By: Darren W. King | Wealth Management
Equity markets staged a historic rally in the fourth quarter, as economic growth surprised to the upside and fixed income markets began to anticipate the Fed cutting rates in 2024. The S&P 500 finished 2023 up 26.26% for the year and gained 11.68% in the 4th quarter alone. The Technology-heavy NASDAQ led the market recovery up 44.7% in 2023, while the DOW Jones Industrial Average was up only 16.18%. The Russell 2000 Small Cap Index was up 16.88% over the same period. International developed market equities, as measured by the Morgan Stanley Capital International Europe, Australasia, and Far East Index (MSCI EAFE), closed the year up 18.95% in US dollar terms and up 16.16% in local currency. The MSCI Emerging Markets Share Price Index closed 2023 up 10.1% in US dollar terms.
2022 saw high valuation technology, internet commerce and growth shares in general lag the overall market. 2023 saw these same sectors, hit hardest in 2022, post the strongest recovery on optimism for the rise of adoption of AI technology. S&P 500 sector results through 12/31/23: Technology 57.84%, Communication Services 55.80%, Consumer Discretionary 42.30%, S&P 500 26.26%, Industrials 18.08%, Materials 12.54%, Real Estate 12.27%, Financials 12.10%, Health Care 2.06%, Consumer Staples .51%, Energy -1.42% and Utilities -7.08%. Subtracting out the tech stock rally, equity markets made much less ground during the year, as returns were concentrated in 2022’s laggards, while value, defensive, and interest-rate sensitive stocks posted less impressive returns.
Based on current consensus earnings forecasts, the forward 12-month P/E ratio for the S&P 500 is 19.3X, more expensive than the ten-year average P/E of about 17.6X. Currently, the market is estimating 1% earnings growth on 2.3% revenue growth in 2023. Much of the recent rally in the equity markets has been liquidity driven. Investors have put high cash levels back to work as the economy and corporate earnings have remained more resilient than worst case fears as a recession expected in the first half of 2023 never materialized. Despite lackluster earnings growth in 2023, the index posted 4.9% earnings growth in the third quarter and expects 2.3% year over year earnings growth in the fourth quarter. This is a very positive development after 3 quarters of negative earnings growth prior to the latest two quarters of improvement. In short, equity markets are positioning for a trough in corporate earnings with better growth prospects returning in 2024. Currently, the consensus S&P 500 earnings growth rate for 2024 is expected to be 11.5%, with S&P 500 average equity strategists’ bottom-up price targets 8% higher than current trading levels. We are expecting a more normalized return environment for equities in 2024 with valuations needing to also normalize after the strong fourth quarter rally. The level of interest rates will continue to be the main determinate of equity returns in 2024, especially with the market expecting more interest rate cuts in 2024 than what the Fed has telegraphed.
During their December 2023 meeting, the Federal Reserve kept interest rates steady, and set the table for multiple cuts in 2024 and beyond. Through December, the Federal reserve has initiated eleven interest rate hikes, as the fed funds rate now sits at 5.25%-5.50%, the highest level since 2007. Latest economic projections show an economy that is slowing following unprecedented stimulus during the pandemic. GDP grew 5.9% in 2021, 1.9% in 2022 and is estimated by the Fed to be 2.6% in 2023, revised up from .4% GDP growth estimates assumed earlier in the year. GDP accelerated in the first, second and third quarter, coming in around 5% in September and provided evidence that the Fed has engineered a soft landing following the highest borrowing costs in 16 years. As measured by the Consumer Price Index, inflation ended the fourth quarter at 3.1%, down from 6% in the first quarter, and appreciably below the 40-year high of 9.1% in June of 2022. Market participants are becoming more certain that inflationary pressures are easing, and the Fed will be able to lower the discount rate beginning in the second or third quarter of 2024. The timing of this is completely dependent upon inflation moving closer to 2% over the course of 2024. Current forecasts from the Fed show a fed funds rate of 4.50% by the end of 2024, 75 basis points lower than current levels. Current projections also show a terminal fed funds rate at around 2.75% by year-end 2027. With more conviction from financial markets for the end to the current tightening cycle; a historic stock market rally and appreciably lower fixed income yields surprised the markets in 2023.
The 10-year treasury staged a significant correction through October of 2023, starting the year at 3.88% and ending October at 4.93%. Following improving inflationary numbers and slowing wage pressures, the 10-year treasury staged a significant rally during the remainder of 2023 to end the year at 3.88%; exactly where intermediate treasury rates started the year. Longest duration bonds underperformed shorter duration issues as yields reacted less for longer term maturities. 20+ year treasuries were up 2.66% in 2023, while intermediate treasuries earned 4.28%. In a risk-on trade, higher credit quality underperformed the lowest credit quality issues as credit spreads tightened with recession fears abating. Aaa rated bonds within the Barclays U.S. Aggregate Index were up 4.36% in 2023, while Baa rated bonds earned 9.40% during the same period.
