Q4 2023 Summary – Grim economic forecasts successfully thwarted in 2023

Macroeconomic Environment

The most widely predicted recession in recent history did not materialize in 2023. In late 2022, 85% of economists polled by the Financial Times predicted a recession in 2023. Consumers were also gloomy, affected by post-pandemic blues and worries over rising inflation, especially gas and food prices, and stagnating wages. In 1Q23, an unforeseen regional banking crisis and continued rate hikes portended a potentially bleak remainder of the year. Fast forward to 4Q23.

The trendy term “vibecession,” coined by social media financial influencer Kyla Scanlon to mark the post-pandemic period characterized by economic pessimism (bad vibes) despite reasonably good economic conditions, was pronounced “over” across the media. Consumer confidence, as measured by the Conference Board, surged in December with views of current conditions and expectations both rising sharply. Strong market returns, rising real wages, and moderating inflation helped to brighten consumers’ moods. Economists were also cheerier. A survey from the National Association for Business Economics showed that 76% of economists believed the odds of recession in 2024 are less than 50%. The Fed has thus far successfully navigated the battle against inflation without discernable damage to the labor market or the broader economy.

Markets defied the early 2023 pessimism, and most asset classes and sectors (energy being an exception) posted robust gains for the year. Global stocks surged and the S&P 500 closed the year just shy of a record. Even bond markets (taxable and tax-exempt) sharply reversed course in 4Q to bring 2023 results to an attractive 6%-ish figure. As a stark reminder of how quickly fortunes can be reversed, bond markets were on track to post a third consecutive year of negative returns only three months ago. Gold also nearly hit a record in December, buoyed by geopolitical concerns and the prospect of lower interest rates.

As we enter 2024, the economic outlook has improved from one year ago, but raging wars weigh heavily on our minds and government dysfunction and uncertainty over the lasting impact of sharply higher rates may cast shadows on the economic picture. The path of short-term interest rates is likely downward, but the pace and timing are uncertain.

The Fed held short-term rates steady (5.25% – 5.50%) at both its November and December meetings. In December, it lowered expectations for year-end 2024 rates, adopting a more dovish tone than markets anticipated. The median projection for the year-end 2024 Fed Funds rate was 4.6%, down from 5.1% at the September meeting. No members expected higher rates at the end of 2024. Markets have priced in more cuts than the median Fed projection suggests. As of Dec. 29, the CME FedWatch tool showed a greater than 70% probability of a cut at the March 2024 meeting and a nearly 80% probability that Fed Funds would be 3.5% to 4.0% at year-end 2024.

GDP rose a sharp 4.9% (revised slightly down from the last estimate of 5.2%) in 3Q, annualized. Third quarter growth was driven by consumer spending, inventory building and government spending. Fourth quarter estimates are more muted and range from 1% to 2%. The median expectation from the Fed is 1.4% in 2024 and 1.8% in 2025, a good depiction of a soft landing. Unemployment remained near historical lows at 3.7% (November) but JOLTS job openings fell to 8.7 million in October, down from a March 2022 high of 12 million, in a sign that the labor market is cooling. Job gains remained robust, however, at 204,000 per month in 4Q.

Inflation continued to moderate. The Fed’s favored measure, the Personal Consumption Expenditures (PCE) Price Index, was up only 2.6% year-over-year in November. Notably, over the past six months, the core PCE is right in line with the Fed’s 2% target. Excluding food and energy, the PCE was up 3.2% in November, the lowest since April 2021. The Consumer Price Index (CPI) rose 3.1% year-over-year in November, with core up 4.0%. Falling gasoline prices had the largest impact on declining headline inflation in 2023, dropping 8.9% over the last 12 months (as of November). WTI Crude closed the year at $71.65, down from the March 2023 high of $124.70. Shelter costs, which comprise about 40% of the core CPI and one-third of the CPI, rose 6.5% over the last year and had the biggest impact on both measures. Without shelter, the CPI was up only 1.4% for the trailing 12 months ending November.

Even housing showed signs of promise. Single-family housing starts surged 18% in November, an 18-month high, and permits for future construction of single-family housing increased to a level not seen since May 2022. Mortgage rates have also fallen from recent highs of 7.8% in late October to 6.6% at year-end, according to Freddie Mac.

Disinflation and pauses in rate hikes were also evident outside of the U.S. The European Central Bank (ECB) and Bank of England (BOE) also kept rates on hold. The ECB maintained its benchmark deposit rate at 4%. Inflation in the 20-country region slowed to an annual rate of 2.4% in November, and the core measure (excludes energy, food, alcohol, and tobacco) was 3.6%, the lowest since April 2022. The BOE earlier also kept its bank rate unchanged at 5.25% while inflation slowed to 3.9% over the last 12 months as of November, down from 4.6% in October.

