| In the late 19th and early 20th centuries, it was common for apartments in New York City to be built with the bedrooms on top of each other. If you were the downstairs neighbor, you had the daily experience of hearing your upstairs neighbor’s shoe hit the floor, followed by the silence and preparation for the inevitable “other shoe to drop.” This is the origin of the phrase that we still use today to describe the feeling of waiting for something inevitable to happen. I believe this is how many of us felt for most of 2023. We’d experienced a terrible year in stock and bond markets in 2022, and all anyone could talk about was recession and inflation. So even as the market climbed higher, every bit of volatility caused the feeling to return. To decide if we should prepare for another year with that same gut feeling, let’s look back at the big stories of 2023, and also forward to the big questions of 2024.
5 storylines of 2023 The Fed can raise interest rates and the stock market can still go up. The Federal Reserve chose to raise interest rates four times in 2023, which many thought would lead to them hiking into a recession. While the bank failures of the early spring and the cooling of the housing market were significant negative effects, and several industries, such as technology, saw major layoffs, the S&P 500 returned over 24% for the year and even the bond market finished the year positive after being negative for most of it. It’s a good reminder that the stock market is always re-pricing based on the probability of what will happen in the future, not what is happening today. So even as the Fed was continuing to hike and inflation was too high, there were early signs in the data saying inflation was coming down and the hiking cycle was ending soon, which is the narrative the stock market decided to adopt. The Magnificent Seven led the way for the stock market. The Magnificent Seven stocks – consisting of Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla – made up approximately 60% of the returns of the S&P 500. Even with most areas of the stock market coming out positive on the year, few could compete with those numbers. The Dow Jones, which of the Magnificent Seven only includes Microsoft and Apple, finished up 13%. Other sectors of the economy did much worse, with utilities, energy, and consumer staples all finishing negative on the year and healthcare finishing only slightly positive. Inflation came down dramatically. We entered 2023 with inflation at around 7.5% and finished the year down to 3.1%. While this is still above the Fed’s target of 2%, it is a meaningful improvement. In the aftermath of Covid-19, there were two camps with different opinions on what the path of inflation would be going forward. One group said that inflation was going to be short-lived, as it was related to supply chain shortages. The other group said that inflation would become embedded in the economy, and we would have years of high inflation, if not hyperinflation. While it is too early to declare a final verdict, and the length of high inflation precludes the short-lived crowd from doing a victory lap, at this point the second idea does seem to be most accurate. Luckily, this is great news for investors and consumers alike. Supply bottlenecks proved to be the most important component in the rise and fall of inflation, but excessive government spending was also a contributing factor to runaway inflation on the upside. As for monetary policy, our view is that the Fed clung for too long to the narrative that inflation was only related to supply chain issues, thus causing them to start hiking too late, but the aggressiveness of their hikes combined with easing supply chain concerns contributed to getting inflation under control in 2023. The economy is far more resilient than many thought, heading into the new year. Heading into 2023, the prevailing expectation was that the economy would move into a recession. Many thought unemployment rates would spike, GDP growth would turn negative, and corporate earnings would decline. In reality though, the unemployment rate moved up slightly – from 3.4% to 3.7% (so still near all-time lows) – GDP will almost certainly finish the year having grown by over 2%, and while corporate earnings did decline modestly in the first two quarters, they improved significantly in the 3rd quarter and are expected to improve again when 4th quarter earnings are reported. There were some worrying signs during the bank stresses in the early spring, but since then, nearly every area of the US economy has improved, while inflation has become much more manageable. Geopolitics matter, but in 2023, financial markets mostly shrugged off a lot of the major developments. Russia’s invasion of Ukraine was the major geopolitical story of 2022. In 2023, the war in Ukraine continued and there was also a new geopolitical worry emerging, in the form of the Hamas terrorist attack on Israel and the ongoing conflict in Israel and Palestine. If I had told you at the beginning of 2023 the state of the Russia/Ukraine war as well as the Israel/Palestine situation, without any other pieces of economic data, where would you have guessed the stock market would go in 2023? I know I would have thought much lower. This is an example of how the storylines that rightly deserve our attention, due to the grave loss of human life and jeopardy of peace in our homeland, do not necessarily have the same level of impact on financial markets. The Hamas attack caused a small rally in energy prices – as concern that the attack could disrupt the supply chain of oil in the region made oil prices go up – and a decrease in treasury yields – as some investors chose to flee to safer assets – but the overall market impact has been minimal. This is not to say that geopolitics don’t matter. Who knows- the next major event could have a massive impact on financial markets. This is just to say that it is important for investors to assess not just the social impact of a geopolitical headline but also the economic impact, and realize they are often not one and the same. In better news, there has been some cooling of the tensions between the US and China as seen by Xi Jinping’s recent trip to the US and other statements from diplomats on both sides. China and the US are very much in an economic struggle that doesn’t look likely to slow down anytime soon, but luckily the odds of conflict beyond that seem to have lessened. 