Despite the year’s risks, 2023 ended up being a strong year for financial markets with gains in the equity market in double digits and bonds staging a year-end rally that reversed earlier losses. This was in large part driven by the market consensus that the Federal Reserve may have finally tamed inflation while maintaining a relatively strong economy. This was no doubt a welcome outcome after a challenging 2022 in which rising interest rates and the unwind of pandemic excesses humbled the markets. As we begin 2024, a new set of challenges will likely take shape, but markets are starting the year on good footing and with optimism that the economy will achieve the elusive “soft landing” that policy makers have long sought.
This scenario, where the economy avoids recession following a Fed hiking cycle, has seen its chances ebb and flow over the year. While the ‘AI trade’ powered much of the gains in the first half, economists remained fearful for much of the year that the economy would eventually succumb to the rapid rise in interest rates. This was true well into the 3rd quarter when inflation continued to disappoint, interest rates surged to 5%, and the consumer was showing signs of strain. This all changed, however, in October when key inflation readings fell more than expected, prompting the Federal Reserve to hedge their mention of further rate hikes. Oil and other commodity prices also fell and these developments triggered a buying spree that only accelerated as the consumer outlook stabilized and policy makers started forecasting interest rate cuts in 2024.
The dramatic move in the 10-year treasury yield from 5.0% in mid-October to 3.9% just two months later was pivotal for the market in multiple ways. Not only did this remove the biggest headwind for the market generally, but the easing of financial conditions opened the door for a recovery in many sectors of the market most exposed to higher rates. Small Caps for example, which are more sensitive to funding costs, outperformed Large Caps by 10% from the October low. Investors also bought the dip in dividend-paying Value stocks, which had fallen out of favor due to attractive treasury yields. And regional banks, which experienced a crisis of confidence in the 1st quarter that prompted government intervention, rallied 35% as lower yields help their balance sheets. As a result, the rally dramatically expanded its breadth, which is an important technical indicator as we start the new year.
This broadening of the rally was a welcome development from the dynamic in place for most of the year in which most gains were concentrated in just a few holdings. In fact, in the 3rd quarter pullback, over 100% of the S&P 500’s year-to-date return was concentrated in 10 names, mostly large Technology stocks. The rotation of capital out of these winners and into everything else at year-end brought that number down to a healthier 65%. While still concentrated, this broadening of the rally speaks to the underlying economic resilience being felt across sectors. At the same time, it reflects an economy and market increasingly ripe for rapid changes as technological advancement accelerates.
As we look into 2024, there are a few factors we are watching. First, the rally has caused valuations to increase at a time when top line growth is weakening. Whether companies can support margins and earnings growth in the face of weaker pricing power will be a key focus in the coming months. There is also the question of how new AI technologies will proliferate and impact productivity across the economy. The technology is undoubtedly transformational, but a key question is how quickly we will see the impact. Lastly, geopolitics will remain in focus as wars in Europe and the Middle East coincide with a presential election at home and slowing economy in China. While markets largely shrugged off such concerns in 2023, they require constant monitoring.
So while markets are starting the year on optimism, we will be closely monitoring these developments domestically and globally. We also have confidence that many of the shifts we made in the last year have positioned portfolios well to perform through whatever challenges arise. And when they do, we remain on the lookout for opportunities to add value in portfolios.