China continues to face headwinds with property sector woes, high youth unemployment, weakness in manufacturing, and deflation. Its CPI dropped 0.5% in November (year-over-year), the biggest drop since the height of the pandemic three years ago. Policy leaders have pledged to increase support, but their efforts thus far have been insufficient to improve confidence and stem the crisis in real estate. Despite its problems, most economists think China will hit its official growth target of around 5% in 2023.

Global Equity

The S&P 500 Index approached a record high as the year closed. Of note, 2023 was the first year since 2012 that the S&P failed to reach a high-water mark. That said, the index was up an impressive 11.7% in 4Q and 26.3% for the year. The tech sector was the clear winner for the quarter and the year (+17.2%; +57.8%) while Energy (-6.9%; -1.3%) was the only sector to register both a 4Q and 2023 decline. Small caps (R2000: +14.0%; R1000: +12.0%) outperformed large caps for the quarter but lagged for the year (R2000: +16.9%; R1000: +26.5%). Growth outperformed value in 4Q (R1000 Growth: +14.2%; R1000 Value: +9.5%) and even more substantially for the year (R1000 Growth: +42.7%; R1000 Value: +11.5%).

Index concentration continued to have a notable impact on returns in 4Q. The “Magnificent Seven,” which comprise over 25% of the S&P 500, accounted for 76% of the 2023 return for the index. Fourth quarter and 2023 returns for the bunch were impressive: Alphabet: +6.8%, +58.8%; Amazon: +19.5%, +80.9%; Apple: +12.6%, +49.0%; Meta: +17.9%; +194.1%; Microsoft: +19.3%, +58.2%; NVIDIA: +13.9%, +239.0%; Tesla: -0.7%, +101.7%. The index would have been up only about 10% for the year without these stocks, and the equal-weighted S&P 500 returned 11.9% in 4Q and 13.9% in 2023.

Global ex-U.S. equities (MSCI ACWI ex USA: +9.8%) performed well in 4Q and for the year (+15.6%) but lagged the U.S. Weakness in the U.S. dollar helped 4Q returns across developed markets (MSCI EAFE: +10.4%; MSCI EAFE Local: +5.0%). As in the U.S., growth outperformed value in the quarter (MSCI ACWI ex USA Growth: +11.1%; MSCI ACWI ex USA Value: +8.4%). However, value outperformed growth for the full year (MSCI ACWI ex USA Growth: +14.0%; MSCI ACWI ex USA Value: +17.3%). Mirroring the U.S., Technology was the strongest sector for both the quarter and the year (MSCI ACWI ex USA Information Technology: +20.0%; +36.3%).

Emerging markets (MSCI Emerging Markets: +7.9%) also did well but underperformed developed ex-U.S. Emerging Asia was the weakest region (+6.7%; +7.8%) for both periods, hurt by China. China was a notable laggard (-4.2%; -11.2%). Latin America (+17.6%; +32.7%) was the best-performing region for the quarter and the year with Mexico (+18.6%; +40.9%) and Brazil (+17.8%; +32.7%) up strongly.

Global Fixed Income

The 10-year U.S. Treasury yield was volatile in 2023—ranging from an April low of 3.31% post the regional banking “crisis” to the October high of 4.99% and subsequently declining into year-end for a 3.88% close. Falling rates drove returns for the Bloomberg US Aggregate to +6.8% in 4Q and +5.5% in 2023, a sharp contrast to the -1.2% YTD print as of 9/30. Corporate credit strongly outperformed U.S. Treasuries in 4Q (excess returns of 203 bps) and for the year (455 bps). High yield (Bloomberg US High Yield) climbed 7.2% for the quarter and was up an equity-like 13.4% for the year. The yield curve remained inverted, but to a much lesser extent; 35 bps between the 2-year and 10-year U.S. Treasury yields versus more than 100 bps earlier in the year. The Bloomberg Municipal Bond Index soared 7.9% in 4Q, reversing its YTD 1.4% decline as of 9/30; the index was up 6.4% for the year.

The Bloomberg Global Aggregate ex USD Index rose 9.2% (hedged: +5.4%) in 4Q as rates fell and the U.S. dollar weakened. Full-year results (+8.3% hedged; +5.7% unhedged) were also positive but reflected an overall stronger greenback. Emerging market debt indices also posted solid returns. The hard currency JPM EMBI Global Diversified gained 9.2% in 4Q and 11.1% in 2023. The local currency-denominated JPM GBI-EM Global Diversified returned 8.1% in 4Q and 12.7% for the year.

Closing Thoughts

While 2023 defied most expectations with inflation moderating and the economy displaying resilience, 2024 is not without challenges. Never-ending geopolitical worries and another looming government shutdown may cast shadows on the economic picture. The lagged effect of higher interest rates poses an unknown threat to the outlook, and premature Fed rate cuts could re-ignite inflation. It seems unlikely that the returns experienced in 2023 will be repeated though it is important to recognize that those results were unexpected by most. We continue to recommend a disciplined investment process that includes a well-defined long-term asset-allocation policy.

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