In growing anticipation of a potential Fed easing, bond yields trended lower and stocks moved higher in the final three months of the year. Though the end results were satisfying, the quarter began in bleak fashion. Bond yields rose to heights not seen in more than a decade after strong economic data released in October suggested that the Fed would be unable to ease its current tight monetary policies. Concerns over Treasury funding and higher-than-expected consumer price inflation added to the gloom that gripped stocks during the first month of the quarter.

But markets turned in November, rallying on fresh data that showed renewed inflation progress and constructive comments from Fed Chair Jerome Powell. These positive developments sparked a retreat in bond yields and a celebration in the stock market. In a month’s time, pessimism over conditions potentially holding back the Fed from easing its restrictive policies faded and was replaced by optimism that the rate hike cycle could be finished, and interest rate cuts may be on the table in 2024.

The momentum continued to build in December when the Federal Open Market Committee (FOMC) announced that it was leaving interest rates unchanged, and a survey of its members indicated that up to three interest rate cuts would be possible sometime in 2024. The announcement, coupled with dovish post-meeting comments from Powell, helped drive bond yields sharply lower and stocks higher to close out Q4.

 

ECONOMIC CONDITIONS:

U.S. – Steady Labor

GDP: Q323 economic growth was revised lower, from a 5.2 percent annualized pace to 4.9 percent, primarily due to a downward revision of consumer spending. [7]

Labor: Employers added 199,000 jobs in November, lifted by the return of 30,000 striking auto workers. The number was slightly above the consensus estimate of 190,000. The unemployment rate dropped to 3.7 percent, while wage growth (+0.4 percent month- over-month) was in line with expectations. [8]

Housing: Housing starts topped Wall Street expectations as new housing construction rose 14.8 percent in November.11 Sales of existing homes rose 0.8 percent in November— the first increase since May. Year-over-year sales fell 7.3 percent, the smallest drop since April 2022.12 New home sales dropped 12.2 percent in November, though they were 1.4 percent above last November. [13]

International: Slowing Inflation

Shares were supported by softer inflation figures from both the eurozone and the US, which raised hopes that interest rates may not only have peaked, but that cuts could soon be on the way in 2024. Euro area annual inflation fell to 2.4% in November from 2.9% in October. A year previously, the annual inflation rate was 10.1%. Higher interest rates have weighed on the eurozone economy. Eurozone GDP fell by 0.1% quarter-on-quarter in Q3, Eurostat data showed. The HCOB flash eurozone purchasing managers’ index (PMI) fell to 47.0 in December. This suggests that the region’s economy is likely to have contracted in Q4 as well. (The PMI indices are based on survey data from companies in the manufacturing and services sectors. A reading below 50 indicates contraction, while above 50 signals expansion.)

UK inflation moderated more than expected over the period with the Office for National Statistics (ONS) revealing that the consumer prices index had dropped to 3.9% in November. This contributed to hopes that the Bank of England may have finished its series of interest rate hikes. Meanwhile, revised data from the ONS revealed UK GDP fell in Q3, having previously shown zero growth. Chancellor of the Exchequer Jeremy Hunt announced an Autumn Statement that contained more policy measures than many had expected. Key initiatives included the extension of the 100% capital expenditure allowance, which allows companies to deduct expenditure on plants and machinery from taxable income.

The overall macroeconomic conditions in Japan continued to improve. Somewhat sluggish Q3 GDP data was driven by higher inflation associated with slower wage growth. However, the Bank of Japan (BOJ) tankan survey released in December showed continuous improvement in business sentiment for both the manufacturing and non-manufacturing sectors. Capital expenditure plans also suggested that there would continue to be strong demand in machinery and IT service companies. The BOJ made gradual steps to normalize its extraordinary monetary easing policy at October end and continued to hint that they are likely to take further actions early in 2024.

 

EQUITIES: A Strong Finish

U.S. EQUITIES: For the three months ending on December 31, the Dow Jones Industrial Average gained 12.5 percent while the Standard & Poor’s 500 Index picked up more than 11 percent. The Nasdaq Composite, which led throughout 2023, led again, tacking on nearly 14 percent. [1]

DEVELOPED INTERNATIONAL EQUITIES: The MSCI-EAFE gained 10.10 percent in the fourth quarter thanks to falling inflation, lower yields, and a weakening U.S. dollar.4 Sharp declines in European inflation fed optimism of rate cuts, sending European stocks higher for the quarter, with advances in France (+5.61 percent), Germany (+8.87 percent), Italy (+7.47 percent), and Spain (+7.15 percent). The UK, which lagged for most of the year, gained 1.65 percent. [5]

EMERGING MARKETS: Pacific Rim markets were mostly higher for Q4. Australia picked up 7.69 percent, while Japan added 5.04 percent. The Hang Seng Index trailed with a drop of 4.28 percent, owing to Moody’s downgrade of China’s debt and new government restrictions on gaming. [6]

FIXED INCOME: Falling Yields

U.S. FIXED INCOME: The FOMC elected to leave interest rates unchanged at both its October/November and December meetings. Following its December meeting, the Fed signaled that it may cut interest rates three times in 2024. While careful not to declare a victory in its inflation battle, the Fed acknowledged that inflationary pressures have eased.16 As markets priced in easing conditions, government bond yields fell across the board. The US 10-year Treasury yield fell from 4.57% at the end of Q3 to 3.87% at the end of Q4.

DEVELOPED INTERNATIONAL FIXED INCOME:

Taking cues from the FOMC, other major central banks held steady rates, although they appeared more cautious about inflation. The European Central Bank (ECB) made progress in its plan to unwind some of its Pandemic Emergency Purchase Program support, while highlighting concerns about domestic inflation. However, the market priced in several rate cuts for next year. Despite relatively healthy labor markets across the region, the Purchasing Manager Index (PMI) underscored a pessimistic growth outlook. Meanwhile, the Bank of England’s Monetary Policy Committee remained divided on further tightening. The latest inflation release surprisingly trended downward which extended the gilt market rally. Elsewhere, the Bank of Japan’s decision to make only minor adjustments to its yield curve control policy fell short of market expectations. The UK 10-year gilt yield fell from 4.44% to 3.54%, while the German 10-year Bund yield ended the quarter 0.81% lower at 2.03%.

 

QUARTERLY FOCUS: The Pivot

In 2023, the financial markets were heavily influenced by the Federal Reserve’s policy decisions, which seemed to pivot from the aggressive stance taken in 2022. The year began with the Fed shifting from significant three-quarter percent rate hikes to more modest quarter-point increases, reflecting a nuanced approach to combating inflation without stifling growth. By May, rates had been hiked three times, hitting a target range of 5.00%-5.25%. Interestingly, the market’s reaction was more attuned to investors’ expectations surrounding the Fed’s moves rather than the actions themselves.

In mid-June, the Fed paused rate hikes – a first since March 2022 – suggesting the beginning of a potentially extended period of high-interest rates. This pause came despite persistent high inflation and strong job numbers, signaling the Fed’s desire to observe the cumulative impact of the previous rate hikes on the economy.

The Fed resumed rate increases in July, adjusting the target range to 5.25%-5.50%. Despite this, bond market yields experienced notable fluctuations but ended up cycling back to initial levels in certain segments of the U.S. Treasury market by the year’s end.

A key indicator, the yield on the U.S. Treasury 10-year note – vital for home mortgages and other loans – started the year at approximately 3.8% and remained stable until a sudden climb in August. This climb, which saw yields hitting a 17-year high of around 5%, was driven by unexpected government borrowing, speculated rate hikes in Japan, and a strong job market. However, this spike was transient as the labor market began to cool and inflation reports came in more favorable than expected.

Towards the year’s end, the Fed hinted at potential rate cuts in 2024 which spurred a bond market rally. The markets have since adjusted their outlook, now anticipating significantly lower interest rates in the coming one to two years. The chart to the right illustrates this shift in expectations, marking a critical pivot point in the Fed’s policy approach and its subsequent effects on market sentiment and financial forecasts. The recent pivot has resulted in a broadening participation in the stock market which may continue if interest rate pressures continue to abate.

 

DPWM OUTLOOK: A Broad Perspective

One of the catalysts of last year’s market rally was excitement about the rise of artificial intelligence (AI) and its possible reflection on corporate earnings. Though tech companies may be the first to benefit from AI adoption, the broader promise lies in what it can do for worker productivity and innovation across all industries. Investors may pay close attention to how non-technology companies invest in AI as 2024 progresses. Companies making commitments might signal to investors that they have potential productivity advances and future competitiveness. The risk for investors is that the hype races ahead of reality and enthusiasm can fade.

For much of the last ten years, larger companies have generally performed better. In 2022, smaller-cap stocks briefly outperformed, but mega-cap stocks, particularly the “Magnificent Seven” (Alphabet GOOGL, Amazon.com AMZN, Apple AAPL, Meta Platforms META, Microsoft MSFT, Nvidia NVDA, and Tesla TSLA, have excelled in eight of the past 10 years. For instance, as of December 21, 2023, the Morningstar US Large Cap Index had risen about 29% for the year, outpacing the US Small Cap Index by approximately 9 percentage points.

This chart depicts the extreme moves witnessed in 2023 by the mega-cap stocks, which further widened the gap between large and small. This performance disparity has made small-cap stocks more financially appealing. While large-cap stocks are generally valued appropriately, the average small-cap stock was trading at a 19% discount to its fair value, as estimated by Morningstar analysts, as of December 13, 2023. It’s important to note that smaller companies typically have lower profitability and weaker financial structures compared to their larger counterparts. This could put them at a disadvantage if the U.S. economy deteriorates. However, for long-term investors, investing a moderate amount in small-cap stocks could be a strategic move, especially as a balance against the dominance of large, growth-oriented technology stocks in most major market indices.

This could put them at a disadvantage if the U.S. economy deteriorates. However, for long-term investors, investing a moderate amount in small-cap stocks could be a strategic move, especially as a balance against the dominance of large, growth-oriented technology stocks in most major market indices.

At Denver Private Wealth Management, we build diversified portfolios comprising stocks of various sizes and spanning different geographic regions. Although our portfolios feature some of the prominent Big Tech companies, we also emphasize investments in areas and businesses of different sizes and regions that offer favorable risk-reward opportunities. This approach positions us well to capitalize on potential value opportunities, particularly if the ongoing market rally extends beyond the largest tech firms.

 

 

CITATIONS:

1. WSJ.com, December 31, 2023
2. Advantage.Factset.com, December 8, 2023
3. SectorSPDR.com, December 31, 2023
4. MSCI.com, December 31, 2023
5. MSCI.com, December 31, 2023
6. MSCI.com, December 31, 2023
7. BEA.gov, December 21, 2023
8. CNBC.com, December 12, 2023
9. WSJ.com, December 14, 2023
10. FederalReserve.gov, December 15, 2023
11. MarketWatch.com, December 19, 2023
12. Realtor.com, December 20, 2023
13. Census.gov, December 22, 2023
14. CNBC.com, December 12, 2023
15. Morningstar.com, December 22, 2023
16. WSJ.com, December 13, 2023
17. USNews.com, September 12, 2023
18. Consumeraffairs.com. April 20, 2023
19. Secloc.org, May 16, 20231. WSJ.com, September 30, 2023