Interestingly, while 2023 was far from a tranquil ride – a couple of the biggest bank failures ever, sharply rising interest rates between March and October, ongoing debt-ceiling drama, continuing war in Ukraine and a new war in the Middle East – the US economy defied negative expectations all year. The stock market did, too, as the Standard & Poor’s 500 Index (S&P 500) registered double-digit gains (13.1%) through September 30^th. Or did it? Beneath that 13.1% headline return were the “Magnificent 7” large, AI-levered stocks – Apple, Microsoft, Alphabet, Amazon, NVIDIA, Meta, and Tesla, up 83.9% as a group – driving nearly all that return.  In fact, the equally weighted S&P 500 Index – a better representation of the broad US stock market – was up just 1.8% during that same period. Similarly, the S&P MidCap 400 Index (4.2%), S&P SmallCap 600 Index (0.8%) and MSCI EAFE Index (developed international equities; 7.7%) – all trailed the S&P 500 by significant margins. In short, the further one strayed from the “core” S&P 500, where just seven stocks represent nearly 30% of the index, the more tepid the returns. Meanwhile, bonds struggled with rising interest rates, ending the 3rd quarter with a total return of less than 1%.

Fast forward to the 4th quarter and the entire narrative changed, as both the stock and bond markets quickly bought into the notion that Powell may, indeed, stick the landing. As in previous quarters, the US economy continued to exhibit remarkable resilience. Measures of economic growth, consumer confidence, and retail sales all beat consensus estimates, while the labor market remained strong.

The surprise, and the reason US financial markets caught fire, was much better than expected inflation data. October readings on the Consumer Price Index (CPI), the Producer Price Index (PPI) and the Personal Consumption Expenditures Index (PCE) all came in lower than expected, which had investors quickly betting on a Fed pivot from raising to lowering interest rates. Then, at the December 12-13 Fed meeting, Fed officials explicitly validated that thesis by publishing FFR projections for 2024 that penciled in three 0.25% FFR cuts.

That set off what has been called the “everything rally,” as both stock and bond markets soared and went “all-in” on the elusive soft landing. Perhaps unsurprisingly, the S&P 500 gained 11.7% in the quarter, pushing its full-year total return to an astonishing 26.3%. But what was encouraging, especially for those practicing a value-sensitive, diversified asset allocation approach, was that other equity segments also participated in the advance. For example, the S&P SmallCap 600 led in the quarter, rallying 15.1% to finish 2023 with a total return of 15.9%. Similarly, the S&P MidCap 400, the S&P 500 Equal-Weight and the MSCI EAFE registered 4^th quarter returns of 11.7%, 11.9%, and 10.5% respectively, finishing the year with total returns of 16.4%, 13.8% and 19.0%. Quality intermediate-term bonds, meanwhile – with interest rates plunging on the Fed pivot – turned a middling year into a more historically average 5.1% total return and their first positive result in three years.

Importantly, while 4^th quarter action in US financial markets may seem to have given the “all-clear,” we’re more wary in the near-term. Both stock and bond markets are now overbought – with investor sentiment excessively optimistic – as markets now discount a near-certain soft landing and continued fading of inflation. Recall how wrong recession forecasts were for 2023. It’s entirely possible the current euphoria around imminent rate cuts and a soft landing in 2024 are also misplaced.

To be clear, we remain constructive in the longer term, as the US economy proves its dynamism once again, AI takes center stage, and the Fed ostensibly finishes the job on inflation. As such, we remain fully invested in equities (barbelled between the Magnificent 7 for AI exposure and other, cheaper equity segments like mid-cap, small-cap, and international equities). While still underweight fixed income, we feel bonds can once again fulfill their historical role in portfolios (income and downside protection) given now-higher yields. Perhaps the only question mark in our asset allocation program at present is our allocation to commodities, which have struggled as inflation has come down. A decision on that – as well as optimal equity positioning – awaits in 2024.

2023 turned out to be a remarkably positive year for global equity markets as the economic recession that was widely anticipated at the start of the year failed to materialize. Labor and credit markets remained resilient as the Fed increased interest rates to slow economic activity and inflation. Markets remained volatile, but valuations proved attractive enough to compensate for a decline in corporate earnings and an increase in real interest rates, as discussed in our last update. While valuations are attractive in many market segments and risks from spiking interest rates and declining corporate earnings seem to be receding, expectations are now elevated, and the economic backdrop is still mixed. As a result, we continue to be optimistic about the longer-term opportunities in current markets but expect some short-term volatility as markets complete the adjustment to a higher interest rate environment this year. 

