ISG Market Commentary – January 2024

ISG

January 22, 2024

As we review 2023, we first remind ourselves of the significant financial extremes experienced in 2022, including the highest inflation and the most substantial Federal Reserve (Fed) rate hikes in four decades, along with the steepest yield curve inversion and the highest mortgage rates in over 40 years.  2023 began with overwhelmingly pessimistic forecasts of the macroeconomic landscape which, however, slowly improved as the year progressed.  Market expectations fluctuated between fears of recession, hopes for a ‘soft landing’, and concerns of overheating, with the current consensus leaning towards a ‘soft landing’. Meaning that inflation could be brought back to central banks’ 2% target without significant economic slowdown or major job losses.

The Economy

Economic resilience in 2023 surprised most economists and market participants. At the end of 2022, expectations were that a recession in 2023 was inevitable due to the Fed’s record tightening cycle.  Instead, the economy grew at nearly 3% (estimated), including 4.9% growth logged in the third quarter.

What went wrong with the forecasts?  First, the spending by U.S. consumers and corporations was underestimated.  There were substantial excess savings accumulated during the lockdown years, which needed time to be spent by consumers and businesses alike.

Second, weaker demand from the U.S. and China helped to substantially lower oil prices.  Falling oil prices act as a stimulative measure for households by freeing up more income, which can then be spent on other consumer items.

Third, pent-up demand following years of restricted mobility due to the COVID pandemic continued to unfold, leading consumers to spend on services, from sporting events and vacations to concerts, which led to a booming service economy.

Finally, fiscal initiatives from the Inflation Reduction Act (IRA) and CHIPS and Science Act (CHIPS) led to spending on new manufacturing facilities, from solar and battery to semiconductor plants. All these factors helped offset the weakness in the most interest-rate sensitive parts of the economy: the housing and manufacturing sectors.

Equity Markets

Reversing the trend from 2022, in 2023 growth stocks outpaced value stocks by a wide margin, and cyclical sectors performed better than defensive ones.  Larger stocks outperformed small-cap stocks by the widest margin since the late 1990s.  The Technology sector performed the best, up over 50%, while Utilities and Commodities actually declined for the year.

The markets were assimilating rapid advancements in artificial intelligence (AI) and speculating on its potential effects on long-term productivity and profitability.  This anticipation played a key role in the resilience of the U.S. equity market, even in the face of rising bond yields.  Companies likely to benefit from the AI revolution drove most of the gains in the S&P 500 Index in 2023.  These gains were primarily attributed to what are popularly known as the ‘Magnificent 7’ companies (Amazon, Apple, Alphabet, Meta, Microsoft, Nvidia, and Tesla).  The Magnificent 7 surged on average by over 100%, while the average stock (as represented by the equally weighted S&P 500 Index) gained around 13%.

Although big Tech companies benefited the most from AI advancements in 2023, the beneficiaries of AI can also be found outside the Tech world.  AI-driven applications are spawning innovation across many industries, including pharmaceuticals, banking and even fast food.  McDonald’s is using AI to make its drive-through order systems faster.  Pfizer is employing AI to accelerate the development of new drugs.  JPMorgan Chase is unleashing AI bots to detect identity theft.  The challenge for investors will be to separate the hype from reality amid the expected exponential growth of AI systems over the next decade.

Perhaps the most significant news of the year came from the final meeting of the Federal Open Market Committee (FOMC).  They announced the end of the central bank’s monetary tightening campaign, projecting three rate cuts for 2024.  This shift overshadowed the expected announcement that the U.S. central bank was holding rates at current levels for a third consecutive meeting, with the current range remaining at 5.25% to 5.5%.  The financial markets reacted positively to the Fed’s change in direction, leading to a surge in stock prices and a reduction in government bond yields.  Virtually every sector of the financial markets joined in the broad gains after the meeting: Global stocks soared, world currencies strengthened against the dollar, and corporate bonds saw a significant rally.

As we look ahead to the coming year, we see both challenges and opportunities for the stock markets. Key themes for investors will include inflation and interest rates, slowing economic growth, technological advancements, and geopolitical events.  While there is optimism about the potential for continued growth, uncertainties remain regarding the health of the consumer, the labor market, inflation expectations, central bank policies, and the future trajectory of interest rates.

