- Equity and bond markets shook off a slow start to finish Q4 -and 2023 - strong.
- Expectations for declining interest rates drove strength in both asset classes.
- International stocks generally had positive returns but lagged US stocks.
The fourth quarter of 2023 was like a mirror image of the third quarter. Continuing the downtrend that began in Q3, equity markets stumbled out of the gates to start Q4. However, equity markets then turned on a dime and rallied powerfully to end the year. Adding to this poetic symmetry, the Federal Reserve and its’ expected rate policy was the underlying driver of both turnarounds. While fears of ‘higher for longer’ had suppressed stock valuations and led to higher interest rates in the early fall, sudden hopes for multiple rate cuts over the next year spurred on the rally in equities and in bonds.
Driving strong equity returns, US 10-year treasury yields dropped from almost 5% midway through the quarter to below 4% to close the quarter. From a valuation standpoint, falling rates tend to make stocks more attractive relative to bonds and cash, and lessens the impact of higher rates on profits through lower interest expense.
With the potential tailwind of an easing Fed, credit spreads tightened in the fourth quarter. This led to positive returns in the three major fixed income classes, with more credit-sensitive bonds performing the best.
Returns Recap: Stock Markets Lead the Way, but Bond Markets Rally as Well
US Sectors: Technology Rallies, Energy Lags
With lower rates easing the pressure on valuations, Technology stocks were the strongest performing of the traditional ‘growth’ sectors, while Consumer Discretionary and Communication Services posted returns closer to the market average. As you can see from Table 2 below, ‘value’ sectors saw an even greater dispersion. Industrials and Financials rallied above market average, with strong economic data and falling interest rates providing a tailwind to their respective business models. On the other hand, the Energy sector experienced a negative return quarter, as commodity prices fell sharply this quarter due to worries of oversupply. Real Estate led all sectors in Q4. In our view, this rally was driven by a combination of cheaper financing and low valuations in the sector to start the quarter.
Looking at calendar year 2023, the market's strength was driven to a large extent by growth sectors rebounding after a difficult 2022. Technology and Communication Services more than doubled the market return over the trailing twelve months, and Consumer Discretionary followed closely behind.
International Stocks: Developed Markets Still Lead Over Emerging Ones
International markets trailed US markets in the fourth quarter but were generally able to post positive returns (see Table 3 below). Developed international markets, led by Canada and Europe, were within 1% of S&P 500 returns. This strength was driven by both strong equity and currency returns relative to the US dollar. On the other hand, Emerging markets underperformed most developed markets. This underperformance can be mainly attributed to continued poor returns from Chinese equities, a theme that persisted throughout the year.
Looking Forward: We are Cautiously Optimistic for ‘24
In Q4 2023, equity markets were able to reestablish the positive trends begun in the first half of the year. We remain cautiously optimistic on stocks, as laid out in our 2024 Outlook. Just as in 2023, the Federal Reserve and their fight against inflation will take center stage, in our view.
In our highest probability Base Case, inflation continues to cool (though at an uneven pace), allowing equity markets to moderately continue their uptrend. In a more optimistic Bull Case scenario, inflation cools at a faster and more consistent pace, allowing the Fed to decisively pivot to an easing policy. On the other hand, our Bear Case outcome would involve the return of high inflation and anemic economic growth, placing the Fed in an impossible position, a catalyst for a stock and bond bear market. However, we place only a 25% chance on this negative outcome, suggesting we believe there is a ~75% chance of positive market returns in 2024.
Given our Base Case involves moderately positive but choppy returns, we believe our ‘P.A.T.T.Y’ theme (‘Pay Attention to the Yield’ - a focus on investments with strong yields and cash flows to support them) would be an effective strategy. Specifically, growth stocks with stable and growing free cash flow, cyclical stocks with well-funded dividends, and alternative yield strategies designed to benefit from market volatility are all long-term themes in our Base case scenario.
From a portfolio construction perspective, we continue to slightly favor stocks over bonds in our balanced portfolios. We currently favor US stocks across our balanced portfolios and are tactically cautious on international.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.