2023 Fourth Quarter Review and Outlook
Dear Clients,
2023 was a year of financial crosscurrents, many of them tied to rapidly shifting expectations around inflation and interest rates. Political turmoil in Washington, wars in Europe and the Middle East, a banking crisis, and repeated market reversals also contributed to the sense of uncertainty. In the end, however, it was a far better year for investors than the chorus of gloomy Wall Street forecasters had predicted, with both the bond and stock markets posting strong gains.
The US economy proved more resilient than expected, with job growth, housing, and consumption remaining robust despite dramatically higher interest rates. Meanwhile, inflation proved responsive to the Federal Reserve’s campaign of monetary tightening, falling from a forty-year high of over 9% the previous summer to roughly 3% by year’s end.
Corporations managed to maintain profit margins, helped by the ability to pass along higher wage and materials costs to consumers. S&P 500 companies' earnings in 2023 were 11% higher than they were in 2022.
Perhaps the most notable financial event of the year was Fed Chairman Jerome Powell’s mid-December declaration of victory over inflation. Coming just in time for Christmas, the long-awaited Fed “pivot” away from eighteen months of tightening monetary policy sparked an all-out rally in financial assets, lifting everything from stocks to bonds and from Bitcoin to gold.
Stock markets worldwide posted gains in 2023, led by the +26.3% jump in the S&P 500 Index, with developed international markets ending up over 18% and emerging markets gaining nearly 10%1. After last year’s +22.2% return in the MSCI All-Country World Index, stocks had nearly reversed the previous year’s decline.
Though the market rally broadened towards year-end, US stock market gains remained concentrated in a handful of mega-cap tech companies, whose stock prices were driven higher primarily by the promise of artificial intelligence. In 2023, the top ten stocks in the S&P 500 Index returned +62% and accounted for 84% of the index’s total gain, with the other 490 stocks up a mere +8%. At year end, these top ten stocks represented an unprecedented 32% of the index’s total value. Not surprisingly, the tech giants’ valuations are now far higher than the average stock, creating a disparity that we have not seen since the dotcom bubble in the late 1990s, the bursting of which remains a painful memory for many investors.
Bonds followed the trajectory of inflation expectations last year, rising and falling as investors changed their bets on the direction of inflation and interest rates. After posting gains early on, the bond market fell back into a bear market, only to rally strongly in the fourth quarter as expectations grew that this cycle of monetary tightening would soon be over. Through year-end, the Bloomberg Aggregate Index ended up +5.5%.
Outlook
The ubiquitous pessimism that characterized the beginning of 2023 has shifted to an almost eerily cheerful consensus as we move into the new year. Most forecasters expect a positive environment in which economic growth continues at a slow pace, unemployment remains at low levels, inflation falls close to the Fed’s 2% target, and the US avoids recession.
Reasons for such optimism abound. Unemployment has been below 4% for over two years, the longest period since 1969. The labor participation rate is climbing, wage growth is subsiding to its long-term average, and after three years of record-tight job markets, supply and demand of workers is normalizing, suggesting that overall employment could remain at very healthy levels even at the moderate pace of economic growth anticipated this year.
Consumer price increases have abated in many areas, such as transportation and food, and rents and auto insurance have recently begun to fall, adding to downward pressure on inflation.
We are well aware that 2024 is an election year, and related legal and political drama is a foregone conclusion. Yet it’s worth remembering that stock market returns and economic growth since World War II have been positive on average under Republican, Democratic, and divided governments.
Voters’ perceptions of the economy and the state of the nation tend to depend on whether their preferred party holds the White House, with sentiment being more positive when this is the case, and far more negative when not. In reality, there’s no meaningful correlation between the individual who occupies the Oval Office and how the world’s economies and markets perform during their years in power. Case in point, annual stock market returns for the Dow Jones Industrials were roughly +12% per year under both Presidents Obama and Trump.
Though consumer debt levels are climbing, reflecting the exhaustion of Covid-era savings and several years of rising prices, and though consumer loan defaults are growing, overall spending is still strong. Perhaps most important of all, the Fed is expected to start cutting rates in 2024, which in addition to supporting consumption and the economy, should benefit financial assets of all stripes.
Taking all these factors into consideration, a positive base-case scenario seems justified.
On a more cautious note, bond investors are currently pricing in six rate cuts this year, beginning in June or earlier. Such rosy expectations could easily be dampened if economic data causes the Fed to move more slowly. Reverberations from the war in Israel are already spilling over into neighboring countries, with the risk of interruptions to global trade and an increase in oil prices.
And as we have often noted, monetary policy takes six to twelve months to kick in. With the last interest rate hike in July 2023, the intended and unintended consequences of a tightening cycle that brought the Federal Funds rate to its highest level in 22 years (5.25%-5.50%) will continue to be felt through the first half of 2024, potentially resulting in slower than anticipated growth or other financial pressures. Finally, just as the wide-spread pessimism of last year gave us pause—and proved to be misguided—the chorus of positivity as we enter 2024 suggests a complacency that could be vulnerable to disappointment.
One way or another, we believe that the world is shifting towards a new post-Covid reality in which government stimulus will no longer be the norm, chronic shortages of goods and services have been resolved, steadily rising prices give way to more cyclical patterns, and central bank policy around the globe is less extreme. In other words, a more “normal” world after the profound disruptions of the pandemic.
We think less expensive areas of the market like international stocks may attract investor dollars this year. International stocks may also benefit from the fact that the US dollar exchange rate has historically been closely related to the difference between interest rates in the US and abroad. With interest rates moving lower here, the US currency exchange rate could fall, increasing the value of international holdings in dollar terms.
Though bonds have already enjoyed a strong year-end rally, yields remain attractive compared to the past several years and a decline in interest rates over the coming months could offer investors additional capital gains. With the Federal Reserve preparing to change course, we think bonds are likely to outperform cash.
On a housekeeping note, you can expect to receive Form 1099 tax statements from Schwab in mid-February, and they will also be available on the Schwab Alliance website.
We thank you as ever for your trust and wish you peace, good health, and happiness in the new year!
The LongView Team
[1] 2023 net returns: MSCI EAFE Index +18.24%; MSCI Emerging Markets Index +9.83%.