2023 Markets in Review
Following one of the worst years for diversified stock and bond portfolios in almost a century, investors entered 2023 with elevated levels of concern. Most market prognosticators expected the new year to bring an economic recession, accompanied by volatile equity markets and stable fixed income markets buoyed by lower interest rates. Few predicted the S&P 500 would make their lows on just the 3rd trading day of the year! While certainly not a smooth ride, 2023 ultimately proved fruitful for US equities. Driven by the “Magnificent Seven,” the S&P 500 reclaimed 2022 losses and sits near all-time highs entering 2024.
Fixed income markets bucked forecasts to an even greater extent, as both investors and analysts continuously underestimated the commitment of the Federal Reserve to raise interest rates. Consensus in January priced in several rate cuts and an end of 2023 target Fed Funds rate of around 4%, yet today this rate remains north of 5%. Bonds suffered from the “higher for longer” trade for much of the year, which continued their longest bear market in nearly 150 years. A dovish switch in Federal Reserve commentary, alongside cooling inflation data, finally ended the sell-off, prompting a strong bond rally to close the year. As bond prices move inversely to rates, fixed income investors enter the new year cautiously optimistic that returns can continue improving.
As we highlighted in our preview letter last year, the primary investment debate entering 2023 centered around the trajectory of the domestic economy. January saw markets aggressively price in the prospects of a “soft landing,” with “risk-on” assets (like growth stocks) leading the rally. Those expectations quickly reversed following the failure of a few regional banks in early spring, which faced insolvency due to markdowns in their investment assets and poor yield curve management. Although bank stocks, primarily regional and savings banks, have not fully recovered, the turmoil proved to be company-specific and not the beginning of a widespread crisis.
The massive influx of liquidity into markets to stabilize the banking system increased investor attention to two significant drivers of returns: Money Supply and the Fed’s Balance Sheet. In aggregate, the changes in liquidity levels proved incredibly correlated to index-level stock performance. Contraction in the Money Supply, which experienced a massive spike during the pandemic as monetary and fiscal policies combined to support the economy, was always a prerequisite for reining in inflation. Stock weakness in 2022 tracked the Fed and Treasury’s restrictive efforts, which drove the largest contraction (on a percentage basis) in Money Supply in over 90 years. The influxes of liquidity over the first half of 2023 seemed to help reverse this trend and served as positive catalysts to equity markets.
Another major investment theme of 2023 was the emergence of the “Magnificent Seven,” a group of Technology-oriented behemoths that, in aggregate, posted over seven times the return of the other 493 stocks in the S&P 500. Their combined strength helped drive the performance gap between large capitalization and small-/mid-capitalization stocks (as well as between growth and value stocks) to some of the most extreme levels in several decades. As a result, 2023 joined 2020 and 2021 as some of the most “top-heavy” years in investment history. Such an outcome challenges prudent portfolio management, at least in the short term, as broad diversification across multiple styles and asset classes likely underperformed strategies more directly correlated to the weightings in the S&P 500.
Propelling the outperformance of the “Magnificent Seven” was their ability to grow earnings (up over 30%, in aggregate, from 2022) in an otherwise tepid growth environment. Beyond these seven, earnings for the rest of the companies in the S&P 500 contracted year-over-year. As we posited at this time last year, the ability of companies to protect or expand margins proved to be a major driver of returns. Companies with defensible business models and durable pricing power outperformed by managing the drag of cooling inflation on “top line” revenue growth.
2024 Market Outlook
As we turn the calendar to 2024, the macroeconomic outlook remains more uncertain than usual. The strong rally into the end of the year, driven by benign inflation readings and a notably dovish sentiment shift from the Fed, may have already priced in a “soft landing” scenario for the economy. Additionally, while the range of potential economic outcomes seems more narrowly defined than a year ago, we caution that the “landing” part of a “soft landing” still needs to occur. The implication is that companies may have to navigate a slowing macroeconomic environment, and markets could struggle to discount any impact on earnings. Cracks have already begun to show in economic data. Growing weakness in the health of the consumer bears close monitoring, as their spending resilience has propelled the economy since the beginning of the pandemic. Consumers built a sizable savings cushion during the shutdown in 2020 and subsequently have been “over-spending” versus pre-pandemic levels. As these elevated balances have now been spent down to “normal” levels, any increase in the consumer savings rate to replenish reserves could prove an unwelcome demand shock.
It could also be too early to declare victory in the fight against inflation. Reining in significant inflation has historically been a complex process. Having to contend with smaller “bouts” of inflationary pressures in the coming year (similar to what was seen in the 1970s) would not be a surprise. Above average stock and bond returns this year are likely predicated on inflation remaining contained and the Fed committing to a steady decrease in their target rate. With tepid revenue growth rates expected in 2024 and forward earnings estimates that appear somewhat optimistic, equity returns will need to be at least partially driven by valuation multiple expansion. Falling interest rates could prove the catalyst for this expansion, as typically lower rates can help justify higher multiples by making future cash flows more valuable.
Commodity pricing should continue to prove an important “battleground” in the fight against inflation. Geopolitical pressures on supply may work against the major domestic incentives to keep oil and gas prices low. It’s important to remember that although geopolitics do have the ability to drastically affect markets, the actual scope and impact of a disruption is often much more important than the initial reaction to the event. Even these past two years have seen the Ukraine war deeply disrupt global grain and oil markets, while the horrific events in Israel have so far been limited in their specific market impacts rather than spreading to other markets. Going forward, investors will hope for increased clarity in US-China relations. A de-escalation of tensions would clearly be well-received, while any potential escalation serves as a tail risk for our national security and, of course, company-specific outlooks.
