2023 Fourth Quarter Investment Market Report

Since the end of the third quarter, we’ve seen the mood of the markets transform from somber to jubilant. Chances are that both will prove to be overreactions, but the last two years have been rather gut-wrenching for many investors as the markets have ridden a roller coaster of volatility—so such mood swings come as no surprise. There is still much uncertainty ahead, but the markets did have reasons to celebrate in the fourth quarter. Thanks to reports of slowing inflation, the Federal Reserve was able to signal that it does not foresee the need to hike interest rates any further, likely ending one of the more severe rate hiking campaigns on record, which had been necessitated by skyrocketing inflation post-pandemic. The timing of this pivot in policy was earlier than expected, so both stock and bond markets took great relief in the news.

We have written much this year about the concentration of the top 7 stocks in the S&P 500 and how they have come to represent about 30% of the entire 503-stock index, which is weighted by market capitalization. Through the first three quarters of 2023, nearly all the return in the U.S. stock market could be attributed to those few stocks, meaning the rest of the U.S. stock market was essentially flat for the year – such a lack of “breadth” generally indicates that market rallies may not be very durable. In a welcome sign of market health, this changed in the fourth quarter as the rest of the U.S. stock market kept pace, and even slightly surpassed the performance of those top stocks. For the quarter, an equal-weighted S&P 500 actually outperformed the market-cap weighted benchmark S&P 500 index, and Small Cap stocks fared even better.

Equities in both Developed Markets and Emerging Markets also rallied on the expectation that the global battle against inflation was turning the corner. With the market perception that inflation is falling more slowly in the rest of the world, the bullish reaction at year-end was slightly more muted abroad than in the U.S., but all equities markets rallied strongly in the quarter. A slight weakening of the dollar, which we see as a longer-term trend, also provided some tailwind to international markets for much of the year. Developed Markets performed better than the broader U.S. market, and Emerging Markets fared quite well considering the continued stumbling of the Chinese economy has weighed down what would have been a very strong performance for most Emerging Market countries.

The Big Story: The Fed and Inflation

“Euphoric” is not an exaggeration in describing the mood of the markets as 2023 drew to a close. After nearly four years of volatility due to the pandemic and the post-pandemic economic effects, the Fed’s pivot away from ever increasing monetary tightening has spawned hope that investors’ lives might be returning to “normal,” at least what they came to know as “normal” in the decade preceding the pandemic. Contributing to this euphoria is a consensus, however historically unlikely, that the Fed has engineered a “soft landing” for the economy – meaning that the Fed was able to slow the economy enough through interest rate hikes to quell inflation, but not so much as to push the economy into recession.

Last year, the consensus heading into 2023 was that the U.S. economy was almost certainly headed for a recession in 2023. The Fed had undertaken the fastest and most severe interest rate hiking campaign in history to try to reign-in out-of-control inflation. The rate hikes had slammed the brakes on the housing market, the office real estate market was collapsing as much of the workforce decided not to return to their offices post-pandemic, and the wealth effect on the economy was surely to be negative as investor portfolios had suffered significant losses in both equities and fixed income. As we progressed through the Winter and Spring, inflation remained stubbornly high, worker shortages put pressure on wages and motivated organized labor to strike in search of substantial wage increases, raising the specter of inflation becoming embedded in the economy. The Fed continued to hike rates, yet the consumer kept spending, employment remained high, economic growth actually reaccelerated in the third quarter, and the “Great Recession of 2023” never materialized, yet the Fed did make significant strides in bringing down inflation. So much for consensus expectations!

With the end-of-year euphoria that the Fed had pivoted away from monetary tightening mode without having pushed the economy into recession, the bond markets reversed course from what had been another year of declines to post a very strong fourth quarter, resulting in strong gains for the year.

What’s Ahead in 2024?

As mentioned above, the consensus market expectation now is that the Fed will indeed achieve a “soft landing” for the economy. At present, most economic indicators do, in fact, indicate that we are headed in that direction. Of course, the signs were at least as strong that we were headed for a recession last year!

As we begin the New Year, the economy has continued to grow at a moderate pace, corporate earnings have held up well, consumers have remained resilient, unemployment remains even lower than what could be considered “full employment,” and recent inflation readings indicate a return to target levels faster than the Fed expected – so there is plenty of fuel for optimism in the markets.

