By Jason Crawshaw, EVP & Portfolio Manager at Polaris Capital
2023 will be remembered as a year of several plot lines. The year started with economists calling for a recession; by summer, the consensus shifted to the “higher for longer” (higher inflation and interest rates for longer period) catch phrase; but by November, the temperature changed to cooling inflation, rate cuts and a “soft landing” scenario. The early anticipated recession did not materialize; in fact, just the opposite occurred with the S&P 500 Index up 26.29% for the year, leveraging gains from a concentrated group of mega-cap tech stocks (“Magnificent Seven”).
Stepping back and looking from a historical perspective, a key driver of returns was accommodative monetary policy — the same tool to deal with every equity market downturn over the past 20 years. Consider the dot.com bubble bust, the 2008 Global Financial Crisis, the European banking crisis and the COVID-19 pandemic. Investors became fixed on cheap and, in some cases, almost free money (i.e. with negative nominal and real interest rates). While low-cost capital provided fuel for economic growth, the unintended consequence was market excess and over-inflated asset values on a global scale… none of which were healthy for long-term capital market stability.
But it certainly boosted residential property in Hong Kong, office buildings in San Francisco, 30-year fixed bonds and growth stock prices as evidenced by the booming S&P 500. Companies with limited near-term earnings but high expected growth rates (resulting in longer dated cash flows) were the biggest beneficiaries. But “time might be up” for growth stocks…
The single biggest influence on equity markets this past year was the unprecedented speed at which interest rates rose. The markets whipsawed in the fourth quarter, as the Fed signaled rate cuts in the second half of 2024; we expect an environment of modest rate cuts by the end of 2024, targeting real interest rates at levels around 0.5% for short-term maturities to upwards of 2.0% for 20- and 30-year bonds. If inflation moderates, nominal rates should follow.
However, there are risks to decelerating inflation, namely wage inflation, shipping interruptions, duplicate supply chains and other cost pressures that companies must either pass through or suffer margin pressures that will not be good for equity valuations. Based on our dialogue with management teams worldwide, it appears moderating prices have been helped by destocking. As inventory reductions turn to rebuilding, it is possible supply chains will tighten up and prices may start to trend up again.
Regardless of the near-term rate challenges, we suspect that the Fed and other central banks will keep rates at more stabilized levels especially in real, after-inflation terms, departing from the ill-advised period of artificially low rates. While the timing of interest rate cuts is uncertain, the Fed had penciled in three rate cuts for 2024 in its last meeting. More appropriately priced cost of capital has far-reaching implications and is particularly beneficial for value stocks. In simple terms, when the cost of capital is no longer zero, it matters what you pay for things.
In international markets, value investing benchmarks changed direction; we will watch if U.S. markets follow. But U.S. markets have a ways to go, as a combination of variables resulted in the perfect storm for an overheated U.S. growth market over the past 10+ years. Artificially low interest rates, growth of earnings, COVID-19 disruption, retail investors fueling a meme stock mania and excess liquidity are just a few. U.S. stocks reached some of their most expensive levels, with valuations stretched in relative and absolute terms. The trend continued throughout 2023, with the U.S. euphoria driven by “The Magnificent Seven” capitalizing on hype surrounding artificial intelligence. Yet, unrealistic company valuations don’t jive with the actual growth of cash flows at some of these companies.
(One note: we would be hypocritical in not mentioning we have benefitted from one Magnificent Seven holding, Microsoft Corp., which has been a long-term and well-timed Polaris value investing holding going back more than a decade.)
Investors are finally starting to pause and re-evaluate the heady growth projections of some U.S. companies, noting the pronounced disparity between U.S. and international stock market valuations. As of January 31, 2024, the MSCI USA Index was trading at a price/earnings ratio of 25.4x, compared with the MSCI EAFE Index trading in the mid-teens. Industry pundits are now advocating to broaden their foreign exposure… with good reason. We obviously concur with this assessment, as our global portfolios have been underweight the U.S. market for years, finding more value investing opportunities in non-U.S. markets in Europe, Asia and emerging countries. Geographic rotation is only one snapshot of an evolving market; sector/industry rotation is also on order.
