4Q 2023 Review and Outlook
Capping a surprisingly strong year, the final three months of 2023 featured an “everything rally” that produced solid gains across nearly all asset categories. Large-company U.S. stock benchmarks climbed between +11% and +14%; small-caps were marginally stronger, on average. Overseas, developed-market stocks (+11%) bested the emerging-market category (+8%). Real-estate investments were among the top performers, posting percentage-point gains in the high teens. Commodities were a decidedly mixed bag: gold jumped +11% and copper rose +4%, but crude oil sank -17% and natural gas plummeted -26%. Noteworthy action in the bond market saw the benchmark 10-year Treasury yield swoon to 3.88% from a mid-October peak of 5.00%. Narrowing (improving) credit spreads chipped in to produce robust gains across nearly all fixed-income categories, allowing the bond market to avoid a third-consecutive down year.
Among large-company U.S. stocks, the strongest performance was posted by companies in the Technology, Consumer Discretionary, Financial Services and Industrials sectors; Consumer Staples, Energy, Health Care and Utilities were weaker. Reversing the early-year pattern, value-oriented issues outperformed the growth category among both large- and small-company shares.
Review
The October-December quarter began with shocking violence unexpectedly erupting in the Middle East and hawkish Federal Reserve officials stubbornly adhering to their “higher for longer” interest-rate-setting mantra. By the third week of October, bond yields reached their highest level in more than 15 years and global stocks slid into correction territory, largely reversing the six-month recovery that followed an early-year banking (mini-)crisis. But as fears of wider war ebbed and central bankers began grudgingly to acknowledge the taming of inflation, markets rallied relentlessly over the final nine weeks of the year: Treasury yields plummeted 120 basis points (1.20 percentage points) and stocks surged 16%, coming within a whisker of new all-time highs.
The U.S. economy confounded widespread recession calls, with third quarter (July-September) GDP growth coming in at a stemmy annualized rate of +4.9% (a figure flattered by unsustainable surges in construction and government outlays, though underlying “personal consumption expenditures” (PCE) were a still-healthy +3.1%). More recently, purchasing-managers surveys and retail-sales/consumer-spending reports hinted at a modest deceleration, though lower gasoline prices and easing mortgage rates – not to mention soaring stock markets – powered a noticeable uptick in consumer confidence. Employment remained strong, with monthly job gains averaging a healthy 165 thousand and unemployment finishing the year at a very low 3.7%; wage growth was solid, with the latest year-over-year gain at +4.1%. Constrained supply helped house prices defy gravity, with the latest (October) reading showing a gain of nearly 5% nationwide over the past twelve months.
Overseas economic activity underwhelmed. In Europe, third-quarter GDP contracted at an annualized rate of -0.5%, though the result was not as dour as it appeared, with underlying consumption registering +1.3%. More timely reports contained scant indication of a meaningful yearend upturn. Following above-trend readings in the first half of the year, the Japanese economy shrank at a -2.9% annual rate between July and September; recent purchasing-managers surveys suggested only a modest re-acceleration. China’s economy continued to be hobbled by real estate-related headwinds, notching third-quarter growth of just +4.9% (annualized); somewhat half-hearted stimulus measures rolled out in recent months appeared to have engendered an uptick in the fourth quarter.
Inflation continued to ebb around the globe. The year-over-year increase in U.S. headline prices (CPI) slowed to just +3.1%; the Fed’s preferred measure (the core PCE index) fell to +3.2%. These annual gains understate recent improvement: over the past six months, core PCE advanced at an annual rate of just +1.9%. Six-month “core” figures for the Eurozone, U.K. and Japan were +2.4%, +2.4% and +2.7%, respectively (the Chinese economy has recently been experiencing falling prices). Meanwhile, the University of Michigan U.S. consumer survey showed expectations for near-term (one-year) price increases registering a huge drop – from +4.5% to +2.9% – to the lowest level since March 2021. Bond-market-derived gauges indicated investor expectations of 10-year inflation fell below 2.2% – well within the normal pre-pandemic range.
The quarter’s most consequential financial-market development was a surprisingly full-fledged “dovish” pivot by global central banks, paced by the U.S. Federal Reserve. The shift began at the Fed’s October 31/November 1 policy-setting meeting, with chair Jay Powell highlighting “tighter financial and credit conditions” – Treasury yields, and mortgage rates had spiked some 50 basis points in the weeks before the meeting – and downplaying the likelihood of an additional rate hike that had previously been on the table. Six weeks later, and despite a notable easing of financial conditions (bond yields had fallen by around 75 basis points from their peak), Powell & Co. threw in the proverbial towel, sending a consistently dovish message across their official policy statement, summary of economic projections (SEP; the “dot plots” predicting future growth, inflation, and interest rates), and post-meeting commentary. The SEP, which had in November indicated one hike and two cuts through 2024, now showed no hike and three cuts. Further, Powell suggested the Fed’s focus had shifted to the timing and extent of cuts, noting that policy restriction would need to be reduced “well before [inflation reaches] 2%.” Benchmark yields promptly dipped another 30 basis points.
