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Quarterly Market Newsletter – Q4 2023

Key Points

  • Despite subdued expectations, 2023 emerged as a strong year for the markets, driven by the “Magnificent Seven” stocks
  • As inflation steadily cools, the Federal Reserve is prompted to consider a pivot in monetary policy
  • The benchmark 10-year Treasury yield retreated sharply after hitting a high of 5% in late October
  • The economy remained resilient throughout the year, with the labor market’s strength being a significant upside surprise
  • The pace of economic growth is moderating slightly as the economy finally returns to pre-pandemic normalcy
  • Our investment strategy for 2024 is grounded in quality investing and adaptability to evolving market scenarios

2023 Delivers a Surprise

Against seemingly long odds, 2023 unfolded as a banner year for the financial markets.  Driven by an economy that continued to defy recession, the year finished on a strong note, with solid gains in both stock and bond markets. In equities, the year’s performance was bolstered by continuing enthusiasm for the rapidly evolving artificial intelligence (AI) landscape, easing inflation pressures, and growing expectations of Federal Reserve interest rate cuts in the new year. The bond market, too, rebounded from a rate surge that briefly pushed yields to their highest levels since the 2008-09 financial crisis.

The prevailing sentiment entering 2023, however, was not one of optimism.  Throughout the year, recession fears persisted, fueled by higher interest rates from the Fed’s tightening cycle that pressured rate-sensitive sectors including housing, automotive, and commercial real estate.  A bank scare early in the year pressured the financial industry, although the few bank failures from the time were company-specific, resulting from poor risk controls.  The geopolitical landscape remained tense, with the Russian-Ukraine war entering its second year, continuing stress between the US and China over Taiwan, and a land and air war in the Gaza Strip headlining a fraught year.

A notable feature of last year’s market was the dominance of the “Magnificent Seven” stocks, technology giants which captured the bulk of the year’s stock gains following their poor 2022 results.  A key factor was excitement over AI’s business potential, in addition to the Mag Seven’s overall strong profit profile and balance sheet strength.  Beyond this small handful of tech juggernauts, the broader stock market was more restrained.

A “narrow” market often prompts questions regarding the rally’s overall durability, and the risk appetite of investors. However, we saw a broadening of the market rally in the final two months of 2023, as the rally extended beyond these dominant players, an encouraging development for the bulls.

Inflation Cooling Portends a Policy Shift

Following years of relatively low and stable inflation, prices rose sharply as the covid pandemic receded.  The annual inflation rate, as indicated by the Consumer Price Index (CPI), stood at a modest 1.7% in February 2021, reflecting subdued economic activity in a world still struggling with the pandemic, but beginning to reopen.  CPI rose to over 5% by that June, and just a year later, in June 2022, stood at a 40-year high of 9.1%.

The inflation spike can be attributed to several related factors.  In a wave of federal stimulus without precedent, the CARES Act and the American Rescue Plan together authorized an estimated $5 trillion in emergency government spending.  The funding was directed toward supporting households, small businesses, local governments, educational institutions, and other entities around the country.  These expansive fiscal measures spurred strong demand from consumers and businesses at a time of tight labor markets, and exerted upward pressure on wages and prices.

The situation was further complicated by bottlenecks in the supply chain, exacerbating imbalances between supply and demand.  Making matters worse, Russia’s unprovoked invasion of Ukraine in early 2022 triggered not only a surge in energy costs, but also played a pivotal role in driving up global food prices.

Source:  BLS, FactSet, JPMorgan Asset Management

Fortunately, many of the previously intense inflationary pressures have eased significantly.  The CPI has been steadily moderating over the past eighteen months, with November’s number coming in at 3.1%.  Energy prices have come down sharply, as have the prices for used cars and trucks.  Although shelter costs have remained persistently high, the softening in national rent prices suggests a reduction in housing expenses may be forthcoming.

In response to the inflation crisis, The Federal Reserve has made significant adjustments to US monetary policy to lower inflation towards a long-term goal of 2%.  Starting in March 2022, the Federal Reserve implemented eleven consecutive hikes in the benchmark federal funds rate (which now stands between 5.25% and 5.50%), delivering the economy an interest rate shock on a scale not seen since the 1980s.

Over the course of the year, whether as a result of the Fed’s stern measures or the natural re-balancing of supply and demand, inflation has cooled.  Recent communications from the Fed hint it may be considering a shift in its approach, pivoting towards a more supportive policy stance that aligns closer with the evolving business cycle, rather than one that focuses exclusively on inflation control.

According to the median forecasts in the Federal Reserve’s latest “dot plot” – a chart illustrating the individual interest rate projections of Fed officials – the central bank is considering three rate reductions of a quarter percentage point each in 2024.  While the reliability of “dot plots” as predictive tools is subject to debate, it is important to recognize that these projections are primarily intended as estimates, and are likely to evolve in response to incoming data on inflation and labor market conditions.