Election Year

2024 will be significant as voters head to the polls to elect America’s next President. Historically, presidential election years have favored stock investors, a trend dating back to 1928.  On average, the return during such years has been a robust 11.6%, with positive outcomes 83% of the time.  Potential policy shifts and changes in leadership can significantly influence investors’ psyche.  While the presidential election indicator is not infallible and is no guarantee of future results, historical trends suggest that stock markets typically fare well during presidential election years.

Fixed Income

The year was marked by notable fluctuations in bond yields, with the 10-year U.S. Treasury bond escalating to 5% in October, a significant rise from April’s low of 3.3%.  The rates for a 30-year mortgage also surged to 8.9% by October 25, 2023, reaching a level last seen in 2000.  It wasn’t until the fourth quarter where rates on longer-term bonds dropped and performance of the bond market picked up.  The 10-Year Treasury finished the year yielding 3.8% and the Bloomberg U.S. Aggregate Bond Index finished the year with a total return of 5.5%.

This recent shift in market sentiment can be attributed to key factors, particularly the year-over-year CPI data indicating a greater-than-anticipated easing in inflation.  The Fed’s December decision to keep interest rates at a 22-year high was accompanied by new forecasts of 75 basis points worth of cuts in 2024, signaling a more dovish outlook for rates compared to previous projections.  Not only did the Fed signal the end of its multiyear tightening campaign, but officials also considered sharper cuts to borrowing costs in 2024 in an effort to achieve a ‘soft landing’ for the economy.

Alternative Investments

Our Alternative Investments primarily consist of private credit and private real estate at the current time.  Private credit continues to perform very well as higher interest rates have translated into higher income received on loans.  Distribution rates on select funds have increased from 7-8% to 10-11% over the past couple of years.  We believe private credit remains an attractive asset class in the current interest rate environment.

After a relatively strong 2021 and 2022, private real estate struggled in 2023 as interest rates continued to rise.  As rates go up, valuations of commercial real estate (CRE) often go down, despite strong fundamental performance of most of the underlying properties in the portfolio.  With a 4-5% distribution yield, we are optimistic that CRE will again deliver attractive results and add valuable diversification to portfolios as interest rates stabilize and ultimately trend lower in the future.

Conclusion

The 2024 U.S. economic outlook is cautiously optimistic, relying on a ‘soft-landing’ scenario where the economy slows but continues to grow, aided by Federal Reserve rate reductions as inflation moderates.  Although the odds of a ‘soft landing’ have increased as we enter 2024, leading economic indicators continue to point to a slowdown ahead.  Higher equity valuations, slowing corporate earnings, and increasing geopolitical tensions give reason to be cautious.

The market is clearly facing some potential headwinds, however, the economy also appears to be more resilient than expected.  Unemployment is low, wages are up and the U.S. consumer likes to spend.  All key ingredients to continue fueling the U.S. economy.  The strong equity performance in 2023 was heavily concentrated among large technology companies.  In fact, only about a quarter of the companies in the S&P 500 outperformed the index for the year, which is the lowest percentage in over three decades and is well below the long-term average of close to 50%.  Valuations may be rich for many of the 2023 outperformers, but for the majority of the market valuations remain quite reasonable.  

High-quality fixed income finished strong in 2023 and should be helped by a more stable interest rate environment going forward.  We continue to believe core fixed income plays a central role in portfolios as one of the only asset classes that has effectively hedged against past deflationary shocks.  If the slow-down continues, we’d expect fixed income to once again resume its defensive role in portfolios. 

Alternative investments continue to provide diversification and low correlation to more traditional investments.  Their high yields and low volatility make them particularly attractive in the current environment.  As always, we recommend maintaining a long-term view and staying the course.  We remain focused on the core tenets of our investment process – long-term risk adjusted returns and constructing durable diversified portfolios. 

If you have any questions or would like to discuss anything in more detail, please do not hesitate to call your Advisor.

Sincerely,

Your Team at ISG

Sources: James Investments, Hightower Advisors, Capital Group, JP Morgan

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