The late-year rally ignited by the anticipation of impending monetary easing was as broad as it was furious – in marked contrast to the rest of 2023, when gains were concentrated among a handful of the largest stocks. According to Bloomberg data, through October, the mega-cap stocks now dubbed the “Magnificent Seven” (Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia and Tesla) provided a total return of +78.4%, while the remaining 493 names in the S&P 500 Index gained just +0.8%. In November and December, however, the corresponding figures were Mag 7: +16.0%; the rest: +14.4%. For the full fourth quarter, smaller, more economy-sensitive and/or lesser-quality names benefitted disproportionately from falling yields and receding recession fears, allowing the Dow Jones Industrial Average, large-cap value stocks, and small-company stocks to outperform the large-cap-growth-dominated S&P 500 Index.
Across 2023, many overseas stock markets bested the main U.S. benchmarks (all returns in U.S. dollars): Japan +20%; India +23%; Germany +23%; Italy +31%; Brazil +33%; and Mexico +40%. The Chinese and Hong Kong markets, however, fell -11% and -14%, respectively; their large weightings suppressed the results posted by major global stock-market indices.
Among the year’s noteworthy laggards were stocks that pay large cash dividends: within the S&P 500, the four worst-performing industry sectors (Utilities: -7%, Energy: -1%, Consumer Staples: -1% and Health Care: +2%) were all repositories for high-payout names. Conversely – and unsurprisingly – the three best-performing sectors were homes to the Magnificent 7 – only two of which (Apple and Microsoft) pay dividends worth mentioning: Technology (Apple, Microsoft, Nvidia): +56%; Communications Services (Alphabet, Meta): +53%; Consumer Discretionary (Amazon, Tesla): +39%.
Profits posted by the companies that comprise the S&P 500 Index during the fourth quarter (mostly covering the July-September period) were some 5% below those reported in the corresponding period of 2022. Wall Street analysts foresee another small decline (-2%) in the fourth quarter (which would bring the 2023 tally to -2%, as well), though they expect a healthy +12% gain in the New Year.
What’s Changed?
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* Based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to produce the +11.7% S&P 500 total return?
Fourth Quarter (October-December) 2023
Our read: Though 3Q earnings were below the year-ago result, Wall Street optimism regarding 2024 pushed the forward-looking figure higher. That optimism will need to be vindicated to justify the recent run-up in prices.
Outlook
As we enter the New Year, the fundamental investment backdrop appears largely benign, but the eye-popping gains of 2023 mean a lot of good news is already priced into financial markets. This set-up – suggesting ample room for disappointment – seems primed for an early or mid-year correction; but generally supportive fundamentals argue for a “constructive” investment stance poised to take advantage of any meaningful weakness.
In marked contrast to the situation twelve months ago (when nearly every prognosticator foresaw near-term recession), the consensus view of market participants today calls for an economic “soft landing” (i.e., tamed inflation; sustained growth), an increasingly accommodative Fed, lower/falling interest rates, and healthy corporate profits (with possible upside surprises thanks to the promise of generative artificial intelligence). More or less by definition, this rosy view is already reflected in today’s securities prices: if not “priced for perfection,” we think today’s markets are priced for pretty darn good.
Minimal imagination is required to foresee potential disappointments on multiple fronts. The economy is clearly slowing; could acknowledgment of monetary policy’s notorious “long and variable lags” cause recession fears to arise anew? Though a further decline in inflation seems “baked in” (see: newly inked apartment leases vs. lagged inputs to official statistics), incoming data is always “noisy;” unpleasant surprises could lie ahead. As for the Fed: How many rate cuts? And how soon will they begin? The bankers say three and hint the first will come around mid-year; markets are currently priced in anticipation of at least five beginning rather sooner. If the Fed holds its ground, investors will be cranky. Moreover, (per Financial Times columnist Robert Armstrong) what kind of cuts will the Fed deliver? Will the bank ease because inflation is falling or because growth is flagging? Investors would welcome the former, the latter, not so much. Sluggish growth (or even below-expected inflation) could knock profits – which Wall Street expects to expand a none-too-shabby +12% over the course of the year. And even if its promise eventually equals (what we would call very high) expectations, the near-term impact of generative AI could easily underwhelm. Finally, we still have two wars to deal with – either of which could evolve in a market-unfriendly way – not to mention testy relations between the world’s two largest economies that support the world’s two largest militaries.
