EAST OF EDEN

“ The best time to repair the roof is when the sun is shining.”

—John F. Kennedy, 1962

For the last six months, U.S. financial markets have been living in Eden. The economy is expanding briskly. Gross domestic product grew approximately 4% in the second half of 2023. If you believe that number is distorted by government expenditures, even Real Final Sales to Domestic Purchasers grew 3.5% in the second half of 2023. Payroll employment is growing strongly (up 2 million in the last nine months). And those trends seem to have continued into 2024. Even manufacturing activity started to expand in March. The Atlanta Fed’s GDPnow real-time estimate of 1Q 2024 GDP stands at 2.9%. Every two weeks the Richmond Federal Reserve Bank publishes a chart book summarizing the state of the real economy in the U.S. It runs to 60 pages of data comprising a couple hundred summary indicators. In the latest version, I can find two or three metrics that are concerning. As my daughter would say, the U.S. economy is living its best life.

Of course, even Eden has a serpent. Normally, that serpent takes the form of inflation. An economy growing above trend normally runs into resource constraints. Prices rise so much that the Federal Reserve is compelled to tighten financial conditions. I think it’s fair to say that prices have stopped falling. Maybe they’re reaccelerating a little bit. But there is ample evidence that they can re-assume their descent — even if more slowly than before. First, the supply side of the economy is growing as evidenced by the growth in the labor force. As a result, wages are trending between 3.5 – 4%. With productivity increasing around 2%, that’s consistent with the Fed’s inflation target. Second, there is evidence of business capital expenditures growing — first in structures, then in equipment and finally in intellectual property. So, while we can see the serpent, we have not yet succumbed to the Forbidden Fruit. We are still in a state of innocence and bliss.

The problem is investors do not own the real economy as it is. We own a claim on it that prices in where the marginal investor expects the real economy to be in the fullness of time. Right now, that claim is pricing in continued growth and quiescent inflation. There is no precise way to know what odds are being assigned. We look at investor surveys, valuation indicators and forward pricing for financial contracts. In March, we assessed that the central case (disinflation and economic strength) was priced at about an 0.80 to 0.85 likelihood. While we agreed with the baseline scenario, our probability would have been closer to 0.60. We began to harvest some risks that seemed to us most vulnerable to the alternate scenarios playing out. In the following pages, we describe the more detailed reasoning behind some of our recent portfolio changes.

1. We reduced the U.S. equity exposure relative to Europe.

2. We trimmed mega cap tech stocks in the U.S.

3. We favored more defensive stocks in the U.S.

4. We drastically cut our exposure to high yield credits.

5. We increased our exposure to duration in fixed income.

While these moves may sound like we are moving into a safe harbor to wait out a storm, they are more like trimming our sails. Our total risk compared to the market moved from 1 to 0.97. The total effect is to give up fractional upside in exchange for dry powder to spend if the world turns only slightly darker than the current full sunshine. I like JFK’s metaphor quoted above. Anyone who has tried to hire a roofing contractor after a January snowstorm unleashes an ice dam on your eaves can appreciate it. If you don’t, you haven’t lived in the Northeast long enough.

You might also observe that we seem to have spread actions across multiple directions. That is intentional. Our goal is not to express a specific view of how the economic landscape evolves — but rather to benefit from a more diffused set of outcomes. Buying duration in Treasurys might work in opposition to reduced exposure in technology stocks (no landing with AI theme intact) or it might work in concert (hard landing and AI deflation). But the net effect is, we believe, to make our portfolios more resilient to a less certain environment, such that we can be on our front foot come what may. The last place we want to be is demanding liquidity at the same time as everyone else.

Finally, I want to congratulate Akhil Jain and Matt Mead on their promotions to Managing Directors of the firm. Along with Steven Vaccaro, they and their teams have been productive in sourcing new ideas in active managers and strategies that we expect will enhance our portfolios in the future. As I begin my new role, I feel honored to work alongside such a capable group of motivated investors. We are looking forward to meeting you all in person in the months ahead.

—T. Brad Conger, CFA
Deputy Chief Investment Officer

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On a quarterly basis, Hirtle Callaghan publishes our perspective on the current market. If you would like to be added to our distribution list and receive the full version of our latest Investment Perspective piece, please contact us.

To download a pdf of the excerpt, click here: Investment Perspective Q1 2024 Excerpt.