5 things to watch in 2024 Will the Fed achieve their 2% inflation target and what rate actions will it take to get us there? We enter 2024 in a very unusual spot. Inflation, as measured by CPI, is still 1.1% above the Fed’s target of 2%, and yet the market is currently forecasting that the Fed will cut interest rates six times in 2024. We believe that the Fed will achieve their 2% inflation target this year, as core PCE (the Fed’s preferred inflation metric) has been running around 1.8% for the last six months, and there is still some inflated shelter data that will be filtered out over the coming months that should also put downward pressure on the CPI number. Our belief is that the Fed will execute their first rate cut in March, but that they will come up short of the six rate cuts the market is looking for. We think 3-4 rate cuts is the most likely scenario, and this should be enough to loosen policy moderately while still keeping rates high enough to avoid a resurgence in inflation. Will the stock market be led by the same stocks and sectors as last year, or will we see a rotation? Last year was unusual in terms of the dispersion of stock market sectors, as three sectors all returned 39% or more (technology, communications, and consumer discretionary), while three sectors posted negative returns on the year (utilities, consumer staples, and energy). The process of a sector rotation can often take some time, but we are already seeing some possibility of it in the early trading days of 2024. Our view is that given the momentum behind sectors such as technology, we may see some more relative upside in the first quarter, but we’ll also see a rotation throughout the year to some other sectors, such as healthcare and financials. Additionally, we believe small cap stocks provide relative value compared to large caps, and we think there are opportunities to see a continuation of the rally that began in the 4th quarter in small caps. Who will win the 2024 elections for Senate, House, and Presidency, and what effect will it have on financial markets? Historically speaking, returns have been significantly positive for both Democratic and Republican presidencies. When you factor in the role of Congress, the three most positive scenarios for markets historically have been: a Democratic president with a divided congress, a Republican president with a unified Congress, and a Democratic president with a unified Congress. The average returns are not meaningfully different between the three scenarios, however. It is still a little early to determine what the key economic policy positions will be for 2024, but financial markets typically move most on tax policy, spending policy, trade policy, and what the regulatory landscape will look like for various industries. As candidates’ positions on these issues come into clearer view as the election approaches, we will have a better idea of what impact they may have on financial markets. One statistic that may be surprising to many is that in the last 40 years, in election years, the S&P 500 has returned 5% from Election Day to the end of the year, compared to 2.6% in non-election years. To summarize, elections matter, but are often not the greatest contributor to the returns of financial markets. However, depending on which policies rise to the forefront in this election cycle, there may be opportunities for the strategic investor. Can the stock market have two good years in a row? As I’m writing this, it’s the morning after my Michigan Wolverines won the national championship, and I’m already thinking about all the ways the team will probably regress next year. Perhaps that’s just my pessimistic sports brain, but I think investors often do the same thing in the market. A misapplication of the phrase “buy low, sell high” makes people think that since we had good times last year, we must have bad times this year. Luckily though, the historical record tells a very different story. The median return for the S&P 500 in the year following a year where it returned 15% or more, is 13%. Estimates for corporate earnings growth are at around 11%, and with the prospect of looser monetary policy, the prospects for financial markets are quite positive, even after the end of the year rally we experienced in most asset classes. What thing that we aren’t currently talking about will end up being a major storyline in 2024? This is always the most important question, while also the most impossible to answer. Carl Richards says that “risk is what’s left over when you’ve thought of everything.” I read a lot of market forecasts in December of 2019, where the main topic of discussion was the trade war Fed interest rate policy, with very little being said about COVID-19, and then of course COVID-19 would overwhelmingly become the dominant story in markets that following year. It’s the risks we can’t see that cause us to take a diversified approach with our investing. We have convictions on where to invest but have seen enough years in the market to know that at any point a new risk could emerge that wasn’t on our radar, and it’s important to build portfolios that can weather the storms we see coming, as well as the ones we don’t. Whether it’s a year of smooth sailing, or some new geopolitical threat emerges, we want to have portfolios that accept whatever amount of risk you can tolerate. I’ll let you be the judge of whether “the other shoe will drop” in 2024, but hopefully this provides a guide to some of the major storylines we will be watching and some of the ways we are thinking about investing this year. Cheers to 2024! |
Christian’s Q1 Market Commentary