But we can also identify reasons for optimism. To begin with the obvious: the prospect of global monetary easing and lower and/or falling interest rates. Moreover, the decline in yields to date has been accompanied by improving credit spreads, suggesting receding fears of economic stress. Similarly, the recent market rally has been led by semi-conductor stocks – a traditional economic bellwether. Above we noted a nascent improvement in consumer confidence. If sustained, this could combine with a solid job market, healthy wage gains and strong household balance sheets to fuel stronger than expected U.S. economic performance (the bar here is low: most seers peg 2024 GDP growth below 1.5%). The current dissonance between Fed-speak and investor expectations might resolve with the Fed moving gradually in the direction of the market view (there is ample historical precedence for this), which would provide incremental positive impetus to financial markets. Regarding China, the current consensus view is exceptionally negative; incremental positive news – even if it represents merely temporary improvement amidst longer-term malaise – could spur a substantial, positive financial-market response. Finally, growing weariness (impatience?) among Ukraine’s and Israel’s international supporters could push either or both of their conflicts into new, less intense phases that market participants might greet with relief.
As for the looming U.S. election – just one of an almost unprecedented number on tap globally this year – perhaps the less said the better! But we cautiously note that, historically, both the final years of all presidential terms as well as the fourth year of two-term administrations have been associated with above-average stock-market results. Moreover, it seems a reasonable bet the elections will result in continuation of divided federal government, which has also been somewhat more market-friendly than one-party rule, on average.
So perhaps the glass is (something like) half full. But before we get too giddy, we will note that, in the wake of the late-2023 rally, both investor sentiment and market valuation could pose challenges ahead. Bank of America’s most recent institutional-investor survey was the most bullish in more than 18 months and notched its largest monthly increase in over three years. Meanwhile, the American Association of Individual Investors late-December poll featured the most bullish reading since April 2021, capping a notably fast reversal from an extreme bearish stance in early November. Such widespread investor ebullience is often associated with near-term peaks in prices. Meanwhile, coupling a 25% price gain with what looks to be a modest decline in profits, 2023 saw the aggregate valuation of U.S. large-cap stocks (S&P 500) expand from less than 18 times trailing earnings to nearly 22x – well above the historical norm of 15 to 18. Much has also been made of stocks’ “earnings yield” – the inverse of the P/E ratio, i.e., earnings divided by price – falling below the 10-year Treasury yield for the first time since 2009 (although this was a common configuration prior to the major down-leg in bond yields that began in the early 2000s).
Apart from the very largest stocks, however, equity valuation looks less problematic. According to Bespoke Investment Group, in late December the ten largest stocks in the S&P 500 Index traded at an average P/E of 26.9; the remaining 490 index constituents changed hands at a considerably less demanding multiple of 17.4. Shares of smaller companies were even more reasonable, with the P/Es of the S&P mid-cap and small-cap indices standing at 15.7 and 14.7, respectively; in fact, small-cap stocks were trading at the largest valuation discount to large-caps (including the top 10) in more than 25 years. Likewise, according to data for exchange-traded index funds, non-U.S. stocks also traded at steep P/E discounts to the mega-cap-dominated domestic market: the MSCI EAFE (developed-market) index at 14.2x; the MSCI EEM (emerging-markets) at 11.1x. While valuation is not especially useful for timing short-term performance swings, it has historically been a strong predictor of subsequent multi-year results.
As we gratefully admire last year’s surprising results, we think it’s prudent to anticipate a more challenging investment environment – not to say a dearth of opportunities – in the months ahead. Fundamental underpinnings – economic growth, corporate profits, interest rates – seem reasonably likely to remain supportive. And the recent broadening of participation and challenging valuations sported by 2023’s biggest winners suggest less “obvious” investments – value stocks, small-caps, non-U.S. securities – could continue to outperform. Meanwhile, any rise in bond yields from yearend levels (i.e., above 4.0% for the 10-year Treasury) – if not accompanied by renewed inflation worries – could provide an opportunity to “extend duration” of portfolio bond holdings, locking in attractive income streams for the next several years.
Please call or email any member of the Oarsman team if you have questions or suggestions regarding your investments. We wish you a healthy and prosperous New Year.
The Oarsman Team