Financial markets’ strong rebound in 2023 took investors by surprise. It’s hard to believe it was just 12 months ago when market pundits were all but guaranteeing a recession thanks to the Federal Reserve’s aggressive tightening of monetary policy to fight inflation. Fast forward and the most talked about recession in history has yet to materialize. This serves as a reminder that successful long-term investing is not about making great decisions, but about consistently avoiding big mistakes that can result from acting on emotions. This is especially true when sentiment is at extremes, both positive and negative. Instead of taking pre-emptive action around the consensus recession, we focused on the building blocks of successful long-term investing – committing to an appropriate asset allocation, rebalancing portfolios to target allocations, tax loss harvesting when possible, managing duration of fixed income portfolios, managing portfolios in a tax efficient manner, and optimizing returns on cash balances. We believe these actions have served our clients well over the last year.
The US economy, as measured by GDP, grew 2.9% in the third quarter versus a year ago. We expect fourth quarter GDP to grow ~1-2%, in line with our expectations for the full year 2024. We believe consumer spending, which drove above trend growth in 2023, will slow as higher interest rates negatively impact disposable income and the labor market cools. The US labor market added over 2.5 million jobs in 2023, keeping the unemployment rate under 4% (3.7% in November). However, nonfarm payrolls have started to slow, and both job openings and wage growth have trended down since peaking in 2022. While these headwinds could cause a slowdown in economic growth, and decelerating growth makes the economy more susceptible to unexpected “shocks,” we expect any slowdown to be mild given the absence of financial excesses in the economy (such as in lending, inventory, etc.). November’s core PCE index, the Fed’s preferred measure of inflation, measured 3.2% versus a year ago. Slower growing shelter costs should continue to push inflation down. Lower inflation readings continue to clear a path for the Federal Reserve to hold monetary policy steady and possibly loosen (lower interest rates) later this year. Markets have responded positively to the prospect of lower interest rates, as such a trend in rates supports consumers, businesses, and overall asset valuations.
Against this backdrop, global equity markets gained momentum in the fourth quarter. US Large Cap Equities, as measured by the S&P 500 Index, returned +12% in Q4 and finished the year +26%. The rally has pushed valuations higher, with the 12-month forward price-to-earnings ratio back above 19x (as compared to its long term average of ~17x). Corporate earnings, the backbone of long-term equity prices, have overall been more resilient than expected. Current consensus estimates for 2024 and 2025 imply a 12% growth rate above 2023’s consensus expectation of $217. If these estimates are achieved, and we believe they can be, then the market is trading in line with historical averages. But the bar is higher than it was, and we expect more volatility in the coming year as a result. We remain Neutral weight to US Large Cap Equities. We are also cognizant that the overall market of stocks in the US has done worse than the indices make it appear. The top ten stocks in the S&P 500 (which now comprise 32% of the index) were +62% on average in 2023, while the remaining 490 stocks were +8%. These ten stocks collectively trade at 27x forward earnings, while the remaining 490 stocks trade at 17x. History tells us that eventually, high valuations and unattainable growth expectations lead to disappointments and devaluations. We believe this dynamic may not only create risks to traditional market cap indexing going forward, but also create opportunities within the rest of the market. US Mid Cap Equities (S&P 400 Index) and US Small Cap Equities (S&P 600 Index) returned +12% and +15%, respectively, in the fourth quarter but failed to catch up to their larger counterparts for the full year 2023 (+16%). At 14x forward earnings multiples, these asset classes remain historically cheap on an absolute and relative basis. We remain Neutral weight to US Mid and Small Cap Equities in our asset allocation models.
Non–US Developed Markets Equities, as measured by the MSCI EAFE Index, returned +19% in 2023 and Emerging Market Equities, as measured by the MSCI EM Index, returned +10%. Global economies face a myriad of uncertainties: the aftermath of aggressive monetary policy tightening, mounting geo-political tensions, and a slew of important upcoming elections. Despite the reality of these uncertainties, global inflation has fallen sharply and should allow central banks to pivot towards easier monetary policy as the year progresses, helping to protect against significant economic contractions. We already see this playing out in certain Emerging Market economies. Furthermore, we believe that investors are being fairly compensated for these risks with current valuations. The MSCI EAFE index trades at 13x forward earnings and the MSCI EM index trades at 12x forward earnings. These valuations are significantly lower compared to those in the US and remain attractive versus long-term averages. We also think that the recent weakening of the US dollar, after years of strength versus a number of global currencies, is a trend that will continue and will provide a positive tailwind for the performance of Non-US Equities. We remain Neutral weight to Non-US Developed Market Equities and slightly Overweight to Non-US Emerging Market Equities.
While all eyes were on the Federal Reserve and short-term interest rates, long-term interest rates were the real story of 2023. Stronger-than-expected growth, concerns about the US government’s fiscal outlook and the Fed’s pledge to keep interest rates higher for longer initially drove long-term interest rates to levels not seen in decades. The 10 Year Treasury reached 5% in October 2023. When, later in the year, the Federal Reserve changed its tone by acknowledging that inflation was declining sufficiently towards their target 2% level (making further interest rate hikes unlikely), long-term interest rates headed sharply lower with the 10 Year Treasury finishing the year at 3.9%. Despite the volatility, we continued to take advantage of the opportunity, purchasing high quality bonds at attractive yields to lock in income in client portfolios. We caution those investors wooed by the high interest rates currently offered on cash. Cash interest rates are quite short-term and are only attractive until they are no longer available. If current expectations that the Federal Reserve will lower rates in 2024 prove correct, that time may come sooner than later. Non-Investment Grade Bonds, as measured by the Barclays High Yield index, returned 14% in 2023. Credit spreads over Treasuries – the premium charged by investors to hold below Investment Grade bonds – have narrowed considerably. Given the combination of already rising default rates and attractive interest rates on Treasuries, Municipals and Investment Grade Corporates, we are Overweight US Investment Grade Bonds in our asset allocation models and Neutral to Strategic (Non-Investment Grade) Bonds.
This is the time of year for forecasts, which are essentially educated guesses based on available data. The truth is we do not know exactly what 2024 will bring (nobody does). Nor do we know what direction the stock market will head in the short-term. But we are confident that investing in a diversified portfolio of equities will almost certainly provide higher rates of return than cash and fixed income over long periods of time. After the last several years of double-digit market returns (both positive and negative), we think it important to reiterate how investors achieve market average returns. The S&P 500 has delivered an annual average return of ~10% since 1926. In reality, these average returns are rarely achieved in a given year. The market has returned close to the average (between 8% and 12%) in only 6 of the past 98 years. In most years, the index’s return was outside of the range – often above or below by a wide margin – with no obvious pattern. The last several years have been no different. While we cannot predict what 2024 will bring, we do feel good reviewing portfolios with clients, as we believe many asset classes have attractive valuations that will continue to help them to meet their long-term goals.
