Q4 Market Analysis
Dear Client
What a difference a year makes. In 2022, high inflation and the Fed’s commitment to tame it led to sharply rising interest rates and negative returns for both stocks and bonds. In 2023, much to the surprise of many forecasters, global stock and bond markets ignored widespread expectations that we were headed for a recession and were able to shake off a host of uncertainties to post strong gains for the year.
Aided by a powerful year-end rally, U.S. stocks (S&P 500 Index) jumped nearly 12% in the fourth quarter to finish up 26% for the year, and end within a whisper of its all-time high. Smaller-cap stocks (Russell 2000 Index), which lagged their larger counterparts for most of the year, also rallied sharply in the fourth quarter (+14%) to end the year with a respectable gain of 17%.
Developed International and emerging-market stocks also posted solid gains. Developed International stocks (MSCI EAFE) finished the year up 18%, while emerging-market stocks (MSCI EM Index) posted a nearly 10% return.
Bonds also rallied sharply in the fourth quarter aided by a significant drop in Treasury yields. The benchmark 10-year Treasury yield declined over 100bps in the fourth quarter resulting in a 6.8% return for the Bloomberg U.S. Aggregate Bond Index. Interestingly, despite massive intra-year volatility, the 10-year Treasury yield ended the year exactly where it started. For the year, U.S. core bonds (Bloomberg U.S. Aggregate Bond Index) finished up 5.5%. Credit was a standout performer both in the fourth quarter and for the full year. High-Yield bonds (ICE BofA High Yield Index) were up 7% in the quarter, finishing up 13.4% for the year.
Investment Outlook and Portfolio Positioning
Since the Fed started their aggressive tightening cycle, the debate has been about the odds of a “soft landing” or “hard landing” for the economy. In other words, would the Fed be able to thread the monetary policy needle and raise interest rates enough to stamp out inflation, but not so high it slams the brakes on the economy and tips it into recession.
In November, the Fed made it clear they believe the end of the war on inflation is near, and not only are they done raising rates this cycle, they are also anticipating interest-rate cuts in 2024. In response, interest rates declined sharply triggering a powerful rally in stocks and bonds to close out the year.
Looking ahead to 2024, all eyes will continue to be on the Fed. When will the Fed start to cut rates, by how much, and why? Will the Fed cut rates enough to meet the markets’ lofty expectations? While these questions will be in focus, monetary policy is just one of many factors that will influence markets. Geopolitical risk, the U.S. presidential election, labor markets, and inflation will likely fill the headlines and all could be sources of volatility.
From an economic perspective, we enter the year on solid footing and believe a recession is unlikely in the first half of 2024. There are several factors supporting solid economic and corporate earnings growth, while inflation continues to decline. We think the biggest recession risk will come from weakness among consumers in the latter half of the year and we will continue to closely monitor economic data and adjust our views accordingly.
Within the U.S. stock market, performance in 2023 was driven by the handful of mega-cap growth stocks, dubbed the “Magnificent 7” (Apple, Microsoft, Nvidia, Facebook, Alphabet, Netflix, Amazon). These stocks had an average return in-excess of 100% for 2023 and now represent a combined weight of more than 28% in the S&P 500 – near historic highs. However, much of the return in these stocks were driven by expanding valuation multiples leaving them expensive relative to the broader market.
In an encouraging sign, we saw a shift in market leadership and the equity rally broaden out beyond the “Magnificent 7” to include areas of the market that had lagged. For example, value and quality stocks and smaller-cap stocks both outperformed growth stocks in the fourth quarter. We believe this trend has the potential to persist in 2024 and will continue to look towards higher-quality, more attractively valued strategies that we believe present better opportunity.
Although we reduced our overall exposure, our overall equity allocation invests in another unloved segment of the market – foreign stocks. Heading into 2024, the valuation discount for developed international and emerging-market stocks versus the U.S. is the widest it’s been in decades. All else equal, lower starting valuations imply better long-term expected returns and provide more of a valuation cushion should multiples contract in a stock market sell-off.
We remain positive on Core Investment Grade bonds and short-term U.S. Treasuries. Overall, credit fundamentals remain relatively healthy and current yields are attractive. In addition to core bonds, we continue to have meaningful exposure to higher-yielding, actively managed, flexible bond funds run by experienced teams with broad opportunity sets. There are several fixed-income sectors outside of the traditional parts of the bond market that provide attractive risk-return potential, and we access them through active managers. Some of these funds are currently yielding in the high single digits, while maintaining an eye on capital preservation.
Closing Thoughts
We think it is quite possible that 2024 will be a year where investors again enjoy some of the classic underpinnings of investing, where stocks and bonds are less correlated and provide diversification benefits to portfolios. This was not the case in 2022 and 2023, when stocks and bonds both declined meaningfully and then posted gains.
While there are likely to be bouts of volatility, these inevitably create opportunities. Currently, we see opportunities within the stock market, particularly as we expect a broadening out into areas of the market that have lagged. Within fixed-income, we believe that rates have peaked, inflation is under control for now, and that interest rates will decline though not back to zero. In this environment we continue to take advantage of the inverted yield curve, capturing higher yields from shorter-term securities, while also benefiting from more attractive yields across the bond market. We will also look for any opportunities that arise as a result of the Fed not meeting market expectations around the timing and magnitude of rate cuts.
As we enter 2024, we extend our gratitude for your continued trust and confidence. We wish you and your loved ones peace, happiness, and good health in the new year.
Best regards,
ClearPath Capital Partners
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