Expect copious analyst commentary on the upcoming elections and their potential impact on markets. Although many assume that politics drive markets, markets and the economy often drive election outcomes. In the past 100 years, no president has been re-elected when there has been a recession in the two years preceding the election. Broad stock market returns, alongside economic conditions (most notably consumer sentiment and commodity prices), will likely be a more significant driver of President Biden’s re-election odds than any political developments would be to investment outcomes. We can look to recent history when annualized market returns were almost identical during the terms of Presidents Obama and Trump. However, Obama did not face a recession and was subsequently re-elected, while President Trump endured a downturn and lost his re-election bid.
Equities
Within equities, the dispersion between winners and losers in 2023 is likely to widen this year. A tougher business environment and the higher operating costs (from tighter credit and higher borrowing rates) should make life difficult for weaker companies. Elevated operating costs should impact “long-duration” growth companies (that are not self-sustaining) the most, as they have been reliant on low rates and easy access to financing. We maintain our preference for “shorter-duration” equities – those with internally generated cash flows to fund operations rather than those needing credit to drive growth. In many cases hese high cash flow businesses include, but are not limited to, more traditionally “defensive” dividend payers. “Big Tech” companies, the darlings of the past decade, have outperformed in large part due to the incredible durability of their revenues in a myriad of operating environments. We reiterate the importance of not getting mired in “old-school” market thinking that delineates “defensive” from “growth” sectors, but rather focusing on individual companies and their cash flows. A “Big Tech” company growing self-sufficiently at 20% a year with low debt levels and high cash flow levels could be significantly more “valuable” than one growing 40% a year but reliant on new debt and equity issuances. Durable, self-sustaining growth also helps justify a premium valuation to markets, and to nominally “defensive” names with tepid growth rates.
While the “Magnificent Seven” now appear richly valued, consistent execution in 2024 might still justify those valuations. Meanwhile, the rest of the market appears relatively inexpensive in aggregate. Last year’s list of winners and losers largely inverted the results from the year before: the three best sectors in 2023 were the worst in 2022 and vice-versa. Inflows into money market funds dwarfed the flow into stock funds over the past two years as investors sought high yields on safe assets. It would not be surprising if dividend stocks returned to favor this year as their high yields become more attractive in a falling rate environment. In the past month, the dovish sentiment shift from the Fed also fueled a surge in incredibly out of favor sectors like Real Estate and Utilities. While we are hesitant to predict any defensive sector becoming a leader in 2024, the combination of cheap valuations and changing market sentiment warrants consideration.
Fixed Income
In Fixed Income markets, bonds should continue to present compelling total return opportunities across maturities on the yield curve. While rates are down a bit from their levels in the early fall, investors can still build a “ladder” of bonds at some of the most attractive rates seen over the past 15 years. Treasuries and Money Market funds offer attractive, safe return opportunities at the short end of the curve, where yields are still the highest. The long end of the curve also presents an opportunity to “lock in” attractive returns for years to come, especially should rates decline further. For example, investors can find “tax equivalent yields” greater than 7% on high quality, investment-grade municipal bonds more than 15 years to maturity. With yields still at elevated levels, which have historically correlated with strong forward total returns, there remains a greater opportunity in fixed income than we have seen in well over a decade.
The dispersion we are seeing between winners and losers in equity markets is likely to also manifest in the corporate bond market. In aggregate, companies had a relatively low level of debt maturities and re-financing requirements in 2023 but that “debt wall” gets notably larger in 2024. This necessary re-financing of debt in what is now a significantly higher rate environment will increase interest costs and hamper the ability of “cash poor” companies to service their debt. So far, this contagion has mostly been contained to finance and real estate companies, but investors will need to be cognizant of widening spreads and higher default risks percolating through other sectors. Just as equity investors need to be prudent in their analysis of company operations and their cash flows, fixed income investors will need to be diligent when seeking to capitalize on the current bond environment.
Portfolio Management
At the portfolio level, the renewed attractiveness of bonds has helped usher in the return of the classic “60/40 portfolio.” A diversified portfolio of 60% equities and 40% bonds posted its worst performance in decades over the past two years. Coming out of an extremely low-rate environment, bonds were priced so richly that they could not serve their traditional function as a mitigator of stock market volatility in a diversified portfolio. With one of the longest bear markets in bond history coming to a close, bonds have now re-priced to a level from which they can once again provide an adequate hedge to equities and deliver positive returns over current inflation rates.
While over-concentration in the “Magnificent Seven” stocks would have served a portfolio well in 2023, they will be hard-pressed to drive markets again in 2024. The “Equal Weighted” S&P 500 Index’s performance relative to the headline S&P 500 Index has already started to inflect positively over the past two months. As we continue to emphasize, investors need to remain humble, flexible, and positioned for several potential market outcomes given the continued macroeconomic uncertainty. Diversified portfolios, built with companies able to outperform throughout the various of an economic cycle and complimented by a well-structured fixed income portfolio, can help provide the balance needed to navigate this uncertainty. Discipline and thorough company analysis remains as important as ever in what should continue to be a tough operating environment.
At the Wise Investor Group, we thank you for your continued trust in our team to help secure your financial future. Why not start the new calendar year with a portfolio discussion and a fresh look at your financial plan? We look forward to connecting soon. Best wishes for a happy, safe, and prosperous New Year!
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the Wise Investor Group and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Investments mentioned may not be suitable for all investors. The companies engaged in the communications and technology industries are subject to fierce competition and their products and services may be subject to rapid obsolescence. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise. There are special risks associated with investing with bonds such as interest rate risk, market risk, call risk, prepayment risk, credit risk, reinvestment risk, and unique tax consequences. To learn more about these risks and the suitability of these bonds for you, please contact our office. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