For better or worse, it seems likely that equity markets will remain fixated on every hint of monetary policy adjustment in 2024. The yield curve remains inverted and the Leading Economic Indicators remain mired in negative territory, which are classic indications that risk of an economic recession is high. Monetary policy has a notoriously long and variable lag and the impact of the cumulative increase in interest rates over the past few years could exact a toll on economic growth in the coming year. The Fed acknowledged this risk in December when they indicated that interest rates can likely be reduced in 2024 if inflation continues to subside. It seems inevitable that the stock market will second guess the timing and magnitude of the Fed’s rate cuts and turn volatile as the economy approaches stall speed. 

Volatility in equity markets is expected nearly every year, though our view is that volatility in 2024 may present a long-term buying opportunity unless a meaningful deterioration in the credit or labor markets begins to appear. The economic data remains mixed, but valuations are attractive across most global equities with the exception of the handful of market darlings that drove equity markets last year. The Magnificent 7, (Microsoft, Apple, Amazon, NVIDIA, Alphabet, Meta, and Tesla) posted average returns of over 111% in 2023 as AI arose as a catalyst for productivity enhancing investment. Valuations of these companies expanded partly based on their exposure to AI and partly because their growth potential appears insulated from rising interest rates and slowing economic growth. While the consensus expectation of 10% earnings growth for the S&P 500 seems ambitious, the likely return of meaningful earnings growth in 2024 depicted at right dilutes the relative appeal of growth stocks and could provide a catalyst for the rest of the market to catch up to the leaders of 2023. 

Some parts of the equity market have a lot of catching up to do as appreciation in 2023 was incredibly concentrated with the Magnificent 7 stocks responsible for about 60% of the S&P 500 return. Stable dividend-paying sectors that are especially sensitive to interest rates – such as Consumer Staples or Utilities – declined in 2023 while the S&P 500 returned 26%. Other styles and market segments such as value stocks and small-cap stocks have been out of favor for years and trade at unusual discounts to broad market averages.  It seems unlikely that all of these areas will outperform simultaneously, instead it may be the value-oriented dividend stocks that thrive as economic growth slows and interest rates decline in 2024. Areas like small caps may require economic reacceleration before they consistently outperform their larger peers. None of this suggests that the Magnificent 7 are egregiously overvalued and primed to plummet—as occurred the last time we saw this level of market concentration during the tech bubble of the late ’90s. Instead, these market behemoths look reasonably valued given their dominant market position and AI exposure, although we do see more compelling opportunities elsewhere at the moment. As a result, we continue to seek a balanced approach that participates in the market-leading Magnificent 7, while maintaining a more diversified and attractively valued portfolio than the S&P 500.

While equity markets present opportunity in 2024, risks are elevated. In addition to the potential for the Fed’s rapid removal of policy stimulus to derail economic growth, 2024 is also a year of significant exogenous risks for US investors. Economic activity in China has significantly disappointed expectations and adds to heightened geopolitical uncertainty as conflicts rage in both Eastern Europe and the Middle East. Add the potential for domestic political turmoil in an unusual presidential election cycle into the mix, and 2024 feels as though it could be a continuation of the roller coaster ride of the past few years. Ultimately, our assessment at the dawn of this new year is a cautiously optimistic one. Businesses have weathered the adjustment to higher interest rates reasonably well, new secular growth opportunities are emerging, and valuations remain downright cheap in many areas. While we expect ongoing volatility in 2024, we remain confident in our disciplined investment approach and the long-term investment opportunities it seems likely to uncover over the course of this new year.

