upticks in layoffs, labor weakness did not metastasize as feared. Instead, it was more than offset by strong job creation. As of now, labor demand is still outpacing labor supply, albeit at a slowing rate. But so long as that remains true, the most anticipated recession ever remains elusive.


U.S. Labor Market


Beyond employment, many leading economic indicators staged unexpected rebounds in 2023. This is summarized by the OECD's Composite Leading Indicator (CLI) index which aggregates multiple economic measures. The CLI was on an 18-month downtrend that was expected to continue into 2023. Instead, it reversed into an uptrend, supported by persistent strength in employment and consumption.


OECD CLI Index

These developments were enough to flip the consensus expectation among economists. The latest Chief Economists Outlook shows only 18% of economists expect weaker U.S. economic growth in the year ahead. In other words, 82% expect stronger growth. The consensus turned a full 180 degrees since the start of the year.


Q4 2023 Chief Economists Outlook



After being wrong in 2023, investors may question the new consensus. Yet, the economy still matters. Investors know that and show it by reacting to Federal Reserve policy.


Rumors that the Fed might cut interest rates were enough to reverse the July to October selloff in stocks. The Fed's December statement that cuts were possible in 2024 was all that was needed for stocks to take off and end the year on a high note.


What we just don't know


As usual, the question now is what should we expect in the year ahead? After last year's flip-flopping, I can confidently say I do not know. No one really does, not even teams of financial rocket scientists who are 100% confident in their predictions.


What I do know is the importance of recognizing and learning from mistakes. I was wrong in 2023. I expected a high likelihood of recession heading into the year. Based on that expectation our Macro Allocation strategy started the year with a maximum underweight position in risk assets like stocks.


That was a bad decision that resulted in a drag on returns because stocks started the year with a strong rally. I recognized my error as the data changed and increased our risk allocation as the year progressed. In the end, all of our portfolios enjoyed gains, but returns were lower than they would have been without the underweight.

The lesson re-learned is do not assume something will or must happen, instead wait for confirmation. Reflecting on late 2022, I incorrectly assumed an imminent recession based on the doom and gloom I read in economic reports. The various indicators I observed confirmed that bias, but I should have heeded the observation that employment data had not confirmed a recession.


In November 2022 I wrote, "Employment still offers hope for a soft landing, but if that capitulates then recession becomes a near certainty and stocks are likely to see new lows ahead."


While I knew and conceded employment needed to capitulate, I still assumed an imminent recession and moved to a maximum underweight risk position to avoid stock market losses I believed would occur. Other data already pointed to a recession, and most of the world's chief economists agreed. So, how could it not happen? Of course, it would, it must!


But as Mark Twain famously said, "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."

Point taken, Mr. Clemens (aka Mark Twain). I should not have been so sure of an imminent recession, and I should have waited for the data to confirm the thesis.


Fortunately, our MA strategy has target weights and limits built-in (e.g. minimum and maximum weights). They exist for good reason, to prevent extreme, "all or nothing" positions that could result in worst-case scenarios (jumping "all in or out" at the worst times). Said another way, it is to protect us from ourselves because we can always be wrong. Last year they prevented us from veering too far from our strategic targets.


That same understanding should be and will be applied to minimum and maximum risk positions moving forward. In other words, a move to minimum or maximum risk positions will be reserved only for scenarios when outlook confidence is as high as possible.


For example, although the risk of recession was high last year, it was not as high as possible because employment conditions still had not experienced meaningful deterioration (falling labor demand, net negative job creation, rising jobless claims, etc.). In addition, other indicators still were not flashing red, like the Fed still raising interest rates, for instance.


Applying the lesson in real-time, we are starting 2024 with a neutral weight position in risk assets. In other words, our MA portfolios are targeting their strategic risk weights, and neither underweight nor overweight.


Why not an overweight given the absence of recession? The simple answer is that just because a recession was avoided in 2023 does not mean it will not happen. Ironically, the Fed's rate pivot that markets are celebrating may be an omen.


The chart below shows how the Federal Funds Rate (FFR), the short-term interest rate the Fed controls directly, tends to lead the economy. Note that historically U.S. recessions (grey bars) tend to happen AFTER the the FFR (blue line) peaks (red circles). In other words, recessions tend to happen AFTER the Fed stops raising rates and begins to cut them (aka "pivots").



That makes sense because the Fed cuts interest rates when it notices economic weakness or problems, not when conditions are expected to improve. If the Fed stays true to its December statement, then rates have peaked and cuts could start in the year ahead. All else equal, that is not a bullish signal for risky assets like stocks.


Of course, all else is not equal, any indicator can be wrong, and this alone does not make us highly confident of an imminent recession. For one, recessions tend to happen after the Fed cuts and the Fed has not even started to do so. In addition, we would want to see a meaningful breakdown in employment as well as the same widespread deterioration across indicators observed last year to be as confident as possible. Currently, that is not the case.


The bottom line


Entering 2024, there are still reasons to be wary of recession, however, economic conditions also look better than they did a year ago. Heading into 2023, I believed the odds of recession were around ~80%. As of now, I believe they are closer to around ~50%. All things considered, conditions are not especially good, bad, or abnormal, and they could turn either way. As such, we are targeting a neutral weight risk position.


We will continue to carefully monitor relevant data, and tactically adjust risk exposure as new information warrants. However, we expect tactical adjustments will be more modest than last year. Specifically, we will reserve the largest moves (maximum and minimum risk positions) for scenarios when we are as confident as possible regarding economic and market conditions (whether good or bad).


2023 was a challenging year, but another year of growth and progress. We could not have done it without the clients, family, and friends who continue to invest their trust and confidence in BCM. It is your support that keeps us striving to do our best and improve every day. We are always happy to be a resource for you, your family, and your friends, just let me know if you think we can help. Thank you and I wish you a Happy New Year!


My Best,


Victor K. Lai, CFA


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