The Bloomberg Dollar Spot Index weakened 2.7% in 2023, coming off historic dollar strength versus our trading partners. This occurred as markets anticipated domestic interest rates coming down in 2024. The development of US dollar weakness could become a slight tailwind for corporate profits in 2024. Light crude oil futures fell 12.3% in 2023 and were a big component of falling inflation over the course of 2023. WTI oil futures fell to $71.65 at the end of 2023 from $80.45 at the beginning of the year. 30-year mortgage rates rose from 6.66% at the beginning of the year to 6.99% by the end of 2023, while 30-year treasuries rose 6 basis points from 3.97% at year-end 2022 to 4.03% at the end of 2023.
According to the Bureau of Labor Statistics, the December employment report showed 216K jobs gained during the month. This was appreciably above earlier estimates for 160K new jobs created during December. For 2023, 2.7 million new jobs were created by the economy. The December jobs number reported unemployment at 3.7%, slightly above the February 2020 pre-pandemic rate of 3.5%, a 50-year low. The labor force participation rate in December was 62.5%, up from the pandemic trough of 60.2% in April of 2020. For December, hourly earnings rose 4.3%, below the recent wage inflation numbers that were averaging greater than 5% for most of 2023, indicating a slight cooling in wage inflation. The still hot jobs market, despite the Fed’s hiking policy, is keeping pressure on the Fed to hold rates at current levels, probably longer than markets have been suggesting. While the Fed has indicated 75 basis points of cuts to interest rates in 2024, fed funds futures currently show market expectations for 150 basis points of short-term rate reductions in 2024. These two opposed outlooks for interest rate expectations could result in continued volatility in interest rates as we enter 2024.
Retail sales in November increased .3% from the prior month, better than estimates for a .1% to .2% decline, as consumers continue to spend online and at bars and restaurants. Annualized retail sales were up 4.1% over the past year compared to the consumer price index’s measure of inflation up 3.1%. Gasoline station sales aided discretionary spending as gasoline prices fell 9.4% from the prior year. Department store sales were down 5.2% from the prior year. E-commerce and mail-order houses ended the 12-month period with a 10.6% sales gain. Auto sales were up 6.1% from the prior year. Restaurant spending was up 11.3%, furniture store sales were down 7.3%, health care spending was up 10.9% and clothing and accessories were up 1.3%. On another positive note, food costs were only up .4% from the prior year, well below current year over year inflation numbers as supply chains are recovering from the pandemic. Despite a return to spending on restaurants and services since the pandemic shutdowns concluded, we expect real consumption growth to slow over the coming months, especially for big-ticket items related to housing. However, consumer spending on discretionary items remains resilient and better than most estimates coming into the year.
Equity markets enter 2024 having rallied back to just slightly below the all-time highs set in January of 2022. The most anticipated recession in economic history never materialized and Fed plans for interest rate reductions in 2024 were the catalyst for the historic equity market rally in the fourth quarter. While odds for a recession in 2024 are still elevated, the current labor market and employment levels support a softish economic landing. Corporate earnings turning positive after several quarters of negative earnings growth are also a catalyst for equity markets. We believe that the AI tech stock rally has probably run to an extreme. However, it is important to note that 2023’s concentrated growth rebound still places the NASDAQ 10% below the highs of 2022. While we believe that some of 2024’s returns were pushed forward in 2023 with the substantial equity rally in the fourth quarter; value, defensive, small capitalization, and international equities stand to rebound after not participating in the growth-led rally in 2023. In short, we see modest returns for equities in 2024.
Within the fixed income markets, March of 2022 initiated a major shift in Fed policy as interest rate liftoff began in the first quarter of 2022 with the Fed indicating that 2024 will bring the normalization of short rates and the end of the tightening cycle. While longer duration yields have moved appreciably off highs reached in October of 2023; we took advantage of the higher rate environment in 2023 to add bond exposure where appropriate. For clients who remained concerned with inflation and short with fixed income holdings; we highly recommend extending duration of bond holdings and locking in current rates before yields move lower over the next several years. While growing concern of the sustainability of the US government’s fiscal position and still high inflation could keep a lid on further downward pressure on yields, we still see a higher probability of yields moving lower over the next several years. In our opinion, the fixed income markets still offer yields that provide an alternative to equity only investing that has not presented itself in the last decades’ low interest rate environment and would provide a hedge to any severe equity market correction should economic slowing or a recession present itself in 2024 or beyond. In such a scenario, the Fed would lower rates more dramatically and bond prices would provide some cushion to any equity losses.
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Click here to read the Q4 2023 Market Summary.
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Data Sources: Economic: Based on data from U.S. Bureau of Labor Statistics (unemployment, inflation); U.S. Dept. of Commerce (GDP, retail sales, housing); Institute for Supply Management (manufacturing/services). Factset (S&P 500 statistics); Performance: based on data reported in Bloomberg (indexes, oil spot prices, foreign exchange); News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources, such as government agencies, corporate press releases, or trade organizations. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied upon as financial advice. Forecasts are based on current conditions, subject to change, and may not come to pass. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.