Market Commentary Q4 2023

UPSIDE SURPRISE IN 2023

 

The US economy was surprisingly strong in 2023, seeing job growth and higher consumer spending, all while inflation moderated.  The economy benefited from a third consecutive year of fiscal stimulus with a cumulative $10 trillion added since the initial 2020 COVID-19 response.  In a year with strong GDP growth and unemployment below 4%, the budget deficit in 2023 was $1.7 trillion.  Rarely has the US Government run such a large deficit while the economy expanded.  This fiscal stimulus muted the negative impact of monetary tightening.  Nonetheless, inflation moderated as oil prices fell and supply chains normalized.  Inflation is gradually heading down to the target rate, giving the stock market hope that the Fed will begin easing in 2024.

Globally, the US economy outperformed those in Europe, Japan, China and Emerging Markets, a function of the “haves” and “have nots” in their ability and willingness to pump aggressive fiscal stimulus into their economies.  But much of the higher growth in the US is low-quality public spending with very little private sector multiplier.  The US has aggressively purchased short-term economic gains with a tax bill that will come due later.  While 2023 was surprisingly strong, higher government debt levels and interest costs will put pressure on politicians to control spending, dampening the ability to influence economic growth.

Thus far, the economy has stood strong in the face of higher interest rates.  Banks, commercial real estate, and housing are sectors that are highly sensitive to rates and each fared much better than expected.  A weak spot in the economy is manufacturing, which has been contracting for over a year.  The overall impact of manufacturing on our economy is very low though, representing only 10% of GDP and 8% of the workforce.  Despite the upside growth surprise in 2023, we expect an economic slowdown in 2024, pushed lower by a weakening consumer whose excess pandemic savings are depleting and job growth that is showing signs of weakening.

Geopolitical risks were elevated in 2023, highlighted by ongoing tensions with Russia and China and a new conflict in the Middle East.  Supply chain disruptions, which mostly disappeared last year, have reemerged as Houthi pirate raids on cargo vessels are forcing rerouting and even shortages of goods at some ports.  This has the potential to reignite inflation, although not to the same degree as the pandemic shutdown.  Adding to uncertainty, 2024 will also see an above- average number of presidential elections in countries around the globe.  Certainly, the US presidential election promises to be interesting with divergent potential impacts on the economy and markets.  Taxes are likely to come to the forefront as the tax cuts of 2018 are set to expire next year at a time when the federal debt and interest costs have exploded higher.

 

2024: WHAT IS THE FED’S NEXT MOVE?

 

The Fed has signaled that rate hikes are over and that lower rates this year are likely.  The catalyst to lower interest rates will be based on one of two things: 1) core inflation reaches the Fed target of 2%, or 2) the lag effects of higher rates catch up with the economy and employment, and growth begins to contract meaningfully.  Current consensus favors the former, inflation declines to 2% in the first half of 2024 in a soft-landing scenario, allowing the Fed to back off their restrictive policy, giving the economy room to reaccelerate.  Soft landings, a Fed-engineered economic slowdown that brings inflation down without pushing the economy into recession, are rare.  Sixteen of the last eighteen Fed rate hiking cycles resulted in recession.

No two cycles are the same, and we believe this one is unique in the magnitude of fiscal stimulus injected so late in an economic expansion.  The result is a longer lag than normal.  On average, rate hiking cycles take 1-2 years to have an impact.  The second anniversary of this cycle is coming up in March.  While the Fed’s hikes were considered aggressive, they started from 0%, perhaps the most stimulative in history.  It took a year’s worth of rate hikes to even reach a level that could be considered restrictive, which, in addition to late fiscal stimulus, also argues for a longer lag time.  After a surprisingly strong 2023, the Fed and markets have bought into the idea of a soft landing and expect rate cuts to begin this summer.  We doubt the old cycle has played out and a new one is beginning and believe it makes sense to remain cautious in 2024.

 

MARKETS: WHAT IS BAKED IN?

 

November and December witnessed a powerful market rally that was broad in nature, pushing the average stock from loss to gain for the full year in just two short months.  The late surge was fueled by the belief that lower inflation would allow the Fed to move policy from restrictive to easing in 2024.  “No recession” in 2024 is consensus and is baked into current stock prices.

Thanks to Fed Funds at a 16-year high – 5.25%, likely its peak – cash yields are tempting.  Cash significantly outperformed bonds over the past two years and outperformed stocks until the recent run-up.  But whether the coming slowdown is a soft or hard landing, the Fed will likely lower rates, pushing cash yields lower along the way.  A soft landing scenario might see cash yields lower by 1-2%, whereas a hard landing might see them fall 3-4%.  Either way, hiding in cash and earning 5% will likely be a thing of the past as 2024 progresses.

Artificial intelligence (AI) was one of very few investment themes that worked well in 2023.  While we believe much of the AI hype is warranted, we also worry that the speculative frenzy pushed many stocks well above their intrinsic values.  AI has driven big tech R&D budgets higher in a race to develop new products and capture market share.  Semiconductor stocks are the most direct beneficiaries of AI, while data storage REITs also benefit further down the value chain.  Longer-term, AI could drive productivity growth, thus higher profit margins, making today’s lofty valuations less of a concern.

 

EXPANDED MARKET OPPORTUNITIES

 

Despite uncertainty being a constant, over rolling 10-year periods, stocks have outperformed bonds about 85% of the time.  We continue to believe that patient equity investors will generate capital appreciation over the long-term, despite inevitable short-term volatility.  As we head into 2024, the opportunity to earn attractive returns in a diversified portfolio are solid.  Bond yields are high, stock valuations are fair for the broader market, alternatives continue to generate uncorrelated returns, and private markets continue to offer a return premium over publicly traded securities.

 

Respectfully,

Royce W. Medlin, CFA, CAIA

Chief Investment Officer

 

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