Quarterly Economic Update Fourth Quarter 2023
Recap: Stock markets across the globe posted spectacular December returns which added to the substantial gains achieved through the first 11 months of the year. And bond markets too posted solid gains last month providing investors a healthy return for the full year after a difficult 2022. Markets seem to have responded to the surprising resilience of the U.S. economy and its labor market despite the headwinds of still elevated inflation and high interest rates. The Federal Reserve’s signal that the end of their rate hiking campaign had probably arrived gave markets reason to celebrate.
U.S. stocks across the capitalization and style spectrum delivered robust gains in the fourth quarter. Virtually every capitalization and style type posted double digits gains for the quarter. In a return to recent form, growth style stocks handily outpaced value stocks while in a reversal of fortune, small-cap and mid-cap stocks outpaced large cap stocks. The S&P 500 was up 11.7%, the Russell Mid Cap Index was up 12.8%, while Small Cap stocks were up 14.1% in Q4. For the full year, the S&P 500 was 26.3%, while Mid Cap and Small Cap were up 17.2% and 16.8% respectively. All, truly outstanding returns that are well above historical norms.
Bonds too got in on the party! The broad Bloomberg Aggregate posted a 6.8% return for the fourth quarter and a 5.5% return for the full year. With signals that the Federal Reserve is likely done hiking rates and their next move was likely a rate cut, long-dated bonds outpaced shorter term maturities. And not surprisingly, bonds with higher credit risk than U.S. Treasuries posted the highest returns with corporate bonds up 8.2% for the quarter while junk bonds were up 7.2% and the Bloomberg Global Aggregate Bond Index ex-U.S. bonds was up 9.2%.
Outlook: The outlook for stock returns in the near term, despite the strong returns of 2023, remains uncertain given the slowly deteriorating dynamics of the economy, still relatively high interest rates, a Federal Reserve resolute in its battle to fight inflation, and what are historically expensive stock prices. This mix of headwinds will likely continue to weigh on corporate profit growth for some time. The equity markets however seem to have priced in a near certain soft economic landing, with lower interest rates, and reaccelerating corporate profit growth for 2024.
The outlook for bonds continues to look pretty bright, mainly due to the likelihood that the Fed is closer to the end of its rate hiking cycle, inflation is coming down, and now bonds offer a respectable coupon rate after years of ultra-low interest rates. Bond coupon rates finally provide real competition for investment dollars versus stocks for more conservative income-oriented investors, given the more expensive investment profile of stocks in general.
There continue to be downside risks to the capital markets, which should be kept in mind as 2024 unfolds. Those risks include gridlock in a hyper partisan Congress over important issues like the federal budget, immigration, and funding conflicts in Europe and the Middle East. The latter is already impacting trade as ships with cargo are forced to take longer more expensive routes around the southern tip of Africa to avoid blockades and conflicts near the Suez Canal. And we should not forget the races for the Presidency and Congressional seats that are now heating up. Presidential years tend to be positive years for equity returns (though past performance is no guarantee of future results).
Also, historically the Federal Reserve tends to avoid changing their monetary policy in any meaningful way as elections approach so as not to appear partisan. And finally, if forces that could negatively impact inflation (like the price of oil, or commodities, or increased demand for goods and services) slow the decline of inflation or even reverse it, it would be unlikely the Fed would cut rates as much as markets are expecting. Any combination of the above risks could disappoint investors.
The longer-term view of markets suggests that the tailwinds stock and bond investors enjoyed in recent years, including massive fiscal stimulus and declining and ultra-low interest rates, will not resurface soon to smooth over inevitable hard economic times. Securities’ values are more likely to be driven by the organic operational successes of businesses rather than help from the federal government. These conditions should favor astute stock and bond selection.
Economic Recap: U.S. economic activity remained strong in 2023 as the economy withstood the initial shock associated with the rapid pace of monetary tightening. The final reading on U.S. GDP showed that the economy grew by 4.9% (annualized) in the third quarter.
A surprise increase in November retail sales dispelled lingering pessimism about the economy and reinforced growing sentiment that the U.S. could beat inflation without paying the price in significantly weaker growth. Also in November, the unemployment rate fell, inflation cooled, and the Federal Reserve pivoted away from raising interest rates while considering when to cut them. With inflation still too high and the FOMC committed to bringing it down to 2%, it did not fully close the door to additional policy tightening. While further tightening has remained possible, it has grown less probable.
The resilient labor market that supported an unexpectedly strong U.S. economy last year has shown signs of cooling. Continuing jobless claims rose to 1.93 million in mid-November, the highest level since late 2021.
On the production side, the services sector of the economy managed to expand with the ISM services index rising modestly to 52.7 in November. This lackluster growth suggests that activity in the sector has slowed, which should help to keep a lid on service sector inflation and should help wage inflation cool further.
Overall, consumer spending probably remained buoyant over the holiday period, but the momentum may be fading, with consumption growth likely to slow in the coming quarter.
Inflation eased considerably in 2023 amid tight monetary policy, standing at 3.1% in November. Outright declines in energy prices have put the biggest dent in inflation over the past year, but price growth has slowed for other major categories, including food, core goods, housing, and core services.
Smoother functioning supply chains, and restrained consumer spending have helped slow price increases for goods. Lower goods prices could ease inflation’s path down towards the Fed’s target. Prices for services have cooled though demand has persisted. Shelter costs are one factor that could help further slow inflation in coming months.
Outlook: Prospects for economic growth in the U.S. are shifting as the economy progresses into 2024. Real GDP growth will likely slow materially heading into 2024 and a modest contraction in economic activity could well take hold by the second quarter. Economic weakness, which will help push inflation back toward the Fed’s target of 2% on a sustained basis, should then induce the FOMC to begin easing monetary policy. Even as the FOMC eases policy later this year, interest rates will likely settle at a higher level than what prevailed ahead of the pandemic.
The global economy is likely to experience a period of below-trend growth in 2024, with the global economy expanding at just about 2.5%. Growth prospects should be restrained by a U.S. economy potentially experiencing a mild recession in mid-2024, recessions in the Eurozone and U.K., as well as a Chinese economy decelerating amid structural challenges. Some economies could outperform and grow at above-trend rates. Asia, in particular India, should be the region and economy that stands out from a growth perspective.
Sources: Department of Labor, Department of Commerce, Institute for Supply Management, Bloomberg, People’s Bank of China, European Commission, European Central Bank
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