Q4 2023 Outlook:
Investing for the Fourth Turning
The Fourth Turning Is Here is a horror story with a happy ending. The book is a sequel to 1997’s The Fourth Turning which garnered a cult following and pop-culture cachet—it even inspired a Pulitzer-nominated play. The United States is currently in a Fourth Turning or a period of crisis, according to author Neil Howe’s latest book. After the current crisis, Howe sees a bright future by looking to the past. Historical cycles repeat. Although winter is here, a spring of growth and renewal is on the way.
The book argues that U.S. history moves in repeating 80-year cycles. A cycle is composed of four eras, or “turnings.” Each turning arrives in the same order, lasts between 20-25 years, and has a characteristic social mood. We are on the cusp of a transformative period of upheaval, the book claims. It’s not the first cycle for America. Previous fourth turnings—the American Revolution, the Civil War, and WWII—have positively reshaped the nation.
Howe believes the 2008 financial crisis kicked-off the fourth turning. It tipped America into an age of uncertainty. The signs of disorder are familiar to anyone watching the news: political polarization, fiscal dysfunction, higher inflation, and a general feeling of malaise and frustration.
But Howe is an optimist, not an eschatologist. Despite the current crisis, America has a unique ability to trans-form itself.
Reforming current institutions is the necessary chrysalis we must pass through to reach a new civic order. These changes will clearly impact financial markets.
How should investors respond? After a summary of Q3 market activity we focus on three key strategies for navigating market uncertainty and the fourth turning.
Q3 2023 Market and Economic Summary
U.S. Economic Performance: Inflation, Spending, and Debt Up; Savings Down
- In September, CPI rose 0.4% for the month and 3.7% over the last 12 months.
- U.S. national debt tops $33 trillion for the first time as Fitch downgrades U.S. sovereign debt. Since the start of the year, the U.S. government has added $2 trillion in public debt.
- Americans keep spending. Consumer spending increased 0.4% in August. But saving rates dipped to 3.9% from 4.1% in July.
- Unemployment was unchanged at 3.8% in September. Workers are striking while inflation is hot. Just as the months-long Screen Actors Guild strike ended, more strikes are flaring up.
Monetary Policy: Hawkish Pause
- The Fed raised interest rates in July by 25 basis points, bringing them to a range of 5.25%-5.5%, the highest level in more than 22 years. The Fed paused in September but maintains a hawkish stance.
- T-Bill and Chill? The yields on 10-year and 30-year keep climbing, giving long-term holders a painful lesson in duration and new buyers fewer reasons to invest in equities.
- No recession yet, but the Treasury yield curve hit its most inverted level in 40 years.
Credit Market Performance: IG Flat as Leverage Loans Surge, Private Credit Grows
- YTD Investment Grade bonds are flat, High Yield is up 5.9%, and Leveraged Loans (LLs) are up 10%. LLs have had their strongest start to the year since 2009.
- U.S. speculative-grade default rates are expected to rise to 4.5% by June 2024, says S&P Global. This is up from 3.5% in July 2023.
- Banks expect to further tighten their lending standards over the remainder of 2023, says a recent Banking Lending Practices survey.
- Private credit funds have built up nearly $450 billion of dry powder as the asset class keeps growing in popularity. Private credit is increasingly filling the void left by banks pulling back from lending.
U.S. and Global Market Summary: AI is Hot, Crypto and NFTs are Not
- The Nasdaq 100 has surged 34% year-to-date. AI-focused companies keep outperforming.
- Sweet, Crude and Expensive. Brent crude-oil futures traded near $95/barrel at the end of September. Energy prices will continue to impact inflation in the near term.
- The ECB raised the key interest rate to a record high of 4%, marking their 10th consecutive increase as they continue their battle against inflation. This is likely to be the last rate increase, given the weakness of the Eurozone economy.
- It’s so over? The majority of NFTs are now worthless says a new report. 2020’s hottest asset class has gone cold.
How should investors prepare for the Fourth Turning, or any period of extended uncertainty?
We believe that investors should focus on (1) long-term holdings, (2) inflation protection, and (3) asset diversification.
I. Focus on Long-term Investing for Better Results
Long-term investing is key in the context of a Fourth Turning. The economic environment during these transformative periods can be unpredictable, often leading to increased market volatility. Short-term investment strategies may be ill-equipped to navigate this volatility, as they are more likely to be influenced by emotional decision-making and speculative risks. In contrast, a long-term investment approach is more likely to weather the ups and downs, given that it typically involves a diversified portfolio aimed at capital growth over an extended period.
Market history supports long-term holding. Even with severe short-term market fluctuations, the market tends to increase in value over the long haul.
S&P 500 Total Return: % of Time Positive Over Various Timeframes
Source: Bespoke Investment Group via TKer
The U.S. economy has repeatedly shown its resilience. It was barely slowed down by COVID.
Quarterly U.S. Gross Domestic Product
Seasonally adjusted and shown in constant 2012 dollars
Source: Bureau of Economic Analysis, Congressional Budget Office via FRED, The Washington Post
And as tech guru Richard Ngo has pointed out, previous fourth turnings, like the Civil War and WWII, barely slowed down U.S. economic growth.
GDP per Capita, 1650 to 2018
The data is adjusted for inflation and for differences in the cost of living between countries.
Source: Maddison Project Database 2020 (Bolt and van Zanden, 2020). OurWorldinData.org, economic-growth
Note: This data is expressed in international-$ at 2011 prices.
II. Inflation Protection Will Be a Key for the Fourth Turning
Government instability is linked to higher inflation. During times of instability, governments generally increase public spending and typically take on more debt to do so. Investors should therefore contemplate financial vehicles that are resilient to, or even benefit from, inflation.
Investors have traditionally turned to real estate and commodities to hedge against inflation. Real estate is popular because property values and rental income often increase when inflation rises. Commodities like gold or agricultural goods can also provide some insulation, as their intrinsic value often holds up despite currency depreciation.
Modern investors also have the option of investing in floating rate securities. Private credit has surged in popularity with institutional investors allocating more to the asset class. Loans in general have variable interest rates and are tied to a benchmark like SOFR. When interest rates rise, often in response to inflation, the interest on floating-rate loans adjusts upward, benefiting the lender or the investor holding the loan. This makes loans an attractive investment in an inflationary environment where fixed-income assets might see their real value erode.
III. Broad Asset Diversification
Maintaining broad diversification will mitigate against correlated assets simultaneously declining. The old 60/40 stock/bond portfolio is passé for most institutions. Those investors continue to increase their allocations to alternative investments, like hedge funds, private equity, and other less liquid investments.
Diversification should be broad across other dimensions. Allocating across different asset classes, sectors, and even geographical regions can provide a robust risk mitigation strategy. Most U.S. investors are severely underweight international holdings. Including more international assets in your portfolio not only diversifies risk but can also serve as a hedge against domestic inflation and currency depreciation.
“The farther backward you look, the farther forward you are likely to see.”
- Winston Churchill
A criticism of any theory of cyclical history is that it’s procrustean. That the pieces fit only with the benefit of hindsight. Nevertheless, Howe has shown skill in predictions. His 1997 book had forecasted a highly contagious virus sweeping the nation and leading to lockdowns; conflicts in and around Russia; and a massive infrastructure spending uptick.
Financial professionals are used to the idea of cyclical time, which explains The Fourth Turning’s popularity with asset managers. Forewarned is forearmed, and expecting a cycle will make it easier to ride out. A well-diversified asset allocation that protects against inflation is a prudent long-term strategy regardless of what turning or stage of the credit cycle we are in.