It is worth remembering, however, that market euphoria is often followed by market indigestion! There is a reason why the Fed has only ever been able to achieve one “soft landing” – it was 1994 and it was, encouragingly, followed by prosperity for the rest of the decade. The challenge is that the Fed only has very blunt instruments with which to implement monetary policy, and their impact is not felt for 6 to 18 months after they take action. By moving an interest rate that banks use to lend money to each other overnight, the Fed tries to steer the entire economy. Imagine using a sailboat rudder to steer a cruise ship! While the ship’s instruments may all show we are headed in the right direction, we have yet to feel the full effects of “rudder movements” from months ago or other waves ahead that may impact our course. It is perhaps healthier to think of the “soft landing” as an “average expectation” across the range of possibilities. If the Fed can keep the ship on course using its limited tools, a soft landing is possible.

What are some of the potential “waves” ahead that could throw us off course?

There are plenty of variables that could cause the economy and the markets to drift off course, including resurgent inflation, overstimulation of the U.S. economy due to massive government spending programs or even huge defense spending as we continue to supply arms to our allies around the world who are either at war or in a state not far from it (not to mention we will need to restore our own depleted inventories). The U.S. is incurring budget deficits of between 6-8% of GDP, a level you typically would only see in wartime, and we are expected to run these deficits for the foreseeable future. The tightening moves that the Fed has already made will likely continue to have slowing effects on the economy, which could still tip the economy into recession. Record deficit spending and the related borrowing could overwhelm the market’s appetite for U.S. Treasury debt, which would raise interest rates and slow the economy. So how might these variables come together to form different scenarios for investors?

The “Goldilocks” case is the “soft landing” (not too hot, not too cold!). Market optimists think the inflation reports will be benign enough to allow the Fed to start cutting interest rates as early as March, the economy may slow further, but is unlikely to dip into recession, and as rates fall, the recent stresses on real estate and regional banks will lessen, allowing the economy to be able to shift into a stronger phase of growth. Even if we see some of the “Magnificent 7” mega-tech stocks pull back due to a calming of A.I.-mania, the rest of the U.S. stock market would likely enjoy moderate returns, especially small cap stocks. Developed markets stocks should also benefit from falling rates in addition to a weaker dollar, and emerging markets could also prosper (as many of the individual countries have) if the Chinese economy stops acting like an anvil around the neck of the region. Falling interest rates would fuel a strong year for fixed income, and hopefully portfolios benefit from some other less correlated asset classes as well since this would be yet another year where stocks and bonds move in the same direction due to inflation-related issues being a major driver of market movements.

The stubborn inflation case (too hot!) is the one that very few market participants seem to be concerned about, despite the fact that this is the most common source of unpleasant surprises over the last couple of years. Record deficit spending is inflationary. Geopolitical conflict could alter course and make a host of items suddenly more expensive. Labor markets are still tight, and if the economy strengthens, they are likely to get tighter. It might not make any sense for the Fed to start cutting rates and fuel further economic growth in that situation, meaning interest rates stay higher for longer than the market is currently anticipating, or even have to go up further if inflation warrants it. As inflation is the key driver in this scenario, this would be negative for both equities and fixed income markets and would likely further slow the economy, possibly finally tipping it into a recession.

The recession case (too cold!) is the one that preoccupied year-ago forecasts and is still possible. If the rate hikes to date continue to slow the economy, the consumer finally stops spending now that Covid savings are exhausted, stressed bank balance sheets limit lending (especially at the community bank level where so many small businesses are served), and the regional banks start seeing more defaults on the myriad loans they made to build office buildings that are now largely empty, a substantial slowing of the economy is certainly possible, namely a recession. In this case stocks would likely fall as earnings and price multiples decline, but with the Fed likely lowering interest rates, bonds would move in the opposite direction, providing solid returns in fixed income.

And then, of course, there are always a range of scenarios that we cannot even contemplate yet because the events that might drive them have yet to happen. However, we think these are the three most likely major scenarios to play out over the next year. Hopefully, “Goldilocks” wins out, but, as we know, market consensus is more often wrong than it is right.

We have discussed in recent newsletters the dangers posed by inflation-driven markets because stocks and bonds tend to be highly correlated, depriving investors of the diversification benefits they had become accustomed to over the previous 40 years since inflation had essentially been “defeated.” Two of the three scenarios above involve inflation-related scenarios where we would expect this correlation to continue, and in all 3 scenarios, investors can benefit from diversifying into a broader range of asset classes to improve risk-adjusted returns, or essentially the amount of return earned per unit of risk. Thus, as we have been throughout 2023, we at Montis will be discussing with clients the benefits of further diversifying their portfolios.

Investors can benefit from diversifying into a broader range of asset classes to improve risk-adjusted returns.