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Q4 2023 Market Commentary

2023 was a remarkable year for financial markets and the US economy. We entered the year with high inflation, low expectations for stock returns, and economists predicting a recession. The economy and market responded by defying all expectations. 

  • Inflation eased significantly. The Consumer Price Index (CPI) fell from 6.5% in December 2022 to 3.1% in November 2023.
  • The economy was surprisingly resilient. Real GDP growth for 2023 is expected to come in around 2.4%. 
  • The Stock Market Soared. The S&P 500 was up over 26%. Tech stocks led the way with the Nasdaq 100 returning 55% (rebounding from its 32% drop in ‘22). 

The US consumer was the main driver of the economy and market. Despite the challenges of higher interest rates, a troubled commercial real estate sector, and several bank failures that dominated the news, the US consumer kept spending and remained confident. The market rewarded this optimism and resilience. Investors were further encouraged by the prospect of interest rate cuts in 2024. 

2024 Outlook

Expectations for 2024 are more upbeat. The consensus among Wall Street analysts is that the economic growth will slow down but remain positive. They expect a weaker start to the year, followed by an acceleration in the second half. Markets entered the year pricing in 6 interest rate cuts by the Fed. Most forecasters also expect inflation to continue to fall closer to the Fed’s 2% target. The consensus forecast is a Goldilocks scenario- growth that is not too hot to stoke inflation, but not too cold to risk recession. 

I think 2024 is fraught with risks for investors. All the stars must align to meet consensus expectations. If the economy is weaker than predicted we’ll enter a recession. If the economy is stronger than predicted inflation is likely to surge back to uncomfortably high levels, keeping interest rates high. The odds of negative surprises this year far outweigh the odds of positive ones. The biggest risk factors I see going into ‘24 include: 

  • Valuation: The US stock market is extremely overvalued by historical standards
  • Recession: Nearly all leading indicators that have reliably predicted recessions in the past are flashing red warning signs
  • Inflation: The inflation threat is not over yet. We’re still above the Fed’s targets and inflation expectations may become entrenched at these higher levels.

Given these risks, I think investors should take a cautious approach. On the bright side, it looks like fiscal policy will remain stimulative and monetary policy should become more accommodative as rate cuts begin. We’re also in an election year, which historically provides a tailwind to the economy. 

Expensive Stock Market Valuations

As the following chart shows, valuations of US stocks are near their highest levels in history. The only times that valuations have been higher were the tech bubble peak in 1999 and the recent peak in 2021. The US market is significantly more expensive than in 1929 (before the great depression) or in 2007 (before the global financial crisis).

For anyone paying attention to the US stock market, much was made about the performance of the Magnificent 7. The Magnificent 7 is a group of 7 of the largest tech stocks in the US: Apple, Amazon, Google, Meta/Facebook, Microsoft, Nvidia, and Tesla. As the following charts show, these stocks make up a large part of the S&P 500 index and provided a significant part of the Index’s 2023 return: 

The combined value of the Magnificent 7 now exceeds the total stock markets of the UK, China, France, and Japan combined:

Such high stock market concentration has hurt investors in the past (i.e. the Nifty Fifty and Tech Bubble). On many valuation-based forecasts, US stocks are set to underperform short-term treasuries over the next 5-10 years. Even if that forecast is too pessimistic, the risk-reward proposition of stocks priced at these levels is questionable. 

Weak Projected Economic Growth

According to Bloomberg’s consensus forecast, US GDP is expected to grow at a real rate of 1.2% in 2024, roughly ½ of the growth experienced in 2023. That view was reflected in Bank of America’s Fund Manager Survey, with 77% of respondents expecting a ‘soft landing’ or ‘no landing for the US economy. That means the majority of respondents expect the US economy to experience a mild reduction in GDP growth but avoid a recession. 

However, I think that the consensus outlook may be overly optimistic. There is still a significant chance we enter a recession in 2024. The impact of the Fed’s rate hikes, which began in early 2022 and continued until mid-2023, should continue to work its way into the economy. Many consumers and corporations have only begun to feel the bite of those rate hikes, which have increased the cost of borrowing and servicing debt. As more people purchase homes and autos and corporations roll over their debt the impact of higher rates will continue to work its way into the economy.

Most of the industrial/manufacturing side of the US economy was already in recession in 2023. Forward indicators that have predicted past recessions are flashing warning signs today. The following charts show a few worrisome indicators:

The weak industrial side of the economy has been offset by the consumer thus far. In retrospect, many economists believe it was surplus savings that consumers built up during Covid that contributed to that strength. It now appears that most of those savings have been spent and there are emerging signs of stress for the consumer entering 2024: 

  • Exhausted excess savings
  • Flattening wage gains
  • Mandatory restart of student loan payments
  • Credit card delinquencies
  • Subprime auto delinquencies 
  • Rising Unemployment (The unemployment rate rose from 3.4% to 3.7% in 2023 and is expected to rise to 4-4.2% in 2024).

Economic Tailwinds

Not everything looks bleak for the economy heading into the new year. There are tailwinds that could continue to support economic growth and mitigate some of the downside risks. The most important tailwind is stimulative fiscal policy. US government spending remains unusually stimulative. The following chart shows just how significant fiscal spending has been: 

At its current level of around 25% of GDP, fiscal spending is currently above the peak of spending coming out of the global financial crisis. Given that 2024 is an election year it’s likely that fiscal policy will remain a strong force helping the economy. 

Monetary policy has been a major headwind over the past two years. The Fed raised rates at an unprecedented pace and flipped from quantitative easing to quantitative tightening. While the Fed is expected to maintain its balance sheet runoff with quantitative tightening, they are now projecting interest rate cuts in 2024. In December, the Federal Reserve updated its projections for future interest rates to include three 25 basis point cuts in 2024. That would bring the federal funds rate down to ~4.6%. The market believes even more cuts are coming in 2024, with futures beginning the year pricing in 6 rate cuts for a federal funds rate range of 4.00-4.25%. 

Headline CPI inflation dropped from a peak of 9.1% down to 3.1% at the end of 2023. Most of Wall Street expects inflation to continue to fall during 2024 down to the Fed’s target of 2%. Shelter makes up a big component of CPI and as a lagging measure is set to ease significantly in 2024. The following chart shows the makeup of headline inflation and its significant drop:  

Source: JP Morgan Asset Management Guide to the Markets

Decreased inflation has taken a lot of pressure off the economy and is one of the primary drivers of the market’s enthusiasm entering 2024. Most Wall Street Firms and economists are predicting further disinflation, with few predicting much pressure or risk from inflation reigniting. I worry that if the economy remains resilient, inflation could surprise significantly to the upside. Wage pressures, consumer expectations, shipping costs, and energy all have the potential to push inflation higher. Such a surprise would be a major blow to investors as interest rate cuts would not materialize and longer duration bonds would get punished. 

Conclusion

In The Intelligent Investor, Ben Graham set forth the difference between investment and speculation: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

The current market certainly looks speculative to me. Stocks are overvalued and priced to deliver below-average returns over the next ten years while facing high risks. Meanwhile, short-term Treasury Bills offer more than 5% yield, making them a much more attractive risk-reward option. The market may continue to soar in the short run and I wouldn’t rule out hitting another speculative bubble top. However, for investors who care about preserving their capital, a conservative strategy is the only sensible choice in this environment. 

Scott Caufield, CFA, CPA 

01/09/2024