By Eli Levi
My 2023 analysis (conducted in January):
Charlie Munger, the legendary investor, and Warren Buffet’s partner, is known to say, “Show me the incentive and I will show you the outcome.” In 2022 and continuing into 2023 the incentives have changed, namely the Fed Funds rates.
The Fed Funds rate, which sets the tone for the rest of the fixed income market, has gone from the zero bound to 4.5% with four 75 basis point rate hikes in a row. The 30-year fixed mortgage rate in New York is currently 6.7%, with a 20% down payment and a credit score between 700-719. The Fed has remained hawkish and many say this might lead to a recession, yet if inflation is looked at on a month-to-month basis as opposed to the traditional annual rate, currently at 6.5%, it is a different story. For the months of March, April, May, and June, the one-month percent change in the Consumer Price Index was 1.2%, 0.3%, 1.0%, and 1.3%, respectively, whereas from July to November the change was 0.0%, 0.1%, 0.4%, 0.4%, and 0.1%. The most recent CPI data for December was negative 0.1% inflation—deflation. If the Fed sees that its rate hikes have the desired effect, it might be able to let up earlier than the market expects, thereby sidestepping a possible recession. Nevertheless, the 2 and 10-year treasury have crossed paths and it has been one of the strongest indicators of a recession to date. Yet, with nonfarm payroll adding 223,000 jobs and unemployment decreasing to only 3.5%, it is hard to imagine a recession beyond the technical definition of two-quarters of negative GDP.
The most relevant comparison is to the dot com bubble that, while technically a recession, did not affect much other than the bubble of internet stocks. Right now a similar kind of recession will likely occur. Twitter, which laid off almost 66% (probably more now) of its staff still functioning albeit with more glitches. Given low-interest rates and infinite money, large tech companies like Meta and Google had no reason to ever cut or hold back from firing on all fronts and making any bet they thought might pan out from AI to self-driving cars. Now, the top tech companies seeing that Twitter was able to lay off so many and still have a minimum viable product combined with the end of infinite money and investors caring more about the bottom line as opposed to growth at any cost are surely thinking that they can afford to cut costs. Layoffs are pervasive across high-flying tech companies, and Wall Street Meta is cutting 11,000 jobs, Salesforce 8,000, Amazon 18,000, Spotify 600, Credit Suisse 2,700, and Goldman 3,200 which is around 6% for these companies. Google is finally combining Waze and Maps and laying off 12,000, the S&P is down 14%, and the Nasdaq 25% since one year ago. Most of this can still be explained by overhiring and the growth-at-any-cost mindset that was 2021. While all of these layoffs may seem like an indicator of a recession, I think it is an indication of the insane growth of the past decade. Amazon added 800,000 jobs in 2020 and 2021. With this context, the 18,000 employee layoffs should not indicate a recession but rather a healthy reset. The macro story so far seems to be some form of a white-collar recession with a tight labor market giving plenty of cushion for even a hawkish Fed. Additionally, the fact that there are layoffs in the tech sector is healthy; the market was so tight that many startups struggled to hire and find talent. The era of free money is over and that calls for a reset which every market needs. While some individual markets like real estate and crypto might go into their own recession, the broader market should hold steady even if the stock market itself is still down.
While the stock market is not a good indicator of the overall health of the economy, it is what many investors care about the most, especially for any market outlook. With quantitative tightening and rising interest rates the multiples that companies are valued at come down significantly. Ultimately, a company is only worth its cash flows and a recession brings that to the fore. With borrowing costs on the rise, price-to-earnings multiples become restricted. As long as the Fed is raising rates, valuation multiples should remain low.
In Retrospect:
In my early 2023 analysis, I pointed out the significant shift in the Fed’s approach, with four consecutive 75 basis point rate hikes, leading to higher mortgage rates and affecting various sectors. I highlighted the monthly inflation rates and suggested that if the Fed achieved its goals, it might ease up earlier than expected, potentially avoiding a recession. The comparison to the dot-com bubble recession and the observation of layoffs and a shift towards profitability in the tech sector were key aspects.
Looking at what has transpired since then, my assessment seems to have some accuracy. The Fed did continue its hawkish stance, and the tech sector did experience significant layoffs, aligning with the notion of a healthy reset. The stock market downturn and the impact on valuation multiples also support the idea that borrowing costs and rising interest rates influence company valuations. However, the ultimate judgment depends on how the events unfolded post-2023 and whether the broader economic indicators align with the predictions made in the analysis.