Global Market Review and Outlook

Review of Fourth Quarter and 2023

• Economic growth in 2023 proved far more resilient than most anticipated and the much-feared recession failed to materialize; still, inherent lags in monetary policy create scenarios where it may be too soon to definitively rule out a recession in 2024, although prospects for a mild slowing seem high.
• The progress on reducing inflation in 2023 was encouraging, and while most of the improvements were largely driven by the normalization of previous supply-side disruptions, the lagged impact from the Fed’s tightening campaign should help ensure that this continues into 2024.
• The Fed pivot (raising rates versus steady/rate cuts) is essentially now in, while the debate for investors has shifted to both the scale and duration of expected rate cuts in 2024 and beyond. Dampening these prospects is the behavior of the Treasury, where issuance will remain elevated.
• While growth was resilient in 2023, there is still no room for complacency in 2024. The highly skewed performance of the U.S. equity market over the last year and the weight of these stocks (“Magnificent 7” and a few others) in the index will be a headwind to performance in 2024, although it has left other parts of the equity and financial market underappreciated and attractively valued.

Source: FactSet, Strategas

Inflation Has Fallen, Growth Has Remained Resilient, and Higher Rates Did Not Break the Financial System

U.S. economic prognosticators were proven wrong in 2023, when the widely anticipated economic recession failed to materialize. This was despite two significant wars, the Fed’s fastest and most aggressive tightening cycle since at least the 1970s (with rates rising from just 0.06% in March 2022 to 5.33% by July 2023), the Fed’s extremely poor track record of being able to engineer a soft landing following such tightening campaigns, the near collapse of the regional banking system, and the rate increases leading to the deepest inversion of the Treasury yield curve in decades. Not to mention just about all leading economic indicators pointing to at least a mild recession.

2023 did experience an essential halt of capital markets activity (initial public offerings and follow-ons), a potent symptom of higher interest rates. Higher rates also nearly burst the progress of smaller regional banks. A result of a mix of management negligence and a lack of diversity in liabilities, the banks found themselves ill-equipped and overly exposed to the rapid decline in U.S. Treasury prices as rates increased. The mini-crisis led to the demise of three significant financial institutions and could have deteriorated further, were it not for the quick actions by the Fed to limit the fallout.

Many parts of the market held up surprisingly well. High-yield debt, for example, which is often one of the most sensitive areas of financial markets to economic weakness due to the higher risk associated with this asset class, managed a 2023 total return of 13.4%, outperforming the Treasury market and many other financial assets, and continues to offer spreads that are not historically indicative of economic stress.

The equity market, following a 25% peak-to-trough correction during 2022, also defied most expectations, with the S&P 500 increasing 24.2% (without dividends) in 2023, recovering a decent majority of the lost ground from the year prior. The euphoria around the generative AI, ChatGPT, LLMs, and GLP-1 analogues, however, meant that performance was largely skewed toward a handful of larger-cap tech stocks personified by the “Magnificent 7.” Comparatively, on an unweighted basis, the S&P 500 index increased by just 11.6%. This skewed performance gap between the weighted and unweighted index is not normal and has been the widest since 1999, and is a sign of very small basket of companies holding up the market.

Contrasting the internet bubble days of the late 1990s, to which many comparisons are being made, the general market atmosphere has been far less frothy, with few IPOs, significantly less investor bullishness, and an elevated equity risk premium demand; furthermore, the balance sheet quality of companies being bid up today is far better than many of those that were initially deemed market winners in the late 1990s.

Growth in the Real Economy – Resilient

Key features of the economy’s continued strength have been an unemployment rate steady between 3.4% and 3.9% over the course of the year and households’ ability to tap into “excess” savings built up during the pandemic to support post-COVID “revenge spending.” This has allowed real consumer spending (spending after taking into account inflation) to increase by 2.7% in the 12 months to November, which is fractionally higher than the average annual rate of growth experienced over the last decade. With the consumer in good shape, the economy itself has remained similarly buoyant, as depicted in exhibit 2 which shows the NBER recession-dating committee’s favorite economic gauges of economic activity used when assessing business cycle expansions and contractions.