The end of the fourth quarter 2023 marked the second consecutive year where interest rate hikes were all-consuming for fixed income investors, but the focus for 2024 is likely to be on interest rate cuts, geopolitical events, and an intensely contested US presidential election. Another 1% worth of interest rate hikes were enacted by the Federal Open Market Committee (FOMC) through the first three quarters of 2023, and the Fed emphasized inflation fighting, sending the 10-Year Treasury to a yearly high of 5.01% in October. Then, inflation started to cool, the market sniffed out the end of the Fed’s rate hiking campaign, and bonds staged a massive rally in the final two months of the year. After a year of volatility, it is remarkable that interest rates took one big round trip, essentially ending the year where they began it. Thankfully, after challenging years in 2021 and 2022, intermediate bonds returned upwards of 5% in 2023 (Bloomberg US Intermediate Govt/Credit Index).

With inflation pressures abating, the bond market now has interest rate cuts in its forecast for 2024. Chairman Powell and the FOMC actually endorsed this view at their December meeting, setting off a furious rally in risk assets and a downward move in interest rates. Market optimism is also reflected in High Yield credit spreads, where a lower spread means a benign outlook for defaults. Currently, the Bloomberg US Corporate High Yield Index yields only an additional 3.12% over Treasurys, well below its 10-year average spread of 4.26%.

Despite recent market exuberance, we are focused on the challenges that 2024 is likely to deliver. First, inflation is improving broadly, but price pressures in the service sector have been durable, and inflation related to the rental/housing sector could be poised to increase. In addition, while concerns about the US budget deficit have recently been pushed to the back burner, borrowing needs are expected to increase again in 2024. The presidential election may also exacerbate deficit concerns since it is safe to say that neither party’s platform will be one of fiscal restraint. Finally, events in the Middle East, credit concerns in China, or trouble in commercial real estate may have outsized effects on US Treasury yields. In early 2024, we expect interest rates to trend modestly lower before increasing later in the year due to deficit concerns.

Within fixed income markets, there are indicators that are worth watching. The shape of the yield curve, which has been inverted since the middle of 2022, is one of those. Even though it is traditionally a recession warning sign, the economy has been remarkably resilient. As the Fed reduces short-term interest rates, we expect the yield curve to normalize and eventually regain a shape that is upward sloping. If the US economy continues to grow, the re-steepening of the yield curve will be viewed favorably by markets. In 2024, we will also be watching developments in credit markets. Higher funding rates have increased interest payments for businesses and consumers, but there have been few visible negative effects so far. Refinancing needs in the coming year are somewhat challenging for lower credit quality issuers, so we expect a modest increase in default rates. Household delinquencies within automobile loans and credit cards have been increasing as well. Primarily, these challenges mean that investors need to be selective when investing in corporate credit.

In the municipal bond market, we are also monitoring credit quality, valuation, and changes in tax policy. Credit quality remains resilient, and according to Moody’s, bond upgrades accounted for over 75% of all municipal bond rating actions in 2023. In terms of valuation, municipal bonds are modestly overvalued after a torrid rally to end last year. Within portfolios, we are being selective with purchases and looking for valuations to normalize in the first quarter, which has historically been a seasonally weak period for municipal bonds. Anticipated tax policy can also have an outsized effect on municipal bond returns, especially in an election year. Recall that the Tax Cuts and Jobs Act, signed into law in 2017, reduced tax rates and consequently the value of the municipal tax exemption. Immediately prior to that, the 2016 presidential election kicked off some dramatic swings in municipal bond valuations that proved to be attractive buying opportunities. It would not surprise us to see more of the same volatility this year.

When positioning fixed income portfolios, we are mindful of balancing yield and risk. While we remain overweight corporate bonds, we currently have minimal exposure to the High Yield asset class given that recession risks are still present and valuations look stretched. Our duration positioning is neutral, since, in our view the future path of interest rates has a wide range of potential outcomes. With inflation pressures receding, Treasury Inflation Protected Securities (TIPS) look less attractive, and we are likely to reduce our allocation to this asset class. We do not view cash as an appealing sector since short-term rates could move lower quickly. The tax-exempt nature of municipal bonds makes them an attractive long-term investment, but we are currently being selective with purchases. Overall, market yields in fixed income are still close to multi-decade highs, which should bode well for fixed income returns in the future.

As we look back on the sustainable investing market in 2023, it is easy to recount challenges such as the politicization of ESG and valuation compression in clean-tech companies, but there were also a few positive structural developments that should provide a more stable foundation going forward. While we expect an improved foundation, the road will likely remain bumpy heading into the presidential election in November, creating both risk and opportunity for investors. 