Amid the Fed’s tight money regime, 10-year year Treasury yields rose as well, spiking to a peak of 5% in late October, to levels not seen since before the 2008-09 financial crisis. Just as rapidly, the 10-year has fallen, to 3.9% at year-end, and just slightly higher now. There is little question that lower rates helped to encourage the year-end strength in stocks. What we don’t know is whether lower 10-year yields are signaling success in the war on inflation, lower economic growth ahead, or some combination of the two.

With inflation cooling, we appear primed for some easing of rates by the Fed. Ordinarily, rate cuts are viewed favorably by the markets as they tend to lower the cost of doing business, enhance liquidity, and boost market sentiment.  However, the underlying reasons for these rate cuts are crucial.  Ideally, they should be implemented in response to lower inflation, rather than as a reaction to an economic weakening.  Currently, there is considerable debate surrounding the Federal Reserve’s decision-making process.  Having initially delayed its rate hikes, which exacerbated the inflation which was already blooming, there are investor fears that a similar delay in rate reductions could adversely impact the economy.  The year ahead will be another battle of interest rate expectations, and the Fed’s primary challenge lies in the timing of its monetary policy adjustments to avoid reigniting inflation while simultaneously fostering economic growth.

Economy in Focus

For most, life after the pandemic has gradually returned to normal.  However, the US economy today still wrestles with the aftermath of that tumultuous period.  The acute phase of the pandemic may be measured in months, but its disruptions were deep enough that returning to pre-pandemic economic normality has been a complex, multi-year endeavor.

Real Gross Domestic Product:  % Change From Preceding Quarter (Annualized)

Source:  BEA, FactSet, JPMorgan Asset Management

The American economy expanded an annualized 4.9% in the third quarter of 2023, its strongest growth in nearly two years.  Consumer spending, which accounts for over two-thirds of US economic activity, rose a little less than anticipated, but achieved its biggest gain since Q4 2021.  The period also saw strong investment in the private sector, with a notable portion of the increase attributed to rebuilding low inventories.  Additionally, government spending played a supportive role, marked by increases in federal, state and local expenditures.  The third quarter was likely a peak in economic activity for a time; according to the latest data from the Atlanta Fed’s GDPNow model, the economy is projected to grow by 2.3% in last year’s fourth quarter.

One of the biggest upside surprises in 2023 was the strength of the labor market.  US employers have added jobs for 35 consecutive months, a remarkable accomplishment considering the context of rising interest rates and an inflation battle.  Altogether, the economy added 2.7 million jobs in 2023.  The sustained strength of the labor market has been a critical driver of consumer spending and overall economic growth.

The much-feared recession never materialized.  Yet, it is crucial to acknowledge that while the economy maintains its upward trajectory, its pace has moderated.  The massive tailwinds that previously fueled excess demand are now diminishing.  Consumer savings are off their peak, and payroll growth is decelerating, although still positive.  These cooler economic indicators are in fact, the intended consequences of the Federal Reserve’s actions to combat inflation, rather than indicators of an imminent recession.  They reflect a gradual retreat from the extraordinary factors that have driven the economic recovery in the past few years.  Simply put, we are witnessing the economy’s return to its pre-pandemic stage of normalcy.

Outlook for 2024

Crafting a forecast for the year ahead is an integral yet often tricky task in investment management.  Most analysts base their projections on current known factors, and from there develop seemingly logical extrapolations.  However, given the inherent uncertainty of the future, many of these forecasts, despite being well-intentioned, essentially amount to educated guesses.

The consensus for 2024 leans towards a moderately optimistic outlook for the market.  Current projections point toward a firmer recovery in corporate earnings for 2024, following flat profits over the prior two years.  The anticipated easing cycle by the Federal Reserve should act as a significant and lasting tailwind.

On the other hand, there are alternate viewpoints warning of the lagged effects of the Fed’s past aggressive tightening measures, which could potentially trigger a slowdown.  Such a scenario could result in a weakened labor market, lackluster earnings, and a challenging year for the stock market, as stocks likely moved in 2023 in anticipation of a healthy 2024.

Furthermore, 2024 also marks a presidential election year.  While the lasting impacts of elections on markets are often exaggerated, the political climate will surely be vibrant, filled with predictions, poll analyses, and vigorous campaigning from the major political parties as well as third party candidates that could upend the outcome.

At the heart of our investment philosophy lies a commitment to preparedness and adaptability in the face of market unpredictability.  We invest in preparedness, and not in prediction.  Our dedicated investment team remains committed to navigate the investing world’s ever-evolving challenges, keeping our clients’ interests always at the forefront.