It could be foolish to conclude that the real economy has been altogether immune from the impact of higher interest rates, most specifically in reviewing interest-rate-sensitive sectors of the economy, i.e., commercial and residential real estate, where activity has stalled but not yet cracked. While growth in the commercial real estate space has significantly declined and property values have dropped, the fact that many rental contracts are longer-lived and have yet to come up for renewal has given investors some breathing space and not resulted in widespread bankruptcies, although this remains a key area to watch in the coming year. Residential investment has witnessed a 40% slump in existing-home sales since the onset of tightening in 2022, thus far related more to a lack of supply than to a collapse in demand. New-home sales—where the homebuilders have been adding supply—have fallen by 27% over the same period.

Manufacturing activity, meanwhile, has been in recession throughout the past year, with the ISM manufacturing index contracting for the last 14 consecutive months. The latest survey data suggests that companies are becoming more optimistic about growth in the coming year.

Internationally, in most other developed economies, growth has not fared quite as well. While the much-feared cold winter failed to materialize, European growth was still feeling the impact from the war in Ukraine, weak Chinese demand, surging immigration, and Brexit. Conversely, the performance of the Japanese economy has been encouraging, alongside many emerging market economies, despite traditionally being some of the first to be adversely impacted by higher interest rates emanating from the United States. The Chinese economy is still struggling to limit the fallout from an epic property bubble, punitive COVID restrictions, rising geopolitical pressures and the economic decoupling from the West, and the economy’s numerous structural rigidities that are limiting its response to this weakness. All of these problems are becoming increasingly manifested in the return of deflation (exhibit 3).

Inflation – Further Progress to Be Made in 2024

News on inflation over the past year has generally been encouraging and a key reason for the resilient performance of both the economy and the financial markets. The sharp deceleration in price growth has helped confirm that inflation was largely a temporary phenomenon, one that was mostly driven by supply-side constraints, but also one that has responded to the relatively swift response from the Fed and other central banks in helping prevent the de-anchoring of longer-term inflationary expectations.

Lower inflation and the strong prospect for further disinflation in 2024 led Chair Powell and the Fed (at the latest FOMC meeting in December) to take what the market has interpreted as the long-awaited pivot from tightening back to easing. It is now clear that the peak in the fed funds rate has been reached, and the debate has now shifted to the extent and duration of the emerging easing cycle. The Fed’s latest dot plot of members’ rate expectations for 2024 shows an expected decline of 75 basis points (from 5.33% to 4.58%). Financial market participants, meanwhile, anticipate the funds rate to fall by 125 basis points this year (and a modest 240 basis points over the next two or three years). Should an economic recession indeed emerge, the amount of these expected rate cuts will increase sharply.

Not helping the process has been fiscal policy activity. The government is running a 6% budget deficit during a period of economic expansion, and with seemingly little desire to return to a more sustainable level, particularly during an election year and rising geopolitical tensions. This has resulted in a short period of Treasury market volatility through the third and fourth quarters, with 10-year Treasury note yields rising from 3.75% to a peak of 5.0%. While recent good news on inflation helped trim this back to 3.88% at year-end, increased Treasury issuance is likely to prevent Treasury yields from settling back to their pre-COVID equilibrium levels.

Resilience in 2023 Is No Reason for Complacence in 2024

Looking into 2024, with the knowledge that monetary policy acts with lags of one to three years, it is still too early to conclude that the impact of higher interest rates and the recession has been bypassed, although there are reasons to believe that any downturn would likely be more modest relative to history (low unemployment, productivity gains, AI investment, government spending, etc.).

For equity market investors, this could mean both continued volatility and a greater necessity for actively managing portfolios to take advantage of the market dislocations where they appear. If we do witness a move in rates this year, as forecasted, fixed income and balanced investors, may witness a move back down in bond and money market yields, so it is important to stay diligent on managing duration and credit quality within portfolios. With all these moving parts, we look forward to our conversations together as we review 2023 and the new year ahead.

Thank you for your continued trust and confidence.