Confounding the Crowd

As the saying goes, the stock market acts in ways to confound the most people and 2023 certainly lived up to that billing. For the first time in decades, perennially-bullish Wall Street strategists predicted a down year for stocks. The sentiment of individual investors was also decidedly bearish. Yet contrary to the consensus outlook, virtually all major asset classes produced positive returns in 2023.

Moody blues

The prevailing sour mood originated in part from substantial losses most stock and bond investors had previously suffered in 2022. That March, surging inflation induced the Federal Reserve to embark on one of the most aggressive tightening campaigns on record. The short-term policy rate jumped from near zero to 4.5% over nine months, leading the crowd to conclude that a recession — and additional investment losses — were likely in 2023.

After all, as former MIT economist Rudi Dornbusch famously quipped, expansions don’t die of old age, they are murdered by the Fed. Instead, however, U.S. economic growth maintained a moderate pace in 2023 and corporate profits turned back up after a bout of weakness. Meanwhile, inflationary pressures continued to recede. The “most anticipated recession in history” did not rear its head — at least not in 2023.

Wall of worry

Despite ending the year in the black, markets experienced a roller coaster ride, fueled by fluctuating views on Federal Reserve policy, inflation, and the health of the U.S. economy. Market participants have vacillated about the Fed’s intentions — tighten further, pause, cut? — leading to significant volatility.

At the beginning of the year, the 10-year Treasury yield stood at 3.79%. By late October, it had hit a multi-decade high, almost breaching the 5% threshold. But at year-end, the 10-year yield had retreated to 3.88%, essentially where it had begun the period. A mirror image, stock prices took their cue from bond yields, swinging in the opposite direction. Indeed, the S&P 500 stock index hit a low and began rallying two days after yields peaked in October.

In addition to the soft vs. hard landing debate, investors had to factor in a regional bank crisis, contentious debt-ceiling negotiations, two land wars, an autoworkers strike, rising tensions between Washington and Beijing, and the unleashing of the 2024 presidential election cycle.

Magnificent rally

In the final months of the year, the tide turned dramatically for financial markets. Moderating inflation data and an ongoing Fed pause restored confidence that the bank was done raising rates. Then, in December, markets cheered the Fed’s surprisingly dovish pivot after the central bank suggested that rate cuts would be forthcoming, potentially as early as March 2024. Stock markets ended the year on an upbeat note.

During the year, there were some unusual currents below the surface. Like the Titan Atlas with the heavens on his shoulders, the so-called Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla) carried the stock market, accounting for two-thirds of the S&P 500’s total return. Collectively, the other 493 constituents achieved much more modest performance. Driven by robust earnings growth and enthusiasm for generative A.I., these seven stocks now have a combined market value equivalent to the sum of all Japanese, U.K., and Canadian equities; they account for 28% of the S&P 500’s total market capitalization.

The M-7 stocks still seem to have quite a bit of momentum. As an aside, these same companies had previously brought the market down in 2022 when the S&P 500 lost 18% of its value. And despite their hefty 2023 gains, only three outperformed 1-month Treasury Bills over a two-year period. Fortunately, the overall market has broadened in recent months with a majority of stocks and sectors participating in the rally. Such ‘breadth’ represents a healthy signal.

Mission mostly accomplished

Inflation, as measured by the Consumer Price Index, rose 3.4% in 2023 after surging 6.5% the previous year. The more closely watched core rate (excludes food and energy) increased 3.9% last year versus 5.7% in 2022. Inflation has fallen across nearly all categories but the large decline in the headline rate has been disproportionately driven by a drop in energy prices. For core inflation, the move from 4% to 2% has been more grudging than that from 8% to 4%.

Shelter prices have remained sticky and are the main culprit preventing core inflation from hitting the Fed’s goal. For instance, in December, two-thirds of the increase in the core rate stemmed from rising housing costs — as modeled by the Bureau of Labor Statistics.

However, private measures of real-world rental rates tell a different story. A boom in apartment construction has led to a glut, with rising vacancies and motivated landlords. The Apartment List National Rent report indicated that the housing market ended 2023 with a fifth straight month of falling rents. And according to Redfin’s data, asking rents have dropped the last three months and were down 0.8% year over year in December.

These trends will eventually be reflected in the government’s official price gauges so reported inflation should indeed further moderate. Nevertheless, investors will stay glued to monthly inflation readings until they reach the Fed’s 2% target. Expect stock and bond markets to continue gyrating with the headlines.

The rate question

Currently, Fed policymakers anticipate three rate cuts in 2024, totaling 0.75 percentage points. Futures markets are more optimistic, pricing in six, or about 1.5%-points of easing. But much can change between now and March when the cuts are expected to commence. As we have seen time and again over the last decade, both the markets and the Fed are often very wrong when it comes to predicting the timing and direction of interest rate moves.

For investors, the operative question is not the absolute number of rate cuts. Rather, the broader issue relates to whether the Fed will be able to unwind the most intense tightening cycle in decades in sufficient time to forestall a recession. The historical record paints a dim view, but recent stock market action implies that the crowd is not all that worried.

Sticking the landing

The outcome of a soft-landing hinges on the resilience of the American consumer. They defied expectations and kept spending in 2023, reflecting tight labor markets, excess savings, and perhaps a wealth effect from rising equity and home prices. But that three-legged stool may begin wobbling a bit.

The job market still appears relatively healthy, although some cracks have appeared. Payroll employment has increased for 36 consecutive months but the pace of new job growth was cut in half in 2023 (from 400,000/month in 2022). And in the fourth quarter, job creation only averaged 165,000 a month. Meanwhile, job openings continue to trend lower suggesting that workers who lose their jobs will find them more difficult to replace — pressuring the unemployment rate.

As for consumers’ excess savings, that massive post-pandemic stash has been about drawn down according to most estimates. The San Francisco Fed predicts it will be depleted during the first half of 2024. At the same time, interest costs have risen for many consumers; and while low, delinquency rates on auto, credit card, and student loans have turned up.

Looking in the mirror

In contrast to the pessimism that prevailed twelve months ago, the mood today among market participants is rather upbeat. The consensus holds that the economy will navigate the cross currents from Fed policy and continue its expansion. Wall Street analysts forecast double-digit earnings growth for the S&P 500 in 2024. Most strategists expect the stock market to produce additional gains, albeit more muted than 2023’s. As for individual investors, while bears outnumbered bulls by 32%-points in December 2022, a year later, bulls exceeded bears by that same margin.

Given the amount of negative sentiment in 2023, there were more things that could go right than wrong for investors. Today, the opposite is true. We are starting from a point where much good news is already reflected in stock prices, leaving less margin for disappointment. This is not to argue the consensus will be wrong (again) in 2024; it is merely to suggest that we all remain vigilant and mindful of that risk.

— Christopher J. Singleton, CFA, Managing Director
January 17, 2024