Despite inflation remaining above the Fed’s 2.0% target, inflation trended lower in 2023, allowing the Fed to pause interest rate hikes since July. In December, the Fed signaled a shift towards rate cuts in 2024; the “pivot” stoked equity market sentiment that had already rebounded from October month-end lows, sparking a “Santa Pause” rally through the closing trading day of 2023. The attached Q4 Quarterly Market Review provides the breakdown of a fourth-quarter comeback that made 2023 a good year for investors, even though most of the year, it didn’t feel like that would be the outcome. For most of the year, stock market gains were concentrated in seven Mega-cap tech stocks (dubbed “The Magnificent Seven)” driven by the emergence of artificial intelligence (AI) breakthroughs. Fortunately, in the final weeks of 2023, the leaders paused, and the participation in gains spread to the broader market. Lower interest rates also permitted bonds to recover value from the peak yield levels seen in the third quarter.
Throughout 2023, the prevailing economic narrative revolved around inflation and the Federal Reserve’s response. The year commenced with a 6.5% inflation rate, prompting the Fed to raise interest rates despite concerns about potential unemployment and economic downturns. The drop in overall inflation was influenced by a decline in energy prices, with the Consumer Price Index reporting a 5.4% decrease in energy prices and an 8.9% drop in gasoline prices over the 12 months ending in November. However, food prices increased by 2.9%, and shelter prices rose by 6.5%. Amidst the inflation focus, significant events unfolded, including political clashes over the debt ceiling, the looming threat of a government shutdown, bank collapses, labor strikes, the ongoing Ukraine-Russia war, and escalating conflict in the Middle East.
The Federal Reserve, starting in March 2022, aggressively increased interest rates to curb inflation. The Personal Consumption Expenditures (PCE) price index was 5.4% in January, with core prices at 4.7%. Although there was a moderate summer surge, the PCE price index gradually decreased, reaching 2.6% (core prices at 3.2%) for the 12 months ending in November. While inflation trended lower in 2023, the economy absorbed the higher rates and tighter credit conditions, still avoiding recession. Part of the resilience was that consumers and corporations took advantage of the low-interest rates when they were available to refinance mortgages and pay down debt. However, interest-sensitive sectors like housing were adversely affected by the aggressive rate hikes, which spiked mortgage rates to as high as 8.0%. It was the federal government that took on enormous debt to navigate the pandemic era; more on the repercussions of that below.
In March 2023, the failure of three significant U.S. banks startled investors and sent shockwaves through the financial sector. The Federal Reserve intervened, providing emergency loans and assuring the honoring of all deposits, irrespective of standard FDIC limits. Simultaneously, the debt ceiling crisis unfolded, leading to the Fiscal Responsibility Act of 2023, which raised the debt ceiling but imposed a cap on federal government spending.
Despite these challenges, the U.S. economy showcased resilience. Gross domestic product expanded in each of the first three quarters, with consumer spending growing by 3.1% in the third quarter. The job market remained robust, with job growth averaging 240,000 through November and the unemployment rate hovering between 3.5% and 3.8% for most of the year. Average hourly earnings increased by 4.0%, and job openings remained solid at 8.7 million.
Industrial production experienced a 0.4% decline through November, with manufacturing, comprising 78.0% of total production, decreasing by 0.8%. A prolonged strike by U.S. auto workers, coupled with higher borrowing costs and weaker demand, contributed to the manufacturing downturn.
Artificial intelligence played a significant role in investment returns in 2023, leading to increased corporate investment in AI for its expected productivity gains. Corporate investment, measured by capital expenditures and research and development, showed impressive growth in 2023, with expectations of further gains in 2024, especially in manufacturing and the tech sector.
