2023 Year in Review
What a contrast between a sensational 2023 and a difficult 2022 for global financial markets!
Despite all the twists and turns, 2023 turned out roughly the way we postulated in last year’s outlook letter (that occasionally happens). Inflation rates receded, Federal Reserve rate hikes concluded and corporate earnings estimates eased to more realistic levels. This enabled investors to look beyond 2022’s fear of recession to more consistent economic times. The biggest surprise turned out to be that the US economy did not in fact go into recession and the odds continue to shrink that a recession is imminent.
As a result, and as we suggested, US equity markets performed admirably, with the S&P 500 gaining 26.3%. The gain in the overall index is actually a little misleading as performance was led by the very largest companies. The average S&P 500 stock gained 13.9% (as measured by the S&P 500 Equal Weight Index) – still strong but not to the level of the overall index. International equities also participated, gaining 18.2% and 9.8% as measured by the MSCI EAFE index and the MSCI Emerging Market index.
In a similar vein, after experiencing by far their worst annual return in decades during 2022, bonds rose a solid 4%-7% in 2023 depending on the broad fixed income index. Interestingly, 10-Year U.S. Treasury bond yields ended 2023 at 3.87% - very close to the 3.83% yield at the close of 2022. This masks the peak yield of 4.99% reached in October and subsequent decline once inflation fears receded and it was understood that Federal Reserve rate hikes were complete. Most importantly, bonds have returned to playing their traditional role in a diversified portfolio of providing solid income and a reasonable hedge to equity volatility.
In the end, investor mindset entirely flipped and financial markets produced a banner year.
Source: Refinitiv, S&P Global
2024 Market Outlook
As we turn our attention to 2024, there are reasons to be optimistic. We expect a multitude of positive contributors to both equity and bond markets including: a) economic trends - encompassing moderating economic growth, inflation and better labor market balance, b) less restrictive monetary policy and c) re-accelerating corporate earnings growth.
Let’s delve into these contributors a little further.
Economic Trends – The last couple of years have seen incredibly tight labor markets, strong consumer spending on experiences and massive supply disruptions (see Pandemic Impact commentary below). All of this has contributed to outsized inflationary pressures. Long-term economic health requires that these imbalances ease and that is precisely what we expect in 2024. With moderating (but still positive) economic growth, we imagine a return to a lower, but more sustainable, level of consumer spending. We also foresee a more balanced labor market where companies will have an easier time finding workers. As such, we do not expect inflation to be a major story in 2024.
Federal Reserve / Monetary Policy – Current Federal Reserve interest rate policy is restrictive, meaning that high interest rates are slowing economic growth in many sectors. But, with inflation tame and economic growth positive but slowing, the Federal Reserve no longer needs to maintain a restrictive Federal Funds rate. As such, we expect the Federal Reserve will begin to lower interest rates during 2024 - not because there is an imminent need to try to spur economic growth but rather to become less restrictive. We would use the term “normalization”. Lowering the Fed Funds rate to a more neutral level bodes well for the U.S. stock market. One caveat would be if the Fed was forced to lower interest rates quickly to combat a significant economic slowdown that portended a recession. Should that circumstance play out, the outlook for equity markets would be negative. The nuance between the two scenarios (normalization vs. easing) has very different implications for stocks even though they may look the same.
Corporate Earnings - While the U.S. economy did not experience an economic recession, it did suffer through an earnings recession. Year-over-year corporate earnings growth declined for 3 consecutive quarters between the fourth quarter of 2022 and the second quarter of 2023. Fortunately, earnings growth turned positive again during the third quarter of 2023. Importantly, earnings growth is likely to accelerate from the low single-digit growth pace of the second half of 2023 into mid/high single-digit growth in 2024.
Given financial markets’ propensity to look forward, it is likely that some of the positive trends described above have already been partially reflected in financial markets. Still, we do expect solid returns in both equity and fixed income markets during 2024.
U.S. equities should build on their strong 2023 and we forecast 10%-12% gains in the S&P 500 in 2024. Inevitably, potential gains will not be smooth and we would not be surprised to see a typical 10% pullback somewhere over the course of the year.
On the fixed income side, assuming our main scenario plays out, we could see interest rates decline. We expect the Federal Reserve to lower the Fed Funds rate by 75-125 basis points during the year. Intermediate bond returns would likely be a little above the simple income generated by a bond portfolio. As such, we anticipate that intermediate bonds will produce 4%-7% total returns in 2024.
While most U.S. Covid lockdowns ended in late 2020 or early 2021, Covid’s impact on the economy, consumer/corporate behavior and government policy has been ongoing for 3 years. The best analogy is a boulder that has been dropped into a pond (or bathtub!). The ripple effects, over-reactions and under-reactions can last long beyond the time the boulder actually settles to the pond’s bottom. This was certainly true for the global economy, supply chain disruptions, labor supply, consumer underspending and then overspending, real estate market, corporate adjustments and massive government stimulus. From an economic perspective, most traditional forecasting models were rendered useless as these myriad crosscurrents worked their way through the economy. All that said, perhaps, perhaps, perhaps, by the end of 2024 traditional economic relationships will once again re-establish themselves and the pandemic will truly be in our rear-view mirror.
Oh joy, oh bliss. It’s another election year. No matter what side you may prefer, the year will almost certainly bring with it a gamut of emotions and much discomfort. While politics and leadership can play a large role in our feelings for the direction of the United States, its impact on the economic landscape and financial markets tends to be much less – particularly with a dysfunctional government. Because many identify so strongly with their political party it is natural to conflate success or defeat with the direction of financial markets.
Ukraine/Russia, Israel/Palestine, China/Taiwan, Houthis/Red Sea, North Korea. It sounds like the Billy Joel (and now Fall Out Boy) song “We Didn’t Start the Fire”. The song was written to show how every generation deals with immense global challenges. For many, current geo-political issues are having a direct and painful impact. We live in dangerous times and will continue to do so for generations to come. From an economic perspective, some of our global tribulations have more of an impact than others. When analyzing our current set of challenges purely from an economic / financial market perspective, ask yourself whether or not U.S. employment is impacted. That is usually a good guidepost for the true financial market impact.
So now let me end my 2024 outlook as I end all my outlooks: Of course, despite our best laid plans, events through 2024 will likely conspire to force us to alter our thinking. We will continue to be vigilant and adjust our thinking and strategy as events warrant.
Wishing you a Happy, Healthy, Safe and Successful 2024!