During the last quarter of the year, both stocks and bonds experienced significant gains as bond yields decreased, reflecting the increasing anticipation of a potential Federal Reserve easing.
The quarter commenced with a less than promising outlook. At the start of October, the Hamas-led attack on Israel, added to global geopolitical risk concerns and market volatility.
The robust economic data released during the month raised concerns among investors that the Federal Reserve might struggle to loosen its stringent monetary policies.
This apprehension led to bond yields reaching levels not seen in over a decade. Worries about Treasury funding and unexpectedly high consumer price inflation further dampened market sentiment during the first month of the quarter.
However, November brought about a turning point for the markets. They rebounded as new data revealed progress in inflation and Fed Chair Jerome Powell made constructive statements. These positive developments led to a decline in bond yields and a surge in the stock market. Within a month, the pessimism regarding conditions potentially hindering the Fed's easing of policies gave way to optimism, with hopes that the rate hike cycle might be ending, and interest rate cuts could be on the horizon for 2024.
As the quarter ended, equity markets were very close to their all-time highs that were reached in early 2022 on renewed investor optimism.
Investor sentiment has shifted drastically from a pessimistic view at the start of the quarter to a more optimistic outlook with signs of improving economic conditions. This sudden shift in attitude is an excellent reminder to investors as to why reacting emotionally to market developments tends to be more counterproductive than maintaining a long-term investment discipline.
THE FED & INTEREST RATES
In December the Federal Open Market Committee (FOMC) announced its decision to keep interest rates unchanged within the range of 5.25% to 5.5%. A survey of its members indicated the possibility of up to three interest rate cuts in 2024. This announcement, along with dovish remarks from Powell, played a pivotal role in driving bond yields lower and pushing both bond and stock prices higher.
In its official statement, the Fed highlighted that, following an extended period of tightening measures aimed at addressing historically high inflation levels, the pace of U.S. economic growth has moderated. The statement noted that “inflation has eased over the past year but remains elevated.”
According to the median Summary of Economic Projections by Fed officials, the federal funds rate is expected to decrease by three-quarters of a percentage point to 4.6% by the end of 2024 and further drop to 3.6% in 2025. This implies the possibility of four quarter-point rate cuts by 2025. Notably, none of the Fed officials anticipate higher interest rates by the end of the coming year.
The economic landscape, in the latest data release, presents a mixed picture of the US economy. Gross Domestic Product (GDP) growth for the third quarter was 4.9%. Despite a strong overall performance, there may be some underlying weakness in consumer sentiment or spending patterns.
On the employment front, the addition of 199,000 jobs in November, boosted by the return of striking auto workers, slightly exceeded expectations.
The unemployment rate dropping to 3.7% and wage growth meeting expectations at 0.4% month-over-month is a positive sign for the labor market.
Retail sales showed some improvement, rising by 0.3% in November after a revised -0.2% in October. Excluding auto and gasoline sales, retail sales climbed 0.6%, indicating that consumers are still spending, albeit cautiously.
Housing data painted a relatively positive picture, with housing starts exceeding expectations and sales of existing homes showing their first increase since May. New home sales did drop in November, but they remain above last year's levels.
Inflation, as measured by the Consumer Price Index (CPI), showed a slight increase of 0.1% in November, bringing the year-over-year increase to 3.1%. Core inflation, excluding energy and food, increased by 0.3% month-over-month, and reached 4.0% year-over-year. Although this inflation reading remains above the Federal Reserve's target of 2.0%, it was slightly below most economists’ consensus. This in turn supported the narrative that the Fed may be finished with raising rates if the inflation trend continues to slow.
For the quarter, both the S&P 500 and the Dow Jones Industrial Average saw impressive double-digit increases and maintaining its lead from earlier in the year, the Nasdaq Composite once again led the way, outperforming the Dow and S&P.
Small-cap stocks, represented by the Russell 2000 index, managed to outperform their large-cap counterparts. Since small-cap stocks tend to be more sensitive to economic conditions and concerns, the improving inflation readings combined with the Fed’s dovish outlook for its rate policy was supportive for this segment.
