4th Quarter 2023: Market and Economy

Market and Economy

Markets closed out 2023 with a bang as the S&P 500 reported nine consecutive weekly gains to end the year. Considering where we started—on the heels of a brutal 2022, when stocks and bonds were down together—and facing new hurdles like a regional banking crisis and war in Gaza, such a strong rebound was remarkable and a powerful reminder of how markets can defy expectations.

Notably, the annual returns for all but large-cap stocks were gained mostly in the fourth quarter.

Market Lessons from 2023

Even in good years, it is important to reflect on what worked and what didn’t. Here are some of the things we saw in 2023:

Lesson #1: “Volatility” Has Two Sides

It’s a little secret that “volatility” is finance-speak for “losses.” “Volatility” allows financial media and investors like us to use a statistics term to talk about the hard parts of investing without drawing as much attention to falling portfolio values. I can tell you, 2022 was a particularly volatile year!

In reality, volatility works in both directions and is great when it works in your favor. 2023 was just as volatile as 2022, but in the opposite direction. The S&P 500 was just able to earn back all of 2022’s losses to end up 0.08% higher, ending 2023 right back where we started. Other asset classes didn’t quite earn back their 2022 losses but all did post significant gains.

Bonds, which are usually the unexciting foundation of a diversified portfolio, were anything but boring. After the rates on Treasury bonds peaked in late October, rates fell steadily over the final two months of the year, not only fueling stock returns but lifting bond returns out of the red and into strong annual returns.

Lesson #2: Don’t Follow the Herd

The most widely held view among economists and investment analysts last January was to brace for impact. It was not a question of “if” but “how ugly” the coming recession would be. As is often the case with investing, the most widely held view turned out to be very wrong.

The US labor market remained resilient despite high interest rates. Unemployment sits at 3.7% as of November and has now been below 4% for a record 22 consecutive months, allowing consumers to keep spending. US GDP growth is expected to end up at +2.4% in 2023—far from a contraction.

Inflation, as measured by the CPI index, has fallen by nearly two-thirds from a peak of 9.1% in mid-2022 to 3.1% through November and continues to trend lower. As the reason for pushing interest rates higher disappears, the Fed will be able start cutting rates in 2024 as inflation approaches its 2% target.

Lesson #3: Main Street is Not Wall Street

The view on Wall Street differs from that on Main Street. Coming off a strong year for investment returns, it is easy for investors to be optimistic. Companies were able to maintain their earnings over the last few years by passing higher prices through to consumers. Looking forward, investors expect falling interest rates to reduce interest costs for corporations, further juicing earnings. Also, artificial intelligence is generating excitement with grand promises of productivity enhancement. Today’s earnings are less important than the direction those earnings are going. S&P 500 earnings for 2023 are only expected to have grown 0.6%, but 2024’s earnings are expected to grow 12% according to FactSet.

Meanwhile, on Main Street, consumer sentiment has been falling since July. This, despite economic indicators pointing to a rare “soft landing” that avoids a recession. Consumers face everyday costs that have risen faster than wages. Hourly earnings may be up 20% since the start of 2020, but food prices are up 25% and the cost of buying a new home—between rising home prices and 8% mortgage rates—makes moving impossible for millions of families. And unfortunately, most of these higher prices are here to stay, which will continue to put stress on US households.

Themes for 2024

Here’s what we’re watching as we head into the new year:

Slowing Growth

Though interest rates may have started falling, they will continue to weigh on the economy and consumer spending will likely slow. US GDP growth is expected to slow to +1.5% this year according to the Congressional Budget Office—not exactly inspiring but still about the best possible outcome to hope for after an aggressive Fed rate-hike cycle. Some of the slack will be picked up by corporate investment. While AI hype in 2023 focused on the companies developing artificial intelligence technologies, the rest of the economy will begin investing heavily in AI tools to improve operating efficiency and/or offer better products.

Fed No Longer Steering the Ship

In December, Chairman Jerome Powell acknowledged the Fed was finished hiking interest rates and signaled that cuts will likely start in 2024. With the Fed currently pegging short-term interest rates above 5% while inflation is down at 3.1%, higher interest rates just aren’t needed anymore.

Since the financial crisis of 2008, we’ve seen the Fed firmly in control of the narrative around interest rates, but that may have changed in 2023. Fed Chair Powell explained that the Fed is considering cutting rates up to three times in 2024, but based on bond prices and trading in derivative markets, investors are projecting at least five rate cuts. The Fed reacting to markets instead of directing them would be a major shift—but not necessarily a bad one. Prices would be determined more by market participants than by the artificial levels set by the Fed.

Cashing In

It’s been a long time since holding cash has offered any kind of meaningful interest, so with some money market rates currently above 5%, it’s easy to see why people have been more willing to let cash accumulate. Intermediate- and long-term bond rates have already started declining and cash rates will follow quickly when the Fed starts lowering rates. That could lead much of that excess cash to go looking for a better return. We’d expect most to flow into bonds with interest rates that can be locked in for several years, but some will also flow into stocks and other investments like real estate. Once this starts, there may be a race to avoid missing out.

Political Uncertainty

It feels like the 2020 soap opera never ended but already the 2024 election cycle is ramping up. Unfortunately, that isn’t likely to help raise consumer sentiment. We will be flooded by one side telling us why the economy is awful while the other side tells us things are great. It is hard to guess what the results will be in November and even harder to guess the market’s short-term reaction. Luckily, history tells us long-term market returns aren’t much affected by which party is in the White House.

Conclusion

There is no such thing as a “safe” time to invest because clarity only comes in hindsight. Had you gotten out of the market to recession-proof your portfolio heading into 2023, you would have missed out on the recovery. Looking ahead, we continue to face several risks—be it the Fed’s balancing act, potentially overly optimistic investment expectations, the election, or the always-present risk of unforeseen events.

Our strategy remains grounded in the time-tested principle of diversification. We can’t predict the future but we can prepare for its unpredictability. It’s not just about avoiding risks but also not missing out on the opportunities hidden by the veil of uncertainty.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.