By Kristopher Korzi, CFP®, AIF®, on behalf of Stonebridge Financial Group advisors
In what was widely expected to be a difficult year for the economy and capital markets, 2023 ended up being full of positive surprises. The S&P 500 rallied 26.3%, the Bloomberg Aggregate Bond Index returned 5.5%, and the economy was resilient as inflation eased. Consumer spending stayed strong despite relatively low sentiment, and the consensus appears to be that we are now on track for a soft landing.
Much like in 2022, the Federal Reserve spent last year at the center of headlines as it fought to slow inflation without triggering a recession. It paused rate hikes in the summer after reaching a Federal Funds Rate target of 5.25-5.5%, and so far, it has successfully reduced PCE inflation to 2.6% while maintaining economic growth. However, markets expect the Fed will start cutting in March and continue cutting throughout 2024.
These expectations came about in November after the Treasury reversed its decision to issue more long-term debt, and the Fed claimed its hiking campaign was over. From that pivot point to the end of the year, the 10-Year yield fell around 100bps, and stocks rallied over 13%. If the Fed is indeed this aggressive in cutting, we worry that inflation could trend upward again, albeit less drastically than in 2021. Also, even if the Fed does start cutting, we are unlikely to return to the almost-zero rates seen in 2020. Our suspicion is that we have seen a regime change in yields and that their secular downtrend is over. If this is the case, investors may need to expect lower equity returns in general, as shown by the trend in S&P 500 compound annual growth vs. 10-Year Treasury yield below.
We are also not convinced the economy is completely out of the woods yet. The yield curve remains inverted, money supply is shrinking, commercial and industrial loan activity has declined, and in 2024, we might finally see how the consumer looks after government stimulus runs out. The high level of pandemic savings has allowed consumers to save less of their ongoing earnings than usual, but that artificial boost might soon be exhausted. Housing affordability greatly affects spending patterns and is unlikely to get better soon as mortgage rates, home prices and rental costs remain elevated.
Additionally, we may not have seen the full effects of tight monetary policy. Inflation has certainly come down, but it could be due more to supply chain improvement than rate hikes. It is unlikely the Fed has done enough to cause a serious downturn, but a mild recession is still not out of the question. We just hope policymakers don’t become so afraid of a recession, especially in an election year, that they worsen our debt and spending problem. We cannot run deficits this large forever, and large deficits helped temporarily lift spending levels.
At this point, it is too early to make calls on the 2024 election, and we suspect the race will have plenty of unpredictable twists and drama until the end. We do know that stocks have historically performed well in re-election years, which could be because sitting presidents like to prime the economy going into their re-election bids. Stocks also tend to outperform in election years when the incumbent party wins, although long-term returns have been generally similar regardless of which party is in office.
Along with the U.S., nearly 40% of the world economy will be voting for heads of state in 2024, setting the stage for more geopolitical uncertainty after a 2023 with historically few elections. Along with the ongoing conflict in Ukraine and the Middle East, an interesting story to follow will be our relations with China and whether our leaders follow through with attempts to de-escalate trade and military tensions. Given how expensive defense spending has become, at the same time that net interest costs have soared, we might need to be more cautious in choosing our global involvements (see chart below).
Despite all the turmoil overseas, international stocks fared quite well in 2023. However, the biggest story for equities was the success of the tech-heavy names at the top of the U.S. market. The largest seven companies (now commonly referred to as the Magnificent Seven) led the Nasdaq-100 Index to return 55.1%, and they now make up around 27% of the S&P 500 market cap. However, they only account for about 18% of S&P forward earnings and 10% of forward revenues, implying that their capitalization weightings may not be justified.
These high-flying companies could very well continue outperforming, especially if artificial intelligence can significantly enhance productivity, but it is important to be aware of the concentration risk inherent in owning market-cap weighted indices. As a reminder, some of 2023’s highest returners, like NVIDIA, Meta and Tesla, lost over half their value the year before.
2023 was a fantastic year for growth stocks, and while we do have some growth exposure, we want to be cautious of chasing those returns. We continue to see more value in well-established, high-quality dividend growers, which have a history of outperforming during and after rate hike cycles. We are also keen to avoid the concentration risks at the top of the market and in the technology and communications sectors, as alluded to above.
International valuations continue to look quite reasonable, but we are not overweighting them at this point given the ongoing heightened potential for geopolitical unrest. We anticipate the trend of deglobalization will continue, and active management might be necessary to pick specific attractive markets.
The action in fixed-income markets was remarkable in 2023, as the 10-Year took quick and drastic swings. Although the movement of rates has become unusually hard to predict in this environment, we remain underweight duration due to the attractive yield and safety of the short end, along with our view that long rates could have more room to rise than they have to fall. We also continue to prefer high-quality bonds given that high-yield spreads keep narrowing.
In these times of economic and market uncertainty, we still believe allocations to alternative asset classes can provide valuable diversification benefits. A source of uncorrelated returns can help smooth a portfolio’s ride, especially when stocks and bonds are moving in the same direction.
Charts provided by Strategas Research Partners, LLC.
Material discussed is meant for general/informational purposes only, and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary, therefore, the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss. The opinions and forecasts expressed are those of the author and may not actually come to pass. This information is subject to change at any time, based on market and other conditions.
Kris is a Director – Portfolio Management at Stonebridge and creates a range of investment strategies with an emphasis on cost and tax efficiency.. When away from the office, Kris spends his time cooking or hunting.