The big story from 2023 was the politicization of ESG at both the federal and state levels, a dynamic we covered in our July webinar. As we noted then, confusion around ESG had been building for a long time and spilled over into the mainstream media over just the last couple of years. While there are other contributing factors, a significant driver of that confusion is the lack of standards around reporting and language used by the investment industry. Encouragingly, there have been several developments in recent months. 

The first big breakthrough was in June with the launch of corporate sustainability disclosure standards from the ISSB, a division of IFRS, the international accounting standards setting organization. The launch of ISSB standards will reduce the number of reporting frameworks that corporations have to contend with, driving efficiency, improved consistency, and comparability across corporate reporting as standards are adopted. 

The second breakthrough in November was the launch of sustainable investment approach definitions from the CFA Institute, the GSIA, and PRI.  Inconsistent use of terms such as SRI, ESG, and ‘impact’ has been one of the core drivers of confusion both within and outside the investment management industry. As we note often, ESG integration is about risk management within an investment process, something very different from exclusionary screening based on values (SRI) or thematic emphasis intended to capture growth opportunities.  The CFA Institute definitions represent an important first step to create consistent communication around approaches that have distinct risk and return characteristics, implementations, and objectives. Creating transparency and consistency in corporate reporting and clear delineation between sustainable investment approaches should help reduce confusion for investors. 

The other major topic in headlines, particularly in the second half of 2023, was valuation compression of clean-tech related companies. As noted last quarter, private manufacturing construction spending trends have accelerated over the last two years as clean-tech related supply chains are developed in the US. Much of this is early stage with construction work lasting quarters or years. The outlook for businesses tied to this growth remains attractive, with expected multi-year annualized earnings growth of the S&P Global Clean Energy (SPGCE) Index above 12%, more than double the rate expected for the broad market. A combination of high interest rates and a slow and staggered rollout of IRA incentives have contributed to lower valuations in the clean-tech space. The SPGCE trades at 12x forward cash flow compared to the S&P500 at just over 14x. Part of this discrepancy is clearly related to the outlook for 2024. 

As we look forward to 2024, there are five items we expect will be top of mind for sustainable investors. 

First, there will be continued work on the regulatory front globally to launch and refine reporting requirements for corporations. In Europe, the EU Sustainability Reporting Standards, aligned with ISSB, have been adopted and will be a requirement for large, listed companies for 2024 reporting. In the US, California issued climate disclosure laws in October with reporting starting 2026. The SEC is expected to release final climate risk reporting requirements early in 2024. While there will be political blowback around final SEC rules, US corporations generally will be better off with a clear US standard that will supersede state-level and international reporting regulations. 

Second, data providers are expected to launch analytics to aid investor efforts in better assessing climate target credibility. Companies such as MSCI and Bloomberg are working to improve comparability of company-level climate targets and roadmaps, with transparency into drivers of decarbonization and action on past targets.  This level of detail will help investors separate companies taking real action from those less likely to hit targets. 

Third, while climate remains a central consideration for sustainable investors, the launch of final Taskforce on Nature-related Financial Disclosures (TNFD) recommendations in September of 2023 should lead to a broader focus around risks and opportunities tied to natural capital and biodiversity in 2024. As with climate, data providers are expected to launch more tools for investors to assess nature-related risks and opportunities. 

Fourth, and perhaps most importantly, the industry will hang on every shift in polls heading into the election in November. Government support for a more sustainable future is at stake. While there will be a tremendous amount of noise in 2024, we remain confident that in the end money and economics will matter and the IRA will stay largely intact even in a Republican sweep. This view is based on the flow of investment into GOP-led states, where supply chains of the future are being built and jobs are being created.

Lastly, we see a compelling opportunity in companies focused on environmental sustainability. Political noise will create volatility in this part of the market, though with the view that the IRA stays mostly intact, revenue and earnings growth should be well supported. A combination of strong growth and attractive valuations make clean tech-related companies worth watching in 2024.

Alternatives Overview: A Year of Frozen Markets

Fundamentals across most asset classes were solid in 2023, but valuations were negatively impacted by higher financing costs. Buyers desired lower valuations to compensate for higher interest expenses and sellers generally didn’t want to accept lower valuations, which led to relatively frozen markets in 2023. Quarterly private equity transaction volumes were down 47.9% through the third quarter from the peak in the fourth quarter of 2021 according to Pitchbook. The lack of transaction volume was a theme across venture capital and real estate as well.

