2023 Year End Letter from David Katz

As we turn the corner into 2024, its worth taking a few moments to reflect on 2023, remembering what did happen and what did not. Most importantly, what did not happen was a severe recession. At this time a year ago, the consensus was that we were going to have a recession in 2023 as the effects of the Federal Reserve Board's (Fed) tight monetary policy created an economic downturn.

While we didn't have a recession, we did have a continuance of tighter Fed policy, with additional rate increases following the rate increases of 2022. It was mid-year when the Fed stopped raising rates, but instead in September, indicated that we should expect rates to stay higher for longer. After the most recent Fed meeting in December, the Fed reiterated this stance, but did soften their language indicating a possibility of a rate cut in 2024. The "street" jumped on this language and many analysts who were in the camp of no rate cuts in 2024 shifted to expectations of rate cuts as early as March. This, of course, created a massive shift in the markets, both bond and stock, as well as investor sentiment.

As we enter 2024, the consensus is bullish, expecting a continued rally in stocks, mostly fueled by capital chasing the stocks of companies related to the development and use of artificial intelligence (Al), as well as those in the supply chain, such as semiconductors. Further, the expectations of rate cuts just ahead have brought bond yields down, and the yield on the 10-year US Treasury bond closed well below 4% when just two months prior it had been above 5%. The consensus is also on-board with adding capital to longer duration fixed income assets, as the expectation is that lower interest rates by the Fed correlates to higher prices on these assets.

It appears the consensus believes that the much fabled "soft landing" has been engineered by the Fed in that, while we still have high interest rates and above target inflation, we will not have any negative economic outcomes arising from the Fed's rate increases. Their view is that the Fed has brought inflation down and that it is continuing to moderate, and that they can now focus on a normalization of the yield curve bringing short term rates down.

On the other hand, those who hold a contrarian view are of the opinion that we haven't had enough time for the effects of Fed policy to impact the economy because government programs have provided stimulus that has kept spending high. The contrarian view is that the Fed will not reduce short term interest rates as it has not achieved its target on inflation and that remains its primary focus.

They opine that the Fed remains data dependent and that inflation is sticky. Wages are higher, the cost of borrowing is higher, and housing and rental prices have not come down. These are three major components of core inflation. Variable factors such as food prices remain elevated. The only bright spot seems to be oil prices which have come down substantially, which is reflected at the pump.

Contrarians point to high consumer confidence and continued consumer spending which will make it harder for price decrease. Consumer spending, corporate spending and government spending all remain at strong levels which does not correlate with a reduction in demand which would allow prices to fall further.

Let us not forget that we have several domestic issues as well as foreign aid issues that can affect the markets. The Ukraine-Russia war continues to drag on and the Israeli conflict shows no sign of coming to an end. Congress is dealing with developing support for these issues but remains in conflict and cannot achieve agreement. Should the US decide to provide more support, that will be supportive of continued government spending.

We must be cognizant that we are in the fourth year of a Presidential cycle and heading to the Presidential election in November. That suggests that we will see no decline in government spending as well.

The argument goes that the Fed will stay higher for longer to avoid rekindling an inflationary spiral by moving to an easier monetary policy. They cite factors such as rising credit card balances, increasing auto delinquencies, significant trouble with commercial real estate, and other factors to suggest that a spending slowdown may finally be developing.

The question for investors is whether the strong markets of 2023 will continue into 2024. The US stock market, as measured by the S&P 500 Index, was up 24.23% for 2023, driven mostly by the mega-cap technology stocks which benefitted from the focus on artificial intelligence (Al). The US bond market, as measured by the Bloomberg US Aggregate Index, which is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market, was up 5.53%. Both stocks and bonds benefitted from what was seen as a pivot by the Fed in late 2023.

Looking ahead, we think that investors will be rotating out of short-term US Treasuries and money markets where they have been enjoying high returns on cash and taking on more risk. We think that investment capital will flow back into equities and debt as opportunities arise. This will happen over time and accelerate only once short-term rates fall from current levels. Whether the Fed cuts in 2024 or waits until 2025, the backdrop is for lower short-term rates to decline creating a massive shift of capital. We continue to follow the investment theme of "don't fight the Fed" and will invest accordingly.

In the near term we may see profit taking in early 2024 as investors re-balance portfolios, rotating from the high growth mega-cap Al related names into value and broader growth markets. We would expect fixed income investors to extend duration into longer assets to capture current interest rates. For more sophisticated investors, we continue to see opportunities in the non-publicly traded markets of private equity and private credit as risk appetites return. Market corrections are likely to be shallow as capital will look for good entry points. In summary, we expect 2024 and 2025 to be a supportive investment climate for risk capital, even if we only see returns that are more moderate and in line with the long term.

Sincerely,

David Katz, AIF®, AAMS®
Managing Director

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