Value stocks staged a comeback during the quarter. Value stocks gained favor toward the end of the quarter as investors sought refuge in companies with reasonable valuations and established cash flows, given the valuation concerns surrounding the Magnificent 7: Microsoft, Amazon, Nvidia, Meta, Apple, Alphabet and Tesla, which have been responsible for most of the stock market’s 2023 return.
Throughout the first two months of the quarter, companies reported their third-quarter earnings. Prior to the quarter, investors had hoped that strong earnings reports could help lift stocks from the previous month’s stagnation. While corporate earnings weren't spectacular, they did provide encouraging signs for investors. Earnings for the third quarter grew by 2.7% year-over-year, marking the second consecutive quarter of earnings growth after a previous "earnings recession" (two consecutive quarters of earnings declines) that was experienced in the first half of 2023.
Starting the quarter down for the year, The Bloomberg Aggregate Bond Index staged a remarkable recovery, managing to erase all losses for the year and turn positive into mid-single digit returns by the end of the quarter.
Until October, the bond market had been facing the possibility of a third consecutive year of negative returns. A significant shift occurred in November, marked by a sudden dovish pivot that triggered a remarkable turnaround. Notably, the monthly return for November alone stood at the highest monthly gain since May 1985 and this was the best quarterly return for the bond market in the past 3 years.
Before this pivotal shift, the US 10-year Treasury yield had reached its peak at 4.99% in mid-October. As the notion of a soft economic landing in 2024 gained credibility, the market began pricing in the likelihood of additional rate cuts, resulting in the 10-Year yield ending the year over 100 basis points lower than its peak, settling at 3.88%.
Most segments of the Treasury yield curve experienced gains. The large drop in bond yields caused longer-term bonds to outperform intermediate and short-term bonds by a wide margin for the quarter. There was not much of a performance disparity across sectors for the quarter as the bond market’s return was mostly driven by rate changes/expectation and not necessarily an improvement in credit conditions.
In 2023, equity markets surprised with robust performance, delivering double-digit returns for the S&P 500, Dow and Nasdaq. However, more modest expectations for 2024 are advised due to several factors.
Profit growth estimates for the coming year appear ambitious, while volatility, which remained unusually low, may increase. Valuations could face further pressure, and economic growth is expected to decelerate.
Analysts predict earnings to grow by low double digits next year. Margins are expected to remain stable, but revenue growth is likely to slow. Disinflation, slowing economic growth, and challenges faced by consumers may constrain revenues. In the event of a U.S. economic recession, profit growth could contract, negatively impacting stocks.
The unusually low equity volatility experienced in 2023 may prove challenging to maintain in 2024. The Volatility Index (VIX) averaged 16.8 this year, compared to the 19.5 average over the past 15 years, and interest rate volatility has risen to levels reminiscent of the early pandemic period since the Fed began raising rates. If the U.S. economy faces difficulties, interest rate volatility may transfer its impact to equities.
We anticipate a decline in interest rate volatility for two main reasons. Firstly, a slowing economy is expected to keep the Federal Reserve firmly maintaining its current interest rates until at least the first half of 2024. Secondly, assuming the economy avoids a recession in the coming year, we anticipate the Fed will gradually reduce policy rates without making abrupt, aggressive rate cuts. This, in turn, should provide support for the bond market. Taking everything into account, bond investors should prepare for better prospects in terms of both income and capital appreciation.
In terms of equity allocation, we continue to favor quality displayed by large-cap stocks. Small caps have experienced a significant valuation correction but are exposed to domestic growth, which could decelerate. Within large caps, it's less about growth versus value, as there is significant divergence even within sectors and industries.
As we enter the 1st quarter of 2024, it is important to recognize how quickly market sentiment changed in just a few months. Statistically, most investors that change their investment strategy based on short-term media influence or as an emotional reaction to market volatility tend to do so at the most inopportune times. This is why it is imperative to remind yourself that your investment strategy is based on your long-term goals and objectives, not short-term market changes.
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