What We Know, What We Don't Know ...

…and why we think markets still have room to run

The late Colin Powell, while never himself a professional investor, had timeless advice for anyone taking risks in an uncertain world. "Tell me what you know," he would direct his staff. "Tell me what you don't know. And then, based on what you really know and what you really don't know, tell me what you think is most likely to happen."

Amid racing markets and happy talk of “soft landings,” it’s an especially important exercise to separate the three categories. What we know, in fact, paints a pretty rosy picture of the world’s economy. The problem with mostly efficient markets, however, is that bond spreads are now tight and the stock multiples are rich. It’s still perfectly reasonable to believe in “risk” trades, but only if you are clear-eyed on incoming reports of what we don’t know.

So, what do we know?

We know without question that the global economy continues to slow, albeit at different rates in different places. The IMF's latest projections have growth downshifting slightly from 3.0% in 2023 to 2.9% this year, which may sound like running in place but represents a determined effort by the world’s central banks to cool demand. Beneath these averages, the U.S. is forecast to slow from 2.1% to 1.5%, while China moves from 5.0% to 4.2%. The eurozone may accelerate slightly from 0.7% to 1.2%, but that’s only because Germany’s performance was so dismal last year. You can quibble with the specific numbers, but the overall direction looks .

Second, it’s clear the inflationary effects of the pandemic are dissipating fast. Global supply chains are more or less back to normal. Most commodities trade within reasonable historic ranges. Central bankers are still talking tough about vigilance, but the Fed's favorite inflation measure signals unambiguous cooling in price pressures.

Third, we know that underlying global demand still looks resilient. In spite of rapid tightening in monetary policy around the world, December unemployment rates hover near historic lows around most of the developed world. Consumer confidence looks grim in many major markets and global manufacturing readings registered slight contraction in December. But construction is booming and U.S. holiday sales measured by MasterCard grew 3.1% over the previous year, reflecting that wages have so far outpaced inflation. 

What we don't know: 

Above all, we don’t know what accidents may still lurk ahead. So far, beyond tremors in the U.K. gilt market and a few overzealous U.S. regional banks, there have been precious few victims of this especially sharp tightening cycle. More bank capital and closer supervision since the last crisis have clearly helped, but there will be more bankruptcies as firms roll their debts at higher rates and deeper losses for anyone with money in empty urban office buildings.

If the sum total of what we don’t know seems daunting, it’s cause for caution rather than panic.

There are also 40 national elections scheduled this year that account for some 40% of the world's population, even if only two will really affect the risks to global commerce. Taiwan’s presidential vote next Saturday may not trigger immediate military confrontation, but it will fuel more threats from Beijing and trigger calls for more sanctions and tariffs from Washington. And with former President Donald J. Trump leading in current polls, the America’s November election may force investors to assess just how much of his fiery campaign promises of economic nationalism and political retribution may change their investment calculus.

Perhaps the most important mystery before investors is where falling rates will settle. Vast new spending needs on defense, climate transition and care for the elderly may unleash a new round of inflationary spending and debt. Meanwhile, fractured global markets and the imperative of supply chain resilience will likely drive all costs higher. On the other hand, the so-called ‘neutral rate’ may return to pre-pandemic patterns in which technology drives prices lower. Innovation normally triggers gains in productivity and growth, but artificial intelligence in particular may eliminate jobs far faster than comparable new roles will appear.

Now, what do we think?

Well, it’s tempting—-with the S&P 500 up more than 24% last year and the NASDAQ up a shocking 43%--to cut and run. It’s also tempting to raise lots of cash at a time when corporate bond spreads seem so blissfully unaware of the slowing economy or the higher costs of rolling over debt. Plus, there’s the extreme bullish sentiment, which is a “sell” signal to any grizzled contrarian, and on top of that, all those lurking risks.

But if the sum total of what we don’t know seems daunting, it’s cause for caution rather than panic. In addition to the unquestionably robust economic fundamentals and what seems like a resilient financial system, there are technical factors that seem likely to support risk markets for now. At the top of the list is $6 trillion in money markets that will be looking for a home as interest rates start to fall. At the bottom of the list is the still-plausible argument that stocks rise in 79% of U.S. election years as incumbents do what they can to fend off recession.

At this stage, it’s worth considering those parts of the U.S. market that have lagged the Magnificent Seven tech stocks that have delivered flabbergasting returns. It’s also worth exploring international markets that should benefit from stronger currencies and much cheaper valuations. Even beleaguered emerging markets tend to rally when the Fed starts to cut rates and global growth remains resilient. China’s outlook isn’t especially bright, but there’s a lot of bad news already baked into an equity market currently priced at less than half the valuation of the S&P 500.

So stay the course, but listen to the second best investment advice from General Powell: “Fit no stereotypes. Flexibility is all important. Be ready to change on a dime.”