Fourth Quarter 2023 – The Inflation Witch is Dead
Submitted by Alsworth Capital Management, LLC on January 30th, 2024
Market Recap
What a year! In 2022, the combination of high inflation and the Fed dramatically raising interest rates led to deeply negative returns for both stocks and bonds. Going into 2023, an unprecedented number of statistics and virtually every market strategist and economist were all predicting recession. The recession never came and it ended up being a year of investment speculation, with cryptocurrencies shooting higher, the “Magnificent Seven” (Mag7) tech stocks up over 100% and valuations returning close to prior highs. Stocks, bonds and gold were all up strong.
U.S. stocks (S&P 500 Index) jumped nearly 12% in the fourth quarter to finish up 26% for the year. The S&P 500 index of large US stocks was heavily influenced by tech stocks. Excluding the magnificent seven, the index was up 15%, which is still fantastic. Smaller-cap stocks (Russell 2000 Index) rallied sharply in the fourth quarter (+14%) to end the year with a gain of 17%. Developed International and emerging market stocks also posted solid gains. Developed International stocks (MSCI EAFE) finished the year up 18%, while emerging-market stocks (MSCI EM Index) were up nearly 10%. Bonds rose 6.8% in the fourth quarter and ended the year up 5.5%. High-Yield bonds (ICE BofA High Yield Index, lower quality) were up 7% in the quarter and finished up 13.4% for the year. Bitcoin rebounded with a 155% gain for the year.
Investment Outlook and Portfolio Positioning
Since the Fed started their aggressive tightening cycle, the debate has been about the odds of a “soft landing” or “hard landing” for the economy. In other words, would the Fed be able to raise interest rates enough to stamp out inflation, but not so high it slams the brakes on the economy and tips it into recession. Historically, there are no good examples of a similar setup ending in anything other than a protracted recession, until now. In November, the Fed made it clear they believe the end of the war on inflation is near, and not only are they done raising rates this cycle, but they are also anticipating interest-rate cuts in 2024. In response, interest rates declined sharply triggering a powerful rally in stocks and bonds to close out the year.
The soft-landing camp seems to be winning. Inflation has dropped to around 3-4%, a far cry from the recent 9-10% peak and there are no signs of inflation coming back anytime soon. Declining inflation has buoyed consumer confidence and has helped drive strong spending, keeping the economy on a positive trajectory throughout 2023. Consumers aggressively spent down pandemic stimulus funds, largely on travel and discretionary purchases. However, this source of funds is likely drying up, as consumer bank balances have declined to pre-pandemic levels and consumer debts, like credit card balances, have risen. On the positive side, the labor market remains relatively tight and wages are up, providing support for continued growth, so long as corporations don’t start cutting jobs.
The strength of the economy has surprised nearly everyone, including the Fed’s own projections. At this point, there is little sign of recession in the first half of 2024, though we are still expecting a slowdown in the second half. The yield curve is still negative, with over 5% yields on short term rates, dropping down to 4% and below for longer term rates, indicating economic slowdown. Leading Economic Indicators are also still flashing red for likely recession. In addition, high borrowing rates have historically impacted the
economy with a lag of time before the effect is evident. It is always possible to avoid a recession and nobody can predict the future, but probabilities still skew toward a cautious approach to expectations of economic growth, despite speculative behavior in markets.
Stock markets often rhyme with economic trends, but they are not perfectly correlated. While the economy stayed positive in 2023, corporate earnings actually declined. A handful of “Magnificent” companies posted strong earnings, but the average corporation did not. The primary driver was an increase in the largest expense for most corporations, their labor costs. Despite the decline in corporate
earnings, the forward-looking stock market shot higher, driven mostly by speculation that future Fed rate cuts will spur enough growth to offset higher labor costs. It’s certainly possible, but it’s also possible that companies will decide to cut jobs to improve profitability.
Looking ahead to 2024, all eyes will continue to be on the Fed. The market is currently pricing in 6-7 rate cuts of 0.25% each. This would be a very aggressive rate cut trend while the economy is still not in recession. This exuberance feels a little excessive to us. While the Fed will be in focus, monetary policy is just one of many factors that will influence markets. Geopolitical risk, the U.S. presidential election, labor markets, and inflation will likely fill the headlines and all could be sources of volatility. However, if we do see a recession in the latter half of 2024, we expect it to be mild. If we avoid recession all together, we expect tepid growth as companies realign labor costs to address poor profit margins. We also expect that the stock market will broaden to appreciate opportunities in stocks outside of the handful of tech stocks that dominated in 2023.
With inflation risks subsiding, we will be unwinding some of our positions that were specifically intended to hedge inflation risk. We intend to sell off positions that were dramatic winners in 2023 and shift the allocation toward more of the unloved sectors of the investment universe like value stocks, smaller companies and cheap international holdings. We continue to like gold as a hedge against a potential decline in the US dollar, as US federal debts continue to climb. Bonds are now relatively attractive, offering good income yields, and we are seeing opportunity in the high-yield bond sector. While 2023 will go down as a year of speculation, which gave us a nice boost coming out of an awful 2022, we think 2024 could be the year of strong returns on more conservative investments.
We will continue to stay broadly diversified to manage risk, as well as to gain exposure to all kinds of market behaviors. We appreciate the trust you have placed in us to help navigate both the exhilarating ups and the inevitable downs. Please feel free to reach out anytime to discuss your portfolio in more depth or our positioning for the new year.
Cordially,
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only (disclosures on back)
Sources: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, Litman-Gregory, iMGP
*US large stocks (S&P 500 Index), US large cap growth (Russell 1000 Growth Index), US large cap value (Russell 1000 Value Index), US small stocks (Russell 2000 Index), (Developed international stocks (MSCI EAFE Index), Emerging Market stocks (MSCI EAFE EM Index), Core investment-grade bonds (Bloomberg U.S. Aggregate Bond Index), Floating Rate Loans (S&P/LSTA Performing Loan Index), US Dollar (DXY Index), Gold (Aberdeen Physical Gold ETF), Commodities (Bloomberg Commodity Index)
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