• Private Equity: PE portfolio companies are their most leveraged at acquisition, with subsequent growth expected to facilitate deleveraging to the point where they are ready for sale to the next buyer, who may start the cycle of leverage anew. As interest rates have been the key negative factor, the companies most impacted are the excessively valued and leveraged buyouts from 2020 and 2021. Deals from earlier vintages that deleveraged and benefited from the accelerated growth during COVID have largely performed well, even if exits remain elusive.
• Venture Capital: Early-stage companies are the riskiest because their business models, products, and end-markets are largely unknown. As these businesses progress from early- to growth-stage, they typically require capital until they can achieve scale and become self-funding. With greater macroeconomic uncertainty, investors were cautious to deploy capital at the pace seen in recent years and deals that were consummated were for either the best companies or those that needed capital to avoid reckoning. As a result, dispersion was high with AI companies being notable winners.
• Real Estate: Though fundamentals in most sectors excluding office were strong, valuations in real estate were challenged in 2023. The accelerated adjustment from the lofty valuations of 2020-2021 is occurring as many buyers financed themselves with relatively short-term debt. As this debt comes due in an environment with more conservative lenders (putting up less capital), the owners of these properties either need to find additional sources of debt or put up additional equity, even for properties otherwise performing well. For fundamentally underperforming office assets, owners have started handing keys back to lenders instead of putting good money after bad.
• Private Credit: Private credit had an excellent year in 2023 as many of the concerns around consumer and corporate credit stress did not materialize, even if cracks were evident on the margin. In fact, while other asset classes struggled, private credit was a direct beneficiary of floating rates. For context, in 2023 senior lenders to real estate earned 10%+ and senior lenders to middle market corporates earned 11%+. More junior/mezzanine lenders generated returns of 15%+.

2024: Thawing Conditions Across Asset Classes

The alternatives flywheel is currently broken: managers are behind targets with respect to exits and cash distributions back to investors. In response, investors have slowed and reduced their commitments to new vintages. Accelerated economic growth, higher public equity valuations, open capital markets and/or lower interest rates are the quick fixes that could reaccelerate the flywheel, but the path may meander more than originally anticipated. Those with capital to deploy continue to have an above-average opportunity set, provided that they can close transactions.

• Real estate transaction activity is expected to pick up materially in 2024, with almost $700 billion of commercial real estate debt maturing (Morgan Stanley). The mantra ‘Survive to 2025’ has pervaded the market, with hopes that interest rates may decline to levels that are broadly supportive of valuations. After a quiet second half of 2023, we expect to see a broad opportunity for lenders to capture highly attractive risk-adjusted returns and for opportunistic buyers to achieve attractive entry points. Buying fundamentally strong assets from stressed/distressed sellers has historically been a rewarding enterprise.
• Private equity deal volumes should pick up, but sales are expected to remain focused on only the highest quality assets that can command premium valuations. GP-led secondaries (referred to as Continuation Funds in the chart below), where secondary investors buy an asset from a sponsor’s earlier vintage alongside that sponsor to provide liquidity to prior LPs, should be robust in 2024. In addition, more opportunistic strategies that have maintained their transaction volumes through corporate carveouts and debt acquisitions appear to have an attractive and growing opportunity set in 2024.

• The venture capital flywheel is likely to be the slowest to restart. While there is tremendous excitement about AI, the broader venture capital space is waiting on the IPO window to open. Managers want to show their investors that attractive long-term paper gains can be turned into realized profits. While our baseline expectation is that there will be some exiting venture IPOs in 2024, demand for capital is still higher than supply and as such new investors will continue to dictate favorable valuations for themselves, often at the expense of prior investors.
• All indications point to continued strength of absolute returns in private credit. Economic conditions, interest rates and spreads are likely to migrate throughout the year, with the general expectation for some additional degradation in credit to cause a pickup in losses. While credit losses were low in 2023, the market saw a pickup in delinquencies and utilization of Payment in Kind features, which enabled creditors to conserve cash. The path of the economy will dictate the magnitude of changes in key credit variables from here.