Market Update January 2024

Contributing Authors:
Jeff Moeller, Head of Investment Analysis
Josh Tucker, Investment Analyst

Over the last two months of 2023, the S&P 500 jumped 16%, small stocks leapt 24%, and yields on the 10-year Treasury dropped from 5% to almost 3.8%–huge moves in a short period. This optimism grew from lower-than-expected inflation data reported for October, followed by the Federal Reserve’s announcement in December that it believes we are near the peak in the fed funds rate, potentially setting the stage for rate cuts next year as the economy slows in a manageable way (a “soft landing”).

Compared to the pessimism of investors earlier in the fall, where both stocks and bonds slid meaningfully on concerns about rising rates, persistent inflation, and a possible “hard landing,” this was a dramatic reversal in expectations.

We’ll provide our updated view on the markets and the economy in this report, but first we put the October news and volatility in context.

Forecasts, Volatility, and the Importance of Diversification

For context, investors’ attempts to forecast rates, recession, and recovery have dominated markets for the past three years, whip-sawing market prices in historic fashion as predictions come, go and change. October was no exception.

This volatility highlights how inaccurate most forecasts are and how hard they are to make reliably and consistently. This is why a diversified portfolio is so important for most investors. Trying to make investment allocation decisions by anticipating market direction, particularly in this uncertain environment, is a recipe for poor performance.

Ironically, despite the ongoing volatility, cumulative market performance for stocks over the past three years resembles more normal, long-term levels. Annualized performance of the S&P 500, the Nasdaq 100 (Big Tech), and Large Value stocks is 9.5%, 9.2%, and 8.6%, respectively—essentially overriding the swings if you simply stayed invested.

A Better Guide: Recognizing Measurable Extremes

We believe a better approach is to look for objective indicators of pricing extremes. It helps us build portfolios with the proper risk-return profile for clients as conditions evolve.

Currently, here is where we see the important opportunities and risks, from an investment perspective:

• In equities, we believe small and mid-sized stocks offer some of the best long-term potential in public markets, for patient investors. They have lagged large stocks by historic levels over the last five to ten years but that doesn’t persist historically. They would admittedly struggle in recession, however; we would use weakness to add to these positions.
• From a style perspective, we see better relative opportunity in core and value rather than growth. Historically, these styles move in broad cycles, and growth has dominated recently. Each style plays a role in our diversification strategy, but we recommend above-average exposure to core and value given current dynamics.
• For fixed income, improved yield on investment grade bonds (particularly in government, CDs, and agencies) makes them extremely attractive under most scenarios. With recession a wildcard in 2024, we use a barbell approach to Treasuries—blending short-term maturities at very good rates with longer-term bonds if rates continue to fall.
• In contrast, credit spreads for fixed income in areas like high yield are not yet attractive enough to include on a broad basis—they are priced too optimistically. We recommend waiting for weaker economic data, which usually creates better entry points.
• Alternative investments in commercial real estate and private credit became less attractive as high-quality yields increased 12-18 months ago. We may revisit those groups depending on how rates and the economy evolve.

What Might 2024 Bring?

Here’s our quick assessment:

• It is reasonable to believe the Fed is at or near the peak of its policy rate. The Fed increased rates at the fastest clip in history. Key inflation indicators are now down, and the economy is showing signs of slowing.
• For much of 2024, we believe these trends will persist, resulting in lower inflation and interest rates by summer. Whether the economy has a hard or soft landing is a wildcard, which we discuss below. We think rolling recessions are most likely, which means current markets may be too aggressive on how far rates will fall.
• Longer-term, we believe there’s a risk to a resurgence of inflation, meaning that the five-year projection of 2.4% by bond markets may be too aggressive. We have TIPS in portfolios, as appropriate, as a hedge for this outcome.

Impact on Financial Markets once the Fed Stops Raising Rates

How stocks and bonds perform as we reach a peak on policy rates depends on whether there’s a recession, or how severe it is.

According to Oxford Economics:

• Without recession, stocks on average are up over 20% in the 12 months following the last rate hike.
• With mild recessions, returns remain positive but fall closer to 5-10% after 12 months.
• With a severe recession, returns in equities are typically negative for much of the year, although they tend to recover after 12 months, up on average around 10%.

We have been concerned about the risk of recession for 12-18 months. History offers ample evidence: the persistent weakness of leading economic indicators, combined with an inverted yield curve and a rapid rise in interest rates, typically portends economic weakness within 12-24 months—possibly putting the timing of recession between now and summer. Bond markets arguably agree to some extent—yields are lower and futures markets expect up to six rate cuts in the next 12 months to offset weakness (which implies expectations of a “hard landing” in our view).

That said, jobless claims and delinquencies are still low; we would expect them to be rising if recession were imminent. Plus, the recent fall in rates should help improve liquidity for banks and better terms for borrowing by businesses, supporting economic activity.

Bottom Line

In our experience, financial markets tend to look six to twelve months ahead, trying to gauge where rates, inflation and growth will be. The past three years show these predictions have not been reliable or consistent, contributing to considerable volatility.

Currently, markets are becoming optimistic that rates have peaked and inflation is coming under control. We think they are correct on that score. We believe there is vulnerability, however, on how far rates might fall or how much the economy slows. A severe recession would likely spook equities—although they recover over time—and reward bonds in 2024, while a softer landing would broaden the equity rally and dampen enthusiasm for bonds. We believe we have positioned portfolios to navigate these uncertainties, consistent with client risk profiles.

We continue to expect volatile financial markets and look to use our disciplined approach to rebalance and reposition portfolios as opportunities and risks unfold.