Market Commentary - 2023 - Q4

‍Key Takeaways:

• S&P 500 finishes 2023 at all-time high
• Inflation declined faster than many expected
• The Fed is expected to cut rates in 2024
• Growth has been remarkably steady despite what many economists had feared.
• US economy and equity markets continue to outperform the rest of the world
• Outlook - The most important lesson for investors is to stay invested

S&P 500 finishes 2023 at all-time high

2023 marked an inflection point for markets with strong gains across both stocks and bonds. The S&P 500, Dow, and Nasdaq generated exceptional returns of 26.3%, 16.2%, and 44.7% with reinvested dividends last year, respectively. The S&P has come full circle and is now only a fraction of a percentage point below the all-time high from exactly two years ago. The U.S. 10-Year Treasury yield climbed as high as 5% in October before falling to end the year around 3.9%, pushing bond prices higher in the process. International stocks also performed well with developed markets returning 18.9% and emerging markets 10.3%. What drove these results and how could they impact investors in 2024?

Perhaps the most important lesson of 2023 for everyday investors is that news headlines and economic events don't always impact markets in obvious ways. Last year's positive returns occurred despite historic challenges including the worst banking crisis since 2008, rapid Fed rate hikes, debt ceilings and budget battles in Washington, the ongoing war in Ukraine, the conflict in the Middle East, cracks in China's economy, and many more. If you had shared these headlines with an investor at the start of 2023, they would probably have assumed there would be a worsening bear market or a deep recession.

Why isn't this what happened? At the risk of oversimplifying, the key factor driving markets the past few years has been inflation. High inflation affects all parts of the markets and economy including forcing the Fed to raise interest rates, slowing growth, hurting corporate profits, dampening consumer spending, and acting as a drag on bond returns. This is exactly what occurred in 2022 but many of these effects reversed in 2023 as inflation rates improved.

The headline Consumer Price Index, for instance, jumped 9.1% in June 2022 on a year-over-year basis but only grew 3.1% this past November. Unfortunately for consumers and retirees, this does not mean that prices will fall back to pre-pandemic levels - only that they will rise more slowly. For markets, however, what matters is that the rate of change is slowing and that core inflation could gradually approach the Fed's 2% long run target.

Thus, the recession that was anticipated by markets a year ago has not yet occurred. While many still expect economic growth to slow this year, it's not unreasonable to suggest that the Fed could achieve a "soft landing" in which inflation stabilizes without causing a recession. This is why both markets and Fed forecasts show that they could begin to cut policy rates by the middle of the year.

What does this mean for the year ahead? If 2022 was characterized by the worst inflation shock in 40 years, leading to a bear market in stocks and bonds, 2023 saw many of these factors turn around. These trends could continue if the Fed does begin to ease monetary policy. Of course, much is still uncertain and investors should always expect the unexpected when it comes to market, economic, and geopolitical events. After all, markets never move up in a straight line and even the best years experience several short-term pullbacks.

The past year has shown us that it's important to stay invested and diversified across all phases of the market cycle, rather than try to predict exactly what might happen on a daily, weekly, or monthly basis. Below are five key insights into the current market environment that will likely be important in 2024.

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Inflation declined faster than many expected

• CPI is a commonly cited measure of inflation. It uses a basket of goods and services to track price changes for consumers.
• In order to measure the underlying trend in inflation, rather than temporary shocks to food and energy, economists often focus on core CPI.
• Price increases have been cooling but certain areas such as shelter remain high.

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The Fed is expected to cut rates in 2024

Improving inflation coupled with a historically strong job market have helped the Fed to achieve its policy objectives. While it's too early to declare victory, many expect the Fed to begin cutting rates in 2024. The Fed's own projections suggest they could lower rates by 75 basis points by the end of the year. Market-based expectations are much more aggressive and are expecting twice as many cuts. While it's hard to predict exactly what the Fed may do this year, the fact that rates could begin to fall could help to support financial markets and the economy.

• Interest rates rose significantly over the past year to levels not seen in over 15 years, before then declining.
• The 10-year Treasury yield has been volatile as investors worry about the path of economic growth.

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• The yield curve is still inverted due to the elevated level of Fed policy rates.
• The yield curve could begin to re-steepen as the Fed begins to cut rates in 2024.
• Long-term rates could also remain high or rise further if economic growth remains steady.

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• Fed officials have paused further rate hikes and, according to official projections, could cut rates in 2024.
• Many market-based measures also suggest the Fed could cut rates over the next year as inflation approaches its 2% target.

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Growth has been remarkably steady despite what many economists had feared.

The economy has been stronger than many expected over the past twelve months. GDP grew by 4.9% in the third quarter, one of the fastest rates in recent years. Consumer spending helped as did a rebound in business investment as the interest rate outlook stabilized. Unemployment is still only 3.7% and while monthly job gains have slowed somewhat, the labor market is still far stronger than economic theory would have predicted given the sharp increase in interest rates.

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• The economy slowed due to inflation and Fed tightening but the recession some anticipated has not materialized.
• Retail sales are an important way to measure consumer spending.
• Consumer spending has been remarkably steady despite poor consumer confidence in the economy.

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US economy and equity markets continue to outperform the rest of the world

• The stock market has rallied over the past year and the Fed could begin to cut rates in 2024.
• Tech-related stocks led the rally but their rate sensitivity could continue to drive volatility.
• Investors ought to remain focused on the long run rather than the past few days, weeks or months.

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Outlook - The most important lesson for investors is to stay invested

While the past twelve months have been positive for investment portfolios, investors should not become complacent. Volatility in the stock market is both normal and expected with even the best years experiencing short-term swings, as shown in the accompanying chart.

Seasonally there is a pullback in equity markets in January or February, and after the strong year-end rally, our opinion is that we will see a correction in the first quarter of 2024. However, we believe that rates will continue to come down throughout the year and equities will continue to perform well in 2024.

Rather than trying to predict exactly when these pullbacks will occur, it's more important for investors to hold diversified portfolios that can withstand unforeseen events. The past few years are a reminder that holding an appropriate portfolio is the best way for investors to achieve their long-term financial goals.

• This chart shows the performance of the stock market (bars) and the largest intra-year decline (dots) each year.
• The average year sees a stock market drop of -13.5%. However, most years still end in positive territory, averaging 9% gains.
• Volatility is a normal part of investing and investors are often rewarded for staying disciplined through short-term volatility.

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• While bear markets are unavoidable, bull markets are much longer with larger returns.
• Since 1956, the average bear market has lasted one year, two months with a decline of 36%.
• In contrast, the average bull market lasts 5 years 9 months and returns 192%.