2023 was challenging in many ways. The rapid Federal Reserve rate hiking cycle was predicted to cause a major slowdown in the economy. At the start of 2024 there are still concerns that the longest awaited recession in history is still in front of us, although the counter argument is that between 2022 and 2023, we had rolling recessions across different sectors of the economy and the weakness is now behind us. Either way, the US economy has remained far more resilient than expected by most investors as well as the Federal Reserve.
Equity markets and indices were driven largely by the top technology stocks, in this year’s version known as the “Magnificent 7”. The downdraft in technology stocks in 2022 reversed in 2023 as earnings rebounded and this handful of stocks had stellar gains for the year. While artificial intelligence (or AI) has been used in many ways for several years, the introduction of ChatGPT and the possibilities envisioned for that large language model (or LLM) technology sent imaginations soaring and took the stocks most associated with the technology along for the ride. This came at a crucial time for equity markets as concerns about higher rates created a very difficult third quarter; the AI theme ignited a variety of increasingly creative stories and created a bit of frenzy in some of the related stocks.
The balance of the equity market tried to play catch up in the fourth quarter, but the performance of the market cap-weighted S&P 500 was driven substantially by mega-cap technology stocks, as demonstrated by the return on the S&P 500 Total Return at 26.29% vs the Equal Weight S&P 500 at 13.84% for 2023.
The economy remained resilient in the face of rapid rate hikes, and in a surprise move the Federal Reserve chairman Jay Powell gave a speech in mid-December implying the Federal Reserve could be done raising rates. While the financial markets had already “decided” the Fed was done raising rates, hawkish commentary in August and September implied interest rates would remain at “higher levels for longer”. In his December speech, Jay Powell stated that the risk to employment was now as important as the risk to higher inflation, which signaled to stocks and bonds that the hiking cycle was over and, more importantly, created an expectation that the reverse was coming sooner rather than later and with more gusto than had been telegraphed as recently as the beginning of December. Markets took that to mean a cycle of rate cuts would start early in 2024 and stocks and bonds rallied on that speech and into the end of 2023.
Many of the concerns that roiled equity and bond markets in the third quarter of 2023, however, remain. Globally, governments have never been as indebted as they are right now, and the cost of carrying that debt has gone higher. While the bank insolvency issue in the spring of 2023 seems far behind us, government programs put in place at that time for banks will need to be renewed. For the near term, the US government shut down that was avoided in the fall could be revisited as early as March, reminding investors that there are still major unresolved issues in the US budget. The political landscape in the US and globally also remains uncertain, with a presidential election in the US and other important elections globally.
The global economic landscape also remains fraught, with the situation in Ukraine ongoing and the tensions in the Middle East far from resolved. These conflicts are creating risks to global trade, which could impact inflation. Europe is facing their own challenges and the big uplift in global growth expected from China as Covid restrictions eased was not nearly as strong as originally anticipated.
We enter 2024 with higher interest rates than were prevalent in early 2023 and much debate on where rates go in the coming year. The interest rate policy post the financial crisis was unusual by historic standards, with lower rates for an extended period of time. The biggest question going forward is where rates settle post this hiking cycle, are we returning to a pre-crisis level of interest rates, or do we remain in a world where rates go to zero or close to zero when data deteriorates?
The answer to that question will affect asset prices globally, and the question of potential value adjustments and the timing of those adjustments will take time to answer. The current consensus opinion is that the Federal Reserve has navigated the economy to a “soft landing”. Inflation has come down considerably but remains above the targeted 2%. More importantly for consumers, the level of prices is much higher than pre-pandemic for critical goods like food and energy. A slowdown in the rise of prices is nirvana for economists, but levels remain painful for consumers.
The good news is that the labor market has remained stronger than anyone expected at the start of this cycle, and wages have been positive, although not as high as inflation. When Federal Reserve Chairman Jay Powell signaled a change in the thought process of the Federal Reserve, he characterized it as balancing out the labor market risks with the risk of higher inflation. When the cycle started, the only discussion was around inflation given the combination of supply chain constraints and lingering pandemic effects.
Higher interest rates have created stress for consumers, and have essentially closed the existing home sales market, as those with low-cost mortgages do not want to sell their houses at a lower price nor to take on a higher-rate mortgage if they were to sell their house. New home sales have tried to fill that gap but there is still strong demand for housing that is not being met at current price levels. Additionally, auto sales have slowed as the cost of financing has risen and there are signs of stress in credit cards and other loan delinquencies. As rates come down, these higher costs for consumers will come down as well, and hopefully normalize some of the issues that a rapid increase in rates have caused.
The rapid multiple expansion in US equity markets, especially as it pertains to technology stocks, is unlikely to be repeated, and the expectation of 12% earnings growth in 2024 may be ambitious. The markets seem priced for more than just a soft landing - to maintain historically high multiples we need to see economic growth continue. With equities priced at the higher end of the valuation range and an uncertain road ahead, we think that quality balance sheets and cash flow will be important as investors look to factors that will allow companies to perform well in a variety of economic environments.
The views expressed are those of the Alpine Saxon Woods, LLC management team as of the date indicated, and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Performance data quoted represents past performance and does not guarantee future results. All data referenced are from sources deemed to be reliable but cannot be guaranteed. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.
