By Ellen Hazen, CFA®, Chief Market Strategist

December Takeaways:

• The labor market continues to glide to a soft landing. New jobs created in November (reported in December) were 199,000, better than the 185,000 expected. This continues a string of strong but decelerating jobs reports and has underpinned our rationale for economic strength all year.
• Inflation continues to decelerate, also supporting a soft landing. Similar to the labor market, November inflation decelerated a bit from the October reading. The combination of lower food, energy, and services prices underpinned a Consumer Price Index (CPI) reading of 3.1%, down from 3.2%.
• The Federal Reserve held interest rates steady at the December Federal Open Market Committee (FOMC) meeting and indicated that rates are unlikely to increase from here. Indeed, in both the published statement and the press conference, the committee made clear that it is discussing rate cuts in 2024. The market is currently pricing in six cuts of 0.25% each during 2024.
• Longer-term interest rates declined, leading to positive bond returns for the month. The 10-year Treasury bond yield declined from 4.2% at the beginning of December to 3.9% by year end. This capped a notable turnaround in bond performance – as of the end of October, the Bloomberg US Aggregate Bond Index return was negative 2.8%, causing investors to worry that the index would have negative returns for a third straight year. By year end, after the strong November and December rally, the index had climbed to a positive 5.5% return for the year.
• Risk-on assets significantly appreciated. Small capitalization stocks shone in the month, with the S&P Small Cap 600 Index returning 12.8% in the month of December, handily outpacing its larger S&P500 cousin, which returned only 4.5%. Mid-sized stocks also outperformed; the S&P Midcap 400 Index returned 8.7% in the month. However, this did not come close to offsetting the previous eleven months’ underperformance. For the year, while the S&P500 appreciated by over 26%, the small and mid-sized equity indices each returned only about 16%.
• Corporate bond spreads narrowed. Investment-grade spreads over Treasurys tightened from 1.39% to 1.34% in the month, again reflecting risk-on sentiment. Similarly, the spread of high yield bonds over Treasurys tightened from 4.1% in November to 3.7% by yearend.

What We Are Watching in January and 2024

• Earnings, earnings, earnings. Companies will start reporting fourth-quarter earnings during the second week of January. Right now, analysts expect that Q4 2023 earnings will be 0.6% higher than Q4 2022, and -7.0% when compared to Q3 2023.
• Most companies will use their fourth quarter earnings conference calls to broadcast what they believe they will earn in 2024. Currently, analysts expect 10.8% earnings growth in 2024 for the S&P500 (down from 12% a few months ago), and 8.5% earnings growth for the S&P Small Cap 600 Index.
• Economic Data
  • New jobs added in the month of December will be reported on January 5. Consensus is for 170,000 new jobs, a bit below November’s reported additions.
  • Inflation. CPI will be reported on January 11 and the PCE on January 26. Economists are expecting a slight uptick in CPI, to 3.3%.
• Fed meeting January 30-31. Right now, markets are pricing in no cuts or increases at the January meeting. We believe that the markets have it right this time; we do not anticipate any changes for several months. This could change if underlying economic data materially changes.

Interpreting November and December – and what it means for 2024.

The markets correctly sniffed out the “Powell Pivot” – the mid-December meeting when the Fed turned dovish – six weeks ahead of time. Why do we say the market correctly sniffed it out? For the first ten months of the year, there were two driving forces in the markets. The first was stubbornly high interest rates and attendant negative bond returns. Not only did the Fed increase short-term rates by 100 basis points during 2023, but the long end of the curve increased as well. This rise reflected investors’ belief that inflation would remain high and led to bond market losses for the year up through October. The second driving force was the very narrow equity market. Only a handful of stocks – generally, those perceived to be positively exposed to artificial intelligence – rose more than the overall market averages. Growth stocks outperformed value stocks, and large-cap stocks outperformed their smaller brethren.

In November and December, this all reversed. Small- and mid-cap stocks started to outperform, as did value stocks. The narrow market broadened, and rates plummeted.

For the first ten months of the year, both the equity and fixed income market dynamics reflected classic late-cycle dynamics. Late in an economic cycle, growth, quality, and size tend to outperform in the equity markets, while value, cyclicals, and smaller companies tend to underperform. Similarly, the inverted yield curve reflects assumptions that a recession is imminent.

The November-December market action exhibited dynamics more akin to a mid-cycle economic expansion. Smaller and riskier stocks outperformed while growthier stocks gave back some relative performance –which partly eased their stretched valuations. It’s as though the Fed’s apparently skillful handling of rates and inflation turned back the economic cycle clock, giving risk assets a new lease on life.

We believe that this will continue into 2024. If the economy continues to slow gradually, but does not slow so sharply that it tips into recession, then risk assets are likely to continue their November-December trajectory. Importantly, there is more broadening to be done. Although those two months saw unloved portions of the market begin to catch up, they remain far cheaper than history, and far cheaper than the Magnificent 7 stocks.

Reflecting on 2023

2023 was a year that most experts got wrong. Economists forecasted a recession that never occurred.  GDP for Q3 was a robust 5.2% and for the full year looks to be about 2.4%, numbers that are far from a recession. Market analysts forecasted a stock market decline, but instead the S&P500 appreciated by 26%. Fixed income analysts forecasted continued high interest rates and flattish bond returns – but the 100+ basis point interest rate decline in the fourth quarter drove strong positive returns in fixed income.

We were correct about some things and incorrect about others. We expected equity volatility in early 2023 – this did not occur; instead, the market went straight up. On the other hand, we were early and correct in noting that a recession was unlikely given the strong labor market. Some wins, some losses. To get the 2023 equity market entirely correct, an observer basically would have had to predict that AI mania would drive the valuations of seven stocks unusually high, while other growing companies’ multiples would languish.

Thoughts on 2024

Rather than belabor our (and others’) mistakes, or celebrate our (and others’) correct predictions, though, experience guides us to ask a different question. Instead of pondering, “Will a recession occur in 2024?” or “Will interest rates rise this year?” or even “What will equity returns be in 2024?” the more important question to ask is “Given the levels at which various asset classes are valued today, what are the most attractive investment opportunities for our clients across a range of likely or plausible economic scenarios?” All investors are fallible, as we saw this year. We cannot control or necessarily even predict what the markets will do. Even if we correctly forecast corporate earnings using our spreadsheets and reasonable input assumptions, market returns may diverge widely from expectations simply due to price-to-earnings multiple expansion or contraction. What we can do – and what we focus on doing for our clients – is strive to invest assets wisely, knowing that outcomes can be unpredictable.

So, where are the opportunities for 2024? We observe both expensive and inexpensive sub-asset classes across the board. International stocks are cheap. Small cap stocks are cheap. Bonds are fairly valued, indeed more attractive than they have been for years. Many individual stocks look expensive to us, and we have been trimming them. Timing is difficult, though—just because an asset class is expensive today does not mean that it will underperform other asset classes from here, especially within a specific timeframe. Some of the artificial intelligence-related stocks started off 2023 expensive, and then got much more expensive. Similarly, just because an asset class is cheap does not mean that it will outperform by the end of this calendar year. It does, however, mean that over a suitably long period of time, an investor’s chances are better than if they take the opposite approach.

Disclosures