In my review of the 2024 outlooks from economic and market strategists, I encountered various perspectives, but one outlook stood out, emphasizing a return to “normalcy” in 2024. The argument presented was that the years 2020 and 2021 were highly abnormal due to the pandemic, the extreme measures taken in response to the pandemic, and the resulting economic conditions. A consequence of the response to the pandemic, particularly the surge in inflation, led to rapid and extreme rate increases, which was also abnormal. As the fourth anniversary of the pandemic approaches, as noted above in the 2023 data, several key economic and market factors appear to be reverting to trend or near normal levels; however, some aspects remain abnormal.
Entering 2024, the return to normalcy offers several positives. Growth and consumption, inflation, and supply chain disruptions have eased. The United States’ transition to being a producer and net oil exporter has contributed to the normalization of gas and energy prices, though recent military conflict in the Red Sea may reverse that. The labor market, measured by employment and wage growth, is returning to trend. However, some sectors, especially those sensitive to interest rates like commercial and residential real estate and banks, remain challenged by tight credit conditions and a persistently inverted yield curve.
The labor market has undergone what some refer to as a “generational evolution,” with an increase in personal care workers and a decline in supply chain workers. Work-from-home trends, accelerated by the pandemic, continue to reshape the labor market, and plague the commercial office building market.
Healthcare and healthcare technology investment is increasing due to growing consumption by an aging population and technological advances, which should spur profitability and improve profit margins. The healthcare sector, perceived as undervalued, could present attractive opportunities.
However, challenges lie ahead, including a significant amount of treasury debt coming in 2024, potentially leading to interest rate volatility. The U.S. deficit and debt cast a “debt shadow” with concerns about the U.S. reaching a limit to the debt it issues and the potential adverse consequences of more debt. Geopolitical factors like the Russia/Ukraine war, conflicts in the Middle East, and the upcoming presidential election in 2024 also add uncertainties.
With the Federal Reserve signaling a path of cutting the federal funds rate, short-term rates are anticipated to decline in 2024. Bloated treasury issuance, influenced by the need to refinance maturing bonds and cover current deficit spending, supports the case for higher long-term interest rates. The supply-demand dynamic for longer-term bonds has evolved to a dynamic of increasing supply with demand transitioning from price-insensitive “whale” buyers to price-sensitive “traditional” buyers of bonds. In a recent interview on CNBC, former Dallas Fed President Robert Kaplan noted that the US Treasury will need to issue $9 trillion of new bonds in 2024. Partially to refinance approximately $7 trillion of maturing bonds and approximately $2 trillion to pay for current deficit spending. Combining lower short-term and higher long-term rates supports the expectation that the yield curve will normalize (dis-invert) in 2024. The Federal Reserve has influenced the longer end of the yield curve by reducing its balance sheet by letting maturing treasury bonds run off. It’s interesting to note that the December 23 Fed meeting minutes revealed that several members of the Free Open Market Committee (FOMC) suggested that they “…begin to discuss the technical factors that would guide the decision to slow the pace of runoff …“ Which would mean the Fed would repurchase bonds as they mature and thus prop up the net demand needed to absorb higher treasury issuance. Doing so could extend the life of the inverted yield curve. So, these will be the policy decisions we will monitor in 2024 to see if the yield curve follows suit and “normalizes” in 2024.
Amid a more normal economic backdrop, there are lingering abnormalities, especially in interest-rate-sensitive sectors. Factors like the U.S. government approaching its fiscal limit, yield curve inversion, and uncertainty about monetary policy may counter a full return to “normalcy”. The Fed’s current stance has boosted stocks, but high expectations for rate cuts in 2024, whether met or not, could influence market mood and direction.
In navigating 2024, we will first maintain a focus on a long-term strategy with a diversified portfolio aligned with clients’ financial plans and risk tolerance. While the return to normalcy is viewed positively, awareness of remaining abnormalities guides prudent portfolio allocations. Strategies include staying fully invested, adjusting stock exposure based on client profiles, and leaning into the sectors that should benefit from an improving economy and broadening of the market. On the fixed income side, we anticipate gradually transitioning from being slightly overweight short-term, liquid positions, like money markets and treasury bills, into longer-duration bonds that offer higher income while balancing credit quality and maintaining diversification.
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