Following a historically challenging year for investors in 2022, equity markets delivered strong returns in 2023 as the widely expected recession was avoided. Just over a year ago (link) we highlighted our constructive view on the U.S. equity market for 2023. We emphasized that the S&P 500 had delivered positive returns in the 3rd year of the Presidential election cycle (the 12 months following a midterm election) in every instance since 1946, with an average annual return of +16%. The comparable period through November of 2023 was no exception, as the S&P was +22%, despite headwinds from an aggressive Federal Reserve interest rate hiking cycle, concerns around a debt shutdown, and heightened geopolitical risks.
Source: Strategas
We often point to the consistent and powerful influence that the Presidential Cycle exerts on markets. As previously noted, year 3 has historically been the strongest period for stocks with an average return of +16% (Exhibit 1). Although we are no longer in the year 3 sweet spot, the fourth year of the cycle has also been pretty good for stocks - an average S&P 500 return of +7%, with positive returns 100% of the time during re-election years since 1952. We expect episodic spikes in volatility given heightened geopolitical risks and we are prepared to take advantage of opportunities.
Why has the Presidential Cycle had such a consistent and significant influence on markets? Incumbents have a vested interest in keeping the economy on solid footing as they seek a second term by enacting policies to keep their party in the White House. As political strategist James Carville said in 1992, “it’s the economy, stupid,” which is supported by the fact that a president has never been re-elected when a recession has occurred in the 24 months leading up to an election (Exhibit 3).
This lesson is not lost on the Biden Administration. In March and early November of 2023, we witnessed a massive coordinated policy response from the Fed and the U.S. Treasury to support the economy. In addition, we have already begun to hear rhetoric on potential policy actions that could help sustain economic growth: an increase in oil production or use of strategic petroleum reserves, U.S-China trade de-escalation, infrastructure spending, tax cuts, and student loan relief programs, to name a few.
Importantly, while we actively monitor the Presidential Cycle and the potential economic and market implications of policy shifts, we do not attempt to predict election outcomes, nor do we make short-term investment decisions based on potential changes.
Source: Strategas
Markets can be volatile in election years, but long-term stock market performance is agnostic to which party occupies the White House; in fact, since 1936, the +11% average annualized 10-year return of the S&P 500 following the election (of either a Democrat or a Republican) reinforces the merits of a long-term investment approach (Source 4).
For years we have referenced the adage “don’t fight the Fed” to contextualize why higher equity valuations made sense to us throughout the Quantitative Easing era (low opportunity cost of owning high quality stocks given lackluster bond yields) despite consensus views that stocks were overvalued.
In 2022, during a move to more restrictive policies and Fed rate hikes, we articulated that investors would be well served to remember that this dynamic works in both directions. Fed policies (and liquidity growth) became restrictive - a headwind to valuations and asset prices - which created a challenging environment for stocks and bonds in 2022.
Subsequently, in our 2023 outlook we expressed our view that we had seen peak inflation and that:
“moderating inflationary pressures, a reset of earnings growth expectations, and a more accommodative Fed will result in a better environment for stocks and bonds.”
Inflation remains on a downward trajectory as the U.S. consumer and economy are slowing from +4.9% growth in Q3’23 - which will allow the Fed to become more accommodative in 2024.
Source: Morgan Stanley
Market participants spend a lot of time and energy scrutinizing The U.S. Federal Reserve, and for good reason, given the Fed’s influence on markets, through interest rate policy and tools such as Quantitative easing. However, we would argue that investors continue to underestimate the increasingly important role that the U.S. Treasury also plays in driving asset prices.
The chart below tells a very important story that we have been closely monitoring over the past couple of years. It illustrates a more robust view (than Fed Policy alone) of the trend in total liquidity in the U.S. financial system - aggregate liquidly provided by the Fed AND the Treasury.
-> The key takeaway is that the coordinated effort by Janet Yellen (U.S. Secretary of the Treasury, former Fed Chair) and current Fed Chair Jerome Powell led to a huge boost in liquidity following bank failures in March.
Source: Strategas
-> In our view, this significant liquidity infusion from the U.S. Treasury, was a key driver of asset prices in 2023.
-> The S&P 500 is +18% since March, despite more restrictive Fed Policy in the form of higher rates and Quantitative Tightening (Exhibit 4).
On November 1, 2023 Yellen and Powell announced that (1) the Treasury would favor short-term financing over long-term debt issuance and (2) the Fed signaled it was done raising rates.
In the two months following the 11/1/23 liquidity boost:
10-year U.S. bond yields collapsed from 4.8% to 3.9% (prices move inversely to yields)
S&P 500 jumped +13%
Bitcoin spiked +22% (liquidity-driven, speculative asset)
-> The combined Yellen-Powell net liquidity boost more than offset the headwinds from the Fed’s ongoing tightening. Going forward, we will continue to keep an eye on both the Treasury and the Fed.
-> Importantly, we expect an ongoing coordinated approach to net liquidity and financial conditions as we approach the election.
Source: The Capital Group
As we enter the new year we are finding investment opportunities across equities, bonds, and private investments.
The 1-year and 5-year periods following the last Fed rate hike have historically produced above average returns for stocks
Treasury bills have generated much lower returns (Exhibit 6)
Not only do stocks and balanced portfolios outpace their long-term average returns following the last Fed hike, they also materially outperform T-Bill’s and cash instruments. We have been redeploying capital from Treasury bills into equities, balanced portfolios, and private investments over the past year to reposition into more attractive long-term return opportunities.
Following the aggressive rate hiking cycle, money market funds and Treasury bills have attracted significant capital owing to their higher yields. As a result, investors have poured $2.4 trillion into money market funds and bond funds over the past 4 years. During this same period investors have reduced equity exposure by -$240 billion6.
The S&P 500 is +87% over this period versus the U.S. Aggregate Bond index -9% and T-bills +6%7. What is the lesson to learn?
The opportunity cost of holding T-bills (for too long) can be substantial.
In addition to high-quality dividend and growth stocks, we continue to find attractive opportunities across fixed income, alternatives, and tax-managed equity for clients’ balanced portfolios.
Sources:
Source 1: Strategas
Source 2: Strategas
Source 3: Strategas
Source 4: Capital Group
Source 5: Morgan Stanley
Source 6: Strategas
Source 7: FactSet and BlackRock
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