By Ben Norris, CFA, Senior Investment Strategist, Vice President
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Without a doubt, 2023 has been a great year for U.S. investors: The S&P 500 (SPX) has gained nearly 22% so far, and we’re approaching a year-end timeframe that has been historically bullish. The NASDAQ Composite, which is more heavily exposed to large-cap growth stocks, has fared even better, notching a gain of nearly 40%. The Dow Jones Industrial Average and Russell 2000 indices have lagged this year but are in comfortably positive territory with year-to-date gains of 11.7% and 8.3%, respectively. We have touched on the outsized effect that the “Magnificent Seven” has had on SPX in past recaps. We are happy to report that smaller-cap stocks have finally begun to participate in the rally and were a key component of the move higher over the past six weeks when SPX reached a new 2023 high after experiencing an 11% gain. While much has been made of the big move in markets this year, it’s easy to forget that 2022 was a historically bad year for both stocks and bonds. In fact, over the past two years, SPX is down 2%, a disappointing reminder that a loss of 20% requires a gain of 25% to end up in the same place.
Bonds have also seen their fair share of volatility over the past two years as the U.S. Federal Reserve (Fed) has pursued an aggressive campaign of policy tightening. For a variety of fixed-income measures, 2022 was the worst year on record and was an unusually difficult environment where both bonds and stocks were deeply in the red. The magnitude of interest-rate increases off a historically low starting point has been a headache for bond buyers. The Bloomberg U.S. Aggregate (Agg) is still down nearly 11% from its level this time two years ago but has recently seen a boost from sharply falling yields. From its recent October high, the yield on the 10-year U.S. Treasury has fallen from 5.0% to 4.1%, a massive rally (for bonds) that has turned the tables for bond investors, taking them from another disappointing year to a pretty decent one where the Agg is up nearly 3%.
Economic data feels as though it has been watched even more closely than normal in 2023. The relationship between inflation, economic growth and the Fed’s policy moves has dominated the headlines and moved markets both higher and lower. In general, the U.S. economic picture has been better than expected despite the Fed raising interest rates another 1.0% to 5.25-5.5%. Perhaps the most surprising development of 2023 is that the Fed was correct when it said it wouldn’t cut rates in 2023. For most of the year, market indicators reflected an expectation that the Fed would have to cut rates in response to a weakening economy—that hasn’t been the case. The Fed’s dual mandate of pursuing maximum employment and price stability (a fancy way of saying making sure economic conditions are supportive of a strong job market without letting inflation get out of hand) has been steadily headed back in the right direction as the effect of higher rates has begun to take hold. The U.S. Consumer Price Index and the Personal Consumption Expenditures Price Index, the two most popular measures of inflation, have fallen from 6.5% and 5.4% at the beginning of the year to 3.2% and 3.0% in their latest readings.
At the beginning of 2023, many were worried that the Fed would be too aggressive and cause the economy to tip into a recession, but employment and economic growth readings have proved those worries to be unfounded. Nearly every measure of the U.S. labor market has shown that the Fed’s policies are so far working as intended. Initial and continuing jobless claims have remained comfortably under levels that would imply recession, and while the unemployment rate has ticked higher, part of the explanation is that more people are looking for work—a net positive from the Fed’s perspective. Most recently, the Job Openings and Labor Turnover Survey saw the number of job openings fall to its lowest level since March 2021 at 8.73 million. While the number of openings has steadily come down in 2023, it remains well above pre-pandemic levels, which were closer to 7 million, highlighting just how strong the job market has been.
As inflation has moved lower and the job market has remained resilient, U.S. Gross Domestic Product (GDP) growth has managed to surprise to the upside in recent readings. Real GDP growth was revised to a 5.2% annual growth rate in November as strong consumer activity continued to support better-than-expected growth. This marks the fastest growth since 2021 and further supports the Fed’s case that interest rates can and should remain higher for longer. Some economists remain worried that the current level of interest rates paired with a decline in the supply of money will eventually lead to a recession in either 2024 or 2025, but the continued resilience of the economy has led many to rethink that view. One area of concern that we have been monitoring is the effect of higher housing costs and the potential headwinds they could create for consumer activity. Over the past two years, the average 30-year mortgage rate has risen from less than 3% to more than 7%, meaning that mortgage payments have risen at least 40% assuming a 20% down payment on a $300,000 home. The knock-on effects of higher rates have yet to take full effect, as most homeowners will stay put in their low-rate mortgages, but sales of new and existing homes have slowed significantly. Renters have begun to see rates rise as a result of higher rates and home prices, and many are now priced out of buying altogether.
Looking to 2024, expectations are that we will continue down a similar path taken in 2023—inflation will continue to moderate, economic growth may slow but we’ll avoid a recession, stocks should experience decent revenue and earnings growth. Consensus estimates call for an 11% rise in SPX earnings (compared to a slight decline this year) with slightly better results for small- and mid-cap stocks. One headwind is the current valuation picture for large-cap stocks. This year’s rally has been entirely fueled by higher valuations rather than higher earnings, a trend I feel is likely unsustainable given that SPX is trading at a 20% premium to its historic average. One area for optimism is in small- and mid-cap stocks that have more attractive valuation profiles and growth expectations. We think this adds up to a reversal of this year’s environment where just a handful of stocks drove the market and broader participation is the norm. Finally, the Fed should conclude its rate-hiking campaign and potentially cut rates in the second half of the year. Historically, this has been positive for stocks with an average gain of more than 14% between the final rate hike and the first rate cut.
Looking ahead to this week, investor focus will be on Wednesday’s Federal Open Market Committee decision on interest rates and the subsequent press conference with Fed Chair Jerome Powell. Consensus sees the Fed holding steady this week before the focus shifts to 2024 and the potential for a policy pivot. Elsewhere on the economic calendar, updates on U.S. inflation will be of interest as the Fed strives to reach its 2.0% target. Finally, we’ll have an eye on labor and business conditions in data released on Thursday and Friday.
|MONDAY, DEC. 11
|TUESDAY, DEC. 12
|Consumer Price Index (y/y)
|Core CPI (y/y)
|WEDNESDAY, DEC. 13
|FOMC Policy Decision
|Fed Chairman Jerome Powell Press Conference
|Producer Price Index (y/y)
|Core PPI (y/y)
|THURSDAY, DEC. 14
|Initial jobless claims
|Import Price Index
|U.S. Retail Sales
|FRIDAY, DEC. 15
Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Weekly Market Commentary/Market