The Year No One Saw Coming - 2023 Review

Uncertainty around inflation, interest rates, and a possible recession has been the dominant theme in the stock and bond markets this year. The Fed wound down its two-year inflation fighting campaign of interest rate increases this fall as inflation continued its down- ward retreat, all while the economy continued to grow. This resulted in significant gains for the stock market and modest gains for the bond markets in 2023 after an atrocious 2022. Stocks were up 26% in 2023 as measured by the large cap S&P 500 index. The S&P 500 was just 0.6% from its record high of January 3, 2022, a gap of 498 trading days. When this index hits a record, it’s typically good news for stocks in the next year. The index has outperformed its long term average one year later 13 out of 14 times by a median of 13.4%. The Dow Jones Industrial Average advanced 14% and the tech heavy NASDAQ soared 43%.

Behind those numbers there was much differentiation in the market, from size to sectors, to value vs growth. Shares of seven stocks—Apple, Microsoft, Amazon, Nvidia, Alphabet, Tesla and Meta Platforms, also known now as the magnificent seven, jumped 75% in 2023. That has left the other 493 companies in the S&P 500 far behind with a gain of 12%, while the index as a whole has added 26%.

Among the various sectors, technology, communication services, and consumer discretionary soared above all other sectors.

Growth stocks, especially large and mid-size, outperformed the market as well.

Overall, it was not a bad year, especially when considering a vast majority of economists and market pundits predicted a recession in 2023. In comments on the US economic outlook, Treasury Secretary Janet Yellen took a swipe at economists who predicted only a recession would tame inflation.

“Economists who’ve said it’s going to require very high unemployment to get this done are eating their words,” she said. “It doesn’t seem at all like it’s requiring higher unemployment.”-

Instead, the economy continues to grow at a healthy pace with third quarter GDP growing 4.9%. The labor market continues to attract more workers and create more jobs, keeping unemployment near historic lows at 3.7%, while inflation continues to abate. Nearly three quarters of a million people found jobs last month, even more than the half million plus that entered the labor force.

For U.S. consumers, the news is only getting better. Two and a half year lows in gasoline prices and all-time high stock prices are giving shoppers an extra spring in their step and we are seeing the strength in retailers’ sales comments. The housing and real estate industry also looks to be in store for a pivot in 2024 fortunes as lower mortgage rates have given buyers increased appetites.

Inflation continues to fall and if not for housing and auto inflation, the core CPI figure would be lower. Note well that future housing/shelter costs are trending lower given that it lags the raw data. The Fed is walking a fine line: if they don’t begin to cut rates, then they risk wounding the economy; but if they cut rates too soon or cut too much, then they risk a resurgence of inflation.

The personal consumption expenditures (PCE) index measures the changing prices of goods and services. “Core” PCE excludes food and energy prices, which tend to be volatile. For PCE: Personal Consumption Expenditures Price Index (PCE DEFY Index), For core PCE: Personal Consumption Expenditures: All Items Less Food & Energy (PCE CYOY Index), percent change, year over year.

Even downbeat consumers surveyed by University of Michigan recently perked up, largely because they saw inflation abating- all good news to the Fed. The widely watched University of Michigan consumer sentiment index jumped to 69.4 from 61.3 in November, with expectations of inflation in the year ahead falling to 3.1% from 4.5%.

The markets also had notes from many corporations giving us a glance at their Q4 progress. And earnings for next year are expected to grow above average at around 10%, after an expected growth rate this past year of 3%. Bottom line: more companies were seeing a resumption of strength rather than a slowdown. All this good news has led to gains in bonds, stocks and credit.

The bad news is interest rates are unlikely to decline anywhere near as much as the markets are betting. That good employment data means the fed is unlikely to slash interest rates nearly as much as the bond and stock markets are betting. At this point, the bond market is pricing in about six rate cuts, which seems aggressive. The Fed is predicting only three rate cuts next year, assuming inflation is under control. Chair Jerome Powell will likely have to push back against market speculation about lowering rates by one and a half percent or more next year. Such a sharp drop would only make sense in an economy in recession, evidence of which seems scant. But in the absence of deterioration in the economy, the scope for easing of rates is limited. All of which is consistent that interest rates will remain higher for longer.

The action in the bond market has been anything but plain-vanilla over the past year. Ten-year Treasury yields have spanned a huge range—from as low as 3.25% in April in the wake of the banking crisis to as high as 5.02% in October on surprisingly strong third-quarter economic growth. In 2024, we look for lower yields but expect bouts of volatility along the way, as markets continue to try to anticipate shifts in Fed policy. Assuming the Fed continues to lag market expectations for rate cuts, the market will be very at- tuned to every data point, likely causing yields to trade in wide ranges.

Nonetheless, we believe that both short- and long- term yields likely have peaked for the cycle and will continue to fall, assuming inflation behaves in 2024. In our view, much of the inflation driven by supply short- ages early in this cycle has been corrected, but the full impact of the tightening in monetary policy by major central banks is still working its way through the global economy. Slower growth and less inflation pressure should be the result.

Economic indicators will be pivotal in 2024, especially as economists project the Consumer Price Index (CPI) in the U.S. to decrease to 2.7% and the Federal Reserve’s forecast interest rate to be at 4.6% by year’s end. Here’s hoping for a solid New Year in the financial markets, and a happy New Year to you and your family.