Investment Outlook, December 2023

December 20, 2023

With 2023 almost behind us, the U.S. economy has avoided the potential recession that dominated headlines a year ago. Our Federal Reserve continued to hike interest rates aggressively even as inflation declined, the employment market held up, and consumer spending supported our economy. In addition to these economic trends, investors also navigated bank failures last spring, continued Ukraine uncertainty, and, most recently, unrest in the Middle East. Despite higher prices and higher costