By Ben Norris, CFA, Senior Investment Strategist, Vice President
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The fourth quarter of 2023 went out with a bang, with both stocks and bonds seeing sharp gains to round out an altogether impressive year for markets. From August to November, investors took a beat to get their bearings while most major indices traded sideways or sold off. Just in time for the holidays, the U.S. Federal Reserve (Fed) started to feel some monetary policy cheer and hinted that they could be done hiking interest rates (at least temporarily) as inflation began to come down and the economy remained relatively resilient. That was all investors needed to hear; the S&P 500 (SPX), NASDAQ Composite (COMP) and the Dow Jones Industrial Average (DJIA) all saw double-digit gains in the fourth quarter, powering each near or above all-time highs. For the full year, SPX gained 26.3% and DJIA gained 16.2%, while COMP gained a staggering 44.6%.
For much of the year, U.S. equity returns were dominated by the “Magnificent Seven” growth stocks that accounted for nearly all of SPX’s return. However, the fourth quarter saw a broadening out of performance as investors became more comfortable with risk-on trades in small- and mid-cap stocks. In fact, the Russell 2000 outperformed the major large-cap indices in the fourth quarter with a gain of 14.0%. This isn’t surprising considering the change in interest rates during the quarter. The 10-year U.S. Treasury rate fell from a peak of nearly 5% in October before falling to 3.8% by the end of December. Lower interest rates tend to be a tailwind for smaller companies because of their debt burdens, which are often floating rate and can have a larger impact on profitability compared to larger companies. Greater participation from these stocks was a welcome development from investors and strategists alike. Throughout 2023, many voiced concerns that the market had gotten too narrow to be healthy; improved performance from small- and mid-cap stocks should increase confidence that 2023’s rally can continue into the new year.
Bonds also recovered nicely in the fourth quarter as interest rates broadly fell. The Bloomberg Barclays U.S. Aggregate Bond Index gained 6.8% in the fourth quarter, pushing the index’s 2023 return to 5.5%. High-yield bonds fared even better, with a 7.2% fourth-quarter gain, leading to a full-year return of 13.5%, outpacing the Russell 1000 Value Index’s 2023 gain of 11.5%. Rates began the year higher, which is a primary driver of bond returns, but solid credit and tightening spreads also boosted bond performance despite a few brief bumps in the road—we did have a regional banking crisis in 2023, although it feels like a distant memory in today’s market. Bond investors probably had mixed feelings about the Fed in 2023 as Chairman Jerome Powell and company resisted any suggestion that monetary policy would get less restrictive until the final months of the year. When they did finally give in—by projecting approximately 0.75% of rate cuts in 2024—investors wasted no time in buying up bonds. Still, bond investors and the Fed aren’t on the same page when it comes to future monetary policy. While the Fed sees 0.75% of cuts, the CME FedWatch Tool indicates that investors anticipate roughly twice that level of cuts in 2024. My guess is that we end the year somewhere in between those two figures.
While 2023 was a great year to be in the markets, the focus is now firmly on 2024’s prospects, not only from a market perspective but also from an economic standpoint. The first week of a new year always brings prognostications from market forecasters who attempt to predict where the S&P 500, interest rates, GDP growth, etc. will end the year. Unfortunately, they tend to be wrong. However, that won’t stop me from giving you some insights into the current thinking. Consensus S&P 500 earnings estimates call for ~11% growth on revenue growth of just over 5% in 2024. Assuming a stable price-to-earnings ratio, this implies a year-end value just under 5,300. We’ve already covered market and Federal Open Market Committee expectations for interest rates, and if they’re remotely accurate, then bonds should have a decent year as well. Finally, GDP growth and the prospect of an economic recession continue to linger in the background of financial media. Over time, many economists have shifted from the view of certain recession to a more favorable call that the Fed has engineered a soft landing. I see both sides of the argument, but the Fed’s poor track record while navigating a return to neutral monetary policy leaves me wary despite continually stronger-than-expected U.S. GDP growth.
Despite all that, the first week of 2024 was somewhat disappointing. SPX lost nearly 2% during a shortened week of trading, ending the index’s nine-week streak of gains. Both the Russell 2000 and COMP lost more than 3% last week as fourth-quarter winners reversed course. Surprisingly, the Healthcare sector was the top-performing group, followed closely by Utilities. Technology saw the worst declines, with a 4.3% loss. Some of last week’s weakness is likely explained by early-year repositioning from investors after a significant run-up over the past few weeks. Caution following the release of minutes from the Fed’s December policy meeting and a swath of employment data could also be to blame. The labor market has remained surprisingly resilient relative to the amount of economic tightening that has taken place over the past year and a half. Last week, data showed that the U.S. added over 200,000 jobs in December, hourly wages grew more than anticipated and the unemployment rate remains at a steady 3.7%, even as more workers re-enter the labor pool. Despite these figures, the labor market should gradually cool in 2024 as the Fed’s efforts to slow the economy continue to take hold. A shrinking number of job openings and steadily increasing unemployment claims could be a clue that the Fed’s efforts are finally coming to fruition.
Shifting to economic activity, both the ISM Manufacturing and Services indices disappointed relative to expectations last week. The Manufacturing Index marked its 14th consecutive month in contraction territory. Such a long stretch of contraction hasn’t occurred since 2001 and rarely happens outside of a recession. The ISM Services Index is still in expansion territory at 50.6 (readings below 50 signal contraction) but came in well below the expected 52.6. The underlying metrics of the report showed that half of the 18 components of the index contracted in December with employment showing a sharp contraction. The services side of the economy is still stronger than manufacturing but could end up in negative territory in the coming months if conditions don’t improve. This is an area that market watchers will have a close eye on for signs of a recession on the horizon.
Finally, the Fed’s December meeting minutes were released on Wednesday, providing a glimpse into policymakers’ thoughts on the economy and expectations for future policy moves. In general, the minutes confirmed what investors already knew—the Fed believes it has finished its interest rate hiking campaign and is waiting for indications that cuts could be appropriate. As noted above, the market and the Fed have different views of the path forward in 2024, but lower interest rates become a reality at some point this year. Stocks tend to perform well in the period between the final rate hike and the first cut (hence the last two months), and if we can avoid a full-blown recession, the market could continue its climb.
Looking ahead to this week, investor focus will be on Thursday’s inflation data in the form of the U.S. Consumer Price Index (CPI), which is likely to show that inflation rose 3.3% compared to the prior 12 months through December. Core CPI, which excludes the volatile food and energy components, is expected to show a 3.8% year-over-year increase. Elsewhere on the economic calendar, wholesale inflation data will be released and is expected to show a continued downtrend. Finally, the fourth-quarter 2023 earnings season will begin with major U.S. banks.
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Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Weekly Market Commentary/Market