2023 Quarter 4 Commentary

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“To me a soft landing is the economy continues to grow, the labor market remains strong and inflation comes down. And I believe that’s the path we’re on.” - Treasury Secretary Janet Yellen

We hope that everyone has had a happy holiday season and was able to enjoy quality time with family and friends.

Much of the general market conversation over the past year has been inundated with the idea of a ‘soft landing’ for the economy – a situation where the economy continues to thrive, despite tightening monetary policy, i.e. higher interest rates. The idea of the soft landing, which Treasury Secretary Janet Yellen succinctly describes in the quote above, appears to be heavily supported by recent economic data. Necessary components for a soft landing include: 1) a softening-but-growing economy, 2) a robust labor market that shows a bit of slack, and 3) declining inflation.

As seen above, a ‘softening-but-growing economy’ has seemed to pass thus far - the 3rd quarter GDP was incredibly strong at 4.9%, although that may prove to be the peak. Forward estimates for GDP look to be positive but much lower than this most recent 4.9% growth.

However, when it comes to a soft landing, there is also a bit of a “Goldilocks” challenge. The growth in the 3rd quarter would be considered “too hot” to coincide with declining inflation, but if economic growth is negative, then the concern would be that the soft landing scenario could get replaced by a hard landing scenario, more commonly called a recession. Fortunately, the current expectation for the next four quarters of GDP growth seem to align with slow but steady growth. In summary, it appears that the first condition of a soft-but-growing economy is currently met.

The labor market has been very tight since the emergence from the Covid pandemic lockdowns, with more job openings than unemployed workers. In the chart to the right, one can see that the gap between job openings and unemployed, which had been much greater in 2022, is finally reaching more of an equilibrium point. An extremely tight labor market can contribute to inflation as employers seek to hire new workers by raising wages. As more workers enter the workforce and become available, that upward wage pressure diminishes, which eases wage inflation – a critical component of overall inflation.

In another sign of a less tight labor market, the hire rate for new employees is moderating and the separation rate, which includes quits, retirements and other separations, has also declined, as can be seen in the graphic to the left. High quit and hire rates tend to coincide with hot labor markets as workers rotate quickly from one job to another at higher and higher wage levels. And while we note that these indicators are moderating, they still appear quite strong when compared to a long-term historical norm, which implies that the labor market continues to show strength. Once again, according to the most recent data, the second condition of a robust labor market also appears to be met.

Finally, inflation is showing very positive signs of receding. The chart to the right shows the rate of annual growth of Core Personal Consumption Expenditures (PCE, excluding energy and food prices). Produced by the Commerce Department’s Bureau of Economic Analysis, this is the inflation data that the Fed cites most often. The red line shows how inflation is trending on a 1-year basis. For additional context, the blue line shows where the Federal Reserve has the Fed Funds rate, which is currently at 5.5%. The green line is the Fed’s long-term goal for inflation at 2%. With Core PCE at 3.2% and declining rapidly, it does appear that the 2% goal is within sight. This would fulfill the final condition for a soft landing. Possible complications to the soft landing narrative would be a rebound or even a delay in inflation’s continued decline or a worsening of economic data. Thus far, neither of those issues has occurred. This has led the Fed, in its most recent release in mid-December, to indicate that it is most likely to cut the Fed Funds rate three times in 2024. Lower interest rates are generally positive for stocks, but they are not the only factor for the stock market. Corporate earnings for example, are important for stocks because they are fundamental to the value of the underlying businesses in question.

On a different note, 2024 is an election year, and questions from clients often arise about the impact of elections on markets. U.S. Bank recently published a study of election impacts on markets, and the results of the study indicate that elections have a muted impact on S&P stock returns. Interestingly, the two possibilities in which markets showed the most positive three-month gains were ones in which the election outcome was divided government. Factors that appeared to have more impact on markets were more fundamental in nature: whether inflation was rising or falling, and whether economic growth was rising or falling. To no one’s surprise, the best scenario is one in which inflation is falling and economic growth is rising.

Equity markets ended the year in very strong fashion to notch total returns well above long-term historical averages. The chart above compares the trajectory of 2023 returns across three major U.S. indices: the large cap S&P 500 index in blue, the mid cap S&P 400 index in red and the small cap S&P 600 index in green. For nearly the entire year, positive returns were relatively concentrated in large cap stocks, but it is also clear that all three indices rallied very strongly from the beginning of November through the end of the year. In other words, the market rally broadened to include more equity classes, and this was largely the result of very positive inflation news received in November. Inflation had slowed much more quickly than expected. That data, combined with the Fed announcing in December that rate cuts are planned for 2024 has given strength to the soft landing narrative. However, we still believe that some caution should be exercised, given the strong and potentially overbought equity performance of the final two months of 2023.

For the year, the sectors that performed the best were technology related: Communication Services and Information Technology. On the other side, the sectors that struggled were Energy, which was challenged by declining oil prices over the year, and Utilities as investors shifted away from the high dividend payers in this sector to the higher rates available in fixed income. While we remain positive towards equities given the potential for continued global economic growth and declining rates, we continue to believe that diversification across equity market caps and styles is important, because investment performance leadership changes from one period to another. What worked very well in 2023 (large cap growth) does not necessarily imply a repeat in 2024. Value styles remain ‘cheaper’ versus growth styles relative to their long-term historical norm, and small and mid-caps also appear less expensive than their large cap counterparts.

It's also worth noting that this year’s attractive returns aren’t particularly abnormal, keeping in mind the evergreen maxim that past performance doesn’t equal future results. Take the graphic to the left from Albert Bridge Capital, for instance. Over the past one hundred years, the Dow Jones Industrial Average (DJIA) nets positive results quite frequently, and certainly more than net negative. Although the DJIA is a different index than the more commonly cited S&P 500, its returns also boast over 9% per annum. This is to say that years like 2022, in which we saw significant declines, tend to be more significant outliers than years like 2023, where markets boasted positive returns.

Although not particularly known for excitement, fixed income and long duration assets in general also managed to have an eventful year. Longer maturity products were somewhat volatile, climbing in the first few months of 2023. That is, until concerns about a ‘higher interest rates for longer’ economy seemed to be coming closer to reality, and most progress gained from earlier in the year was lost. As seen below, longer securities like the ten-year government bonds shrunk to nearly -6% at its nadir.

In September, when fears subsided that rate hikes would continue, the Federal Reserve announced that rate hikes would pause for the time being, the decision being made given data that indicated that inflation was under control. As a result, these longer bonds began to perform increasingly well, rocketing to new highs, as highlighted in the chart above. It’s hard to understate the rapid rise toward year end, catapulting returns to new heights.

In contrast to the volatility of the ten-year note, the performance of T-Bill securities - T-Bills being parlance for short term government bonds - never stalled; we saw a steady year-to-date return. This is important for fixed income holders drawing on their portfolios in particular – if you were drawing on longer term bonds during October 2023, investors might have to take losses on the asset, even though it rebounded merely months later. Interest rate risk can be the difference between drawing down on a security that is up 4% versus down 4%.

Additionally, commodity-wise, gold performed extremely well year-to-date. The precious medal notched new record highs in December. This might not be a surprise to readers who noticed the surge in popularity when retailers like Costco began selling gold bars beside other wholesale goods. While typically higher interest rates might not support this performance, geopolitical turmoil turned in gold’s favor.

Thank you and stay safe and healthy!

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