Reflecting on any prior time period, in this case Q2 2024, it’s important to do so in the context of the totality of the picture we’re trying to understand. In the present context of economics and investing, how do we know what to value? When and how do things matter together, in what way(s) do they affect the economy’s health, what matters right now, and what are the essential longer-term requisites for our society to thrive?
The Market Environment Today
Growth in the U.S. economy continues to come in above expectations, despite elevated interest rates, weakness in some major international economies, and a drawdown of consumer savings. Although real GDP growth slowed in the first quarter of this year, it’s looking increasingly as though policymakers have helped avoid a recession, all while bringing inflation closer to the Federal Reserve’s preferred 2% target. Consumer spending has remained strong for the first half of 2024 due to sustained improvements in the labor market and stable levels of spending by business and government sectors. These factors are projected to support real GDP growth for the remainder of this year.
This bodes well for continued economic growth for the rest of the year, but of course these general trends, based as they are on historical data points, can be—usually are—affected by other market and exogenous events.
Short-to-medium-term downside risks complicate any outlook. Continued geopolitical conflicts and trade actions will probably cause inflation to stay higher for longer than it otherwise would, which could in turn cause the Fed to raise rates, contrary to the accepted narrative that cuts are coming in Q4. The picture then may look something like: the consumer price index (CPI) inflation stays above the 3% threshold for the third quarter of this year, spooking the Fed’s hawks and another rate hike proposal is put on the table. This is a medium possibility. Less likely but still possible is that, because of the tariffs and geopolitical events in Ukraine, the Middle East, and elsewhere causing a possible oil price shock ($100 or more?), the Fed may be driven to hike rates twice in the near term. Even with this Fed action, in this scenario CPI inflation may stay above 3% well into 2025.
More likely, we believe, is that in the second half of 2024, job growth slows because current levels of job formation are not sustainable given demographics and labor force participation. As a result, the unemployment rate grows in the short term, as the effects of the last series of rate hikes continue to reverberate and discourage new investments in the economy, although this will be partially offset by major investments prompted by the Inflation Reduction Act (IRA), at least in the manufacturing sector. In addition, investments in intellectual property—such as the use of AI and other novel technologies—will continue to drive growth in the business sector, revealed in strong quarterly reports from the companies best able to capitalize on the trend.
What’s a likely scenario for Q3 and Q4? The story is positive overall. Consumer spending will likely continue to rise probably in the same ballpark as the 2.2% increase in 2023. Business investment so far is down a shade in 2024 from a strong 4.5% last year, but is still robust, and government spending will rise at least 2%. If these occur—Green Alpha’s base case scenario—the U.S. economy will probably continue to outperform many other global economies in the short term.
But we can’t overemphasize the risks of a full-blown trade war. Deglobalization trendiness aside, the world is presently economically so interconnected that it is not difficult to imagine significant tariff action slowing GDP growth to under 1%.
Rolling this up, it’s as likely as any outcome that CPI may finally fall a little by the end of 2024, and the Fed will then attempt to engineer their desired “soft landing” by cutting rates once or twice in the second half of 2024 and then continue with cuts until reaching their neutral rate of 2.5% to 3% by 2027.
What Will be the Effects of AI?
AI is more than a buzzword; the increasing sophistication and availability has already replaced some jobs and creating new ones. This transformation will continue—and since technological change is not linear, there is the possibility—even likelihood—of fast changes that help boost productivity significantly. In this scenario, GDP will rise faster than expected and could exceed 3% per year, quite a bit higher than the Fed’s 2% forecast. This scenario also results in higher long-term potential for the economy. In that sense, productivity gains from AI show that rapid economic growth can remain sustainable in the long run. Artificial Intelligence is infusing every sector, leading to productivity gains Green Alpha thinks will continue to accelerate across industries.
Longer Term
Given the uncertainty in the world today, perhaps it’s not surprising that many investors are inclined to choose index funds over active management and stock picking. The index worked historically, so it feels safe, and, even if it isn’t, index investors can feel assured that they’re in the same risk boat as most other investors. Green Alpha thinks differently.
We love finding the most innovative firms across industries and company sizes that are growing faster than underlying GDP and consolidating market share away from solutions of the past. This results in uncorrelated, high active-share portfolios, and that gives us a huge advantage in terms of strategic positioning as the economy evolves.
Green Alpha’s 5-to-10-year focus is our advantage. Our time frame mismatch with the market zeitgeist is working: our relatively volatile performance compared to benchmark indices (both outperforming and underperforming, variously), provides opportunity to acquire exposure to the evolution of the economy entirely outside of today’s ultimately ephemeral CPI discussions. Disruptive innovation offers long-term opportunities for exponential growth not easily found in indexes.
The unprecedented 20-fold increase in interest rates over the last couple of years has created a challenging environment for our style of innovation-focused investing. Higher interest rates increases the discount rate used to calculate the theoretical value today of a guesstimated future stream of cash flows, which makes those cash flows appear less valuable. All of that is, of course, temporary and almost doesn’t matter relative to the larger view of which companies are taking market share with their better mousetraps and are.
When the Fed moves to lower interest rates, companies that have been innovating to make better, cheaper, faster, more productive goods and services will be the first and highest beneficiaries.
The bottom line? The economy is complex, messy, and full of surprises. But if you’re willing to look past the short-term noise and focus on the long game of innovation and productivity gains, there’s a lot to be excited about.
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