Index | YTD | 4Q | 1Y | |
---|---|---|---|---|
S&P 500 | U.S. Large Cap | 26.29% | 11.69% | 26.29% |
DJIA | U.S. Large Cap | 16.18 | 13.09 | 16.18 |
Russell 3000 | U.S. All Cap | 25.96 | 12.07 | 25.96 |
Russell 2000 | U.S. Small Cap | 16.93 | 14.03 | 16.93 |
MSCI EAFE | Developed International | 18.24 | 10.42 | 18.24 |
MSCI EM | Emerging Markets | 9.83 | 7.86 | 9.83 |
Bloomberg U.S. HY | U.S. High Yield | 13.44 | 7.16 | 13.44 |
Bloomberg U.S. Agg | U.S. Core Bond | 5.53 | 6.82 | 5.53 |
Bloomberg Muni | U.S. Muni Bond | 6.40 | 7.89 | 6.40 |
MSCI U.S. REIT GR | U.S. Real Estate | 13.74 | 16.00 | 13.74 |
Source: Factset
In the fourth quarter of 2023, market participants rejoiced and drove stock and bond indices higher at the realization that the Fed had turned from hawkish to dovish, “pivoting” on interest rate policy. Returns for the year were positive across virtually all asset classes, with the S&P 500 leading the way. This is especially noteworthy in a year that was marked by perhaps the most widely anticipated recession that never materialized, the most aggressive Fed tightening in the last half century, and the failure of several prominent regional banks.
After a punishing October, the S&P 500 climbed 17% the last two months of the year as the market started to factor in the much-awaited reversal in interest rate policy. The total return for the S&P for 2023 was an impressive 26% and closed the year marginally below the index’s all-time high reached in early 2022. In similar fashion, bond prices rallied into year-end, taking the 10-year Treasury yield from 5% at the end of October to 3.9% by the last day of December. In the fourth quarter, the Bloomberg U.S. Aggregate rebounded from a slightly negative return going into the fourth quarter to up 5.5% for the year. Small-cap stocks and real estate investment trusts, more interest-rate-sensitive areas of the market, were top-performing indices in the fourth quarter, but substantially lagged the returns of the S&P 500 for the year. As for most of the past decade, U.S. large-cap growth stocks were the largest contributor to portfolio returns in 2023.
The market is often unpredictable and perplexing in its behavior with respect to sentiment, events, and economic data. Thinking back to the beginning of the year, economists were clear that a recession was imminent in 2023. With higher interest rates and too-high-for-comfort inflation, the headwinds of slowing growth and valuation pressure made for a difficult setup for risk assets. One of the most significant events of the year happened toward the end of the first quarter, when the steep move upward in interest rates caused a break in the system. Silicon Valley Bank (SVB) failed as customers (many venture-capital-backed companies) withdrew funds and the bank was forced to sell assets (mostly high-quality government bonds) at losses to fund the withdrawals, creating a downward spiral. Customers waited in lines to get their money out, equity and bondholders lost their investments, and fear was rampant. The demise of SVB was followed in short order by the failures of Signature Bank and First Republic. Ironically, following the initial pullback amid the bank failures, markets launched upward, never returning to the March low for the rest of the year.
Inflation has been enemy No. 1 for the past two years. The Fed has raised interest rates by 525 basis points since March 2022 to slow the economy and batten down inflation. While inflation is not yet back to the Fed’s stated 2% target level, it has come down steadily throughout the year. At a little over 3%, inflation is within shouting distance of the target and well off the 9.1% high of early 2022. With additional impacts of monetary policy still flowing through, the Fed recently expressed confidence that the work it has done will continue to slow the economy and keep inflation in check. Students of economic history know that in the 1980s, inflation reemerged after the Paul Volcker Fed first declared victory. There is reason to believe that “it is different this time” as a result of the supply-side-driven causes of our current predicament, but only time will tell if we are out of the inflation woods.
Monetary policy is an expansive and powerful instrument. As a result of Fed action, GDP growth has slowed, manufacturing has been in a recession for much of the year, and housing is feeling the impact in declining prices. But the economy has been far more resilient than expected, and a soft landing is now becoming consensus. Consumer balance sheets are in good shape from a debt coverage perspective, and most importantly the unemployment rate is holding strong with the most recent reading at a very healthy 3.8%. Wage growth has trailed off and the number of job openings has declined, but it is hard to imagine a recession when nearly everyone who wants a job can get one. Recessions are a natural part of the ebb and flow of the economy, and only time will tell when the next one comes. It is worth remembering the words of economist John Kenneth Galbraith: “We have two classes of forecasters: those who don’t know and those who don’t know they don’t know.” We know we don’t know, which is why we focus on long-term strategic portfolio goals.
A look back at 2023 would not be complete without a mention of the recent euphoria around generative artificial intelligence. In the long term, the powerful technology seems poised to impact businesses across industries, increasing productivity, rendering analytics more effective, and taking over certain jobs of humans. The stock market is forward looking, and AI is seen as the next pervasive theme following the internet and cloud computing. This year, investors furiously piled into names believed to be the AI winners, namely the “Magnificent Seven”—Apple, Microsoft, Amazon, Nvidia, Alphabet, Tesla, and Meta. These seven mega-cap stocks were responsible for much of the lift in the stock market in 2023, rising an average of 110%. The market-cap-weighted S&P 500 returned 26%, while the S&P equal-weighted-index increased by just 11.6%. This skewed performance gap between the weighted and unweighted index was the widest since 1999.
With strong performance comes a larger weight in the S&P index. The top 10 stocks by market cap now account for a record 32% weight in the S&P 500 index. These companies have strong balance sheets and cash flow and are well positioned to continue to invest significantly in technology and development, therefore increasing their growth, creating a positive flywheel effect. The forward price-to-earnings valuation of the top 10 stocks finished the year at 27x earnings, versus the remaining stocks in the index at 17x, in line with the 30-year average. Their higher-than-average valuations reflect these competitive attributes.
Globally, most other developed countries have not fared as well as the U.S., although nearly all major markets outside China experienced positive returns last year. While the much-feared cold winter failed to materialize, Europe has felt the brunt of the impact from the war in Ukraine, weak Chinese demand, surging immigration, and Brexit. Meanwhile, China has swung from the growth engine of the world to an economy struggling to gain footing. It is experiencing an epic property bubble along with vast unemployment and deflation as it emerges from COVID and decouples from the West. In addition to being tragic from a loss-of-life perspective, both the major wars—Ukraine/Russia and Israel/Hamas—could have implications for global supply chains and commodities prices. We continue to favor U.S. stocks over international in the wake of nationalization and geopolitical tensions. We believe U.S. small- and midcap companies are attractive from a long-term growth perspective and on a valuation basis.
Our crystal ball is murky, so we don’t try to time markets. We seek to add value by constructing portfolios for clients that meet their long-term goals without taking undue risk. Fortunately, positive real rates of return on fixed income and cash have created an expanded toolkit, making diversified portfolios more attractive. The current environment keeps us cautiously optimistic and, as always, focused on riding the long-term market waves.
Happy New Year and stay warm!