In 2024, we anticipate that the Fed (and other central banks) will begin lowering rates in small increments, but we will not see a return of artificially low rates. Rates will be a determining factor in driving equity returns in 2024; not all equity returns will be equal, with specific parts of the investment spectrum showing more promise than others. In fact, we have seen a rolling wave of in- and out-of- favor sectors and industries. Companies are adjusting to the “new normal”, with supply chain constraints, pricing/inflation balance, consumption trends, labor dynamics and post-pandemic routines.
High-flying tech stocks led the way in 2023, while defensive sectors languished. 2024 might see a reversal of those fortunes. We see opportunity in a number of areas, some cyclical and some defensive. If the U.S. decisively avoids a recession and manages the “soft landing” scenario, then any number of rate-sensitive cyclicals can take the lead. And we have found value investing picks throughout. A few examples:
Consumer discretionary (homebuilders, autos): “Don’t bet against the American consumer” was a tagline that held its weight in 2023, despite rising rates and increased recession risk. We expect another strong showing in the sector, as 2024’s projected lower rates reduce borrowing costs and ramp up purchasing power, especially on big-ticket items like cars, homes and major appliances.
Financials: The 2023 banking crisis was set off by Silicon Valley Bank and Signature Financial. The collapse of these two tech-laden banks shocked the U.S. banking system and drew scrutiny from Federal regulators. Markets were jittery with the news, and the entire industry was under pressure. At this point, banks are cheap by any standard. The Federal Reserve will likely start to cut rates in the second half of 2024, at which point banks should maintain the pricing of their loans and start to cut back deposit rates; net interest margin improvement should result. Banks with right-sized mortgage books, income generative business and strong credit portfolios may do well; many of these will seek out both organic and acquisitive growth in a more normalized market.
Materials: As rates drift lower and the industrial economy strengthens, commodities look favorable. In addition, if China manages to pull itself out of its current malaise, that will add an extra tailwind.
While focused on economic factors in our outlook, we are equally vigilant of current geopolitical risks (U.S. presidential race, ongoing warring factions, trade tensions). Last year at this time, we discussed navigating the polycrisis (the simultaneous occurrence of crises). As 2023 turns to 2024, the world continues to be marred by continuous rolling conflicts. We keep macroeconomic events in sight as we update our global portfolio, seeking to enhance the risk/return profile with cash-flow generative companies purchased as excellent values. Our value investing portfolio remains substantially underweight the U.S. and has roughly a fifty percent allocation to small and mid-caps. Clearly not the consensus way to be positioned, but one that we believe offers exceptional value.
This blog was penned by Jason Crawshaw, EVP and Portfolio Manager, in February 2024. Mr. Crawshaw joined the firm in January 2014 as an Analyst. In 2015, he became an LLC member and was named an Assistant Portfolio Manager in 2016. He was promoted to Portfolio Manager in January 2021 and was named the firm’s Executive Vice President in late 2023. Mr. Crawshaw is a generalist and conducts fundamental analysis of potential value investing opportunities. He brings 20+ years of investment industry experience to the firm.
IMPORTANT INFORMATION: The views in this article were those of Jason Crawshaw as of the article’s publication date (February 20, 2024) and may be subject to change. Information, particularly facts and figures, are dated and in many cases outdated. Views and opinions of Jason Crawshaw expressed herein do not necessarily state or reflect those of Polaris Capital Management, and are not nor shall be used for advertising or product endorsem*nt purposes. Polaris Capital is an investment adviser registered with the Securities and Exchange Commission. For more information about Polaris or its value investing philosophy and process, please contact us at (617) 951-1365 or at clientservice@polariscapital.com.
