4th 2023 Quarter Market Commentary
Strong Close to 2023, But Gets Tougher From Here
Stocks ended 2023 on a high note, with the S&P 500 Index advancing by 11.7% in the fourth quarter, closing the year with a 26.3% return and within striking distance of all-time highs. The powerful rally could be attributed to continued disinflation traction, increased credibility of the soft economic landing narrative, and a surprisingly dovish pivot from the Federal Reserve, which sent bond yields plummeting. In stark contrast to the prior three quarters, returns were much more evenly distributed across equity market sectors and capitalization. Or, more succinctly, it wasn’t just the mega-cap tech stocks that performed well this quarter.
Bond markets were rattled in the third quarter as excessive government borrowing left investors wondering how high bond yields would have to go in order to absorb the additional supply. The drubbing left most fixed income indices in negative territory for the year as of the end of September. However, that changed dramatically in the final months of 2023 as economic readings gave investors confidence that the Federal Reserve has inflation on the run, and the Fed’s December Summary of Economic Projections suggested three interest rate cuts in 2024. These developments helped to bring interest rates/bond yields down dramatically and propelled fixed income returns firmly into positive territory for the year.
Looking back to the beginning of the year, the consensus among economists and market pundits was that the Federal Reserve’s aggressive tightening cycle would push the economy into a recession. So far, those recession calls have been wrong. Not only have we not experienced a recession, but GDP growth was slightly above long-term trend levels in 2023. The best explanation for the economic and financial market resiliency is how well-prepared consumers and larger corporations were for a higher interest rate environment. Smart borrowers used the historically low-interest rate environment in the first half of 2020 to restructure and refinance their balance sheets. According to real estate brokerage firm Redfin, roughly 80% of homeowners have a fixed-rate mortgage and almost two-thirds of those mortgages have interest rates below 4%. Unless homeowners have been forced to move or relocate, they have been well-insulated from the pain of 7%-8% mortgage rates. Large corporations raised massive amounts of capital in 2020 by issuing long-term bonds at rock-bottom interest rates. In fact, among S&P 500 nonfinancial firms, 92% of debt is fixed rate with a weighted average interest rate of only 3.2% and an average maturity of almost nine years. Obviously, the longer interest rates remain at elevated levels, the more consumers and companies will be impacted. But smart borrowing and refinancing activity in 2020 set the stage for better-than-expected outcomes in 2023.
Turning to 2024, the starting point feels much different than at this time last year. We enter the year with much more optimistic economic predictions and bullish investor sentiment. It’s now difficult to find an economist willing to predict a recession with the consensus view shifting to a soft economic landing and inflation returning to long-term trend levels. Bond markets are pricing in five or six interest rate cuts throughout the year. And equity analysts are penciling in double digits corporate earnings growth for 2024. While each consensus outcome is plausible in and of itself, we’re a bit more skeptical and don’t expect a perfect alignment of outcomes with optimistic expectations. And we’re reminded of the contrarian nature of equity markets – above-average returns often come after investor sentiment, positioning, and outlooks have been severely depressed. We don’t have this tailwind at our backs to kick off the year.
Our outlook for 2024 is for flattish returns for market cap-weighted indices such as the S&P 500 Index and better outcomes from more diversified strategies and portfolios. Concentrated leadership was a painfully evident trend in 2023. The “Magnificent Seven” (Apple, Microsoft, Google, Meta Platforms, Amazon, Nvidia, and Tesla) rebounded from a dismal showing in 2022 and accounted for roughly 85% of the return for the market cap weighted S&P 500 in 2023. However, the massive outperformance from these mega-cap technology stocks has pushed the S&P into concentrated territory, with the top 10 weighted stocks now accounting for one-third of the entire index. This concentrated positioning also represents a headwind from a valuation standpoint, with those top 10 stocks trading at a 45% premium to 25-year historical averages.
Looking forward, we see plenty of opportunities within areas and sectors investors have passed over as they continue to pile in and chase the mega-cap tech rally. Given the extremes in positioning, index weightings, and valuations of the “Magnificent Seven” versus everything else, we feel the rational expectation points to a shift in focus to some of the unloved sectors. And given our diversified exposure, we are much better positioned for a market environment with broader participation.
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Any opinions expressed are opinions held at the time of publishing and are subject to change. It does not constitute an offer, solicitation, or recommendation to purchase any security. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Past performance does not guarantee future results. The performance shown is for illustrative purposes only and the intent is to show the performance of certain segments of the markets. This information is not reflective of the performance of any FPCG client, or the impact of security selection on actual client portfolios. Actual results and developments may be substantially different from the expectations described in the forward-looking statements included herein.
The S&P 500 is a broad-based index of 500 stocks, which is widely recognized as representative of the equity market in general. The Bloomberg U.S. Aggregate Bond Index is a broad-based index of intermediate term investment grade bonds traded in the U.S. These indices are unmanaged and may represent a more diversified list of securities than those recommended by FPCG. In addition, FPCG may invest in securities outside of those represented in the indices. The performance of an index assumes no taxes, transaction costs, management fees or other expenses. Additional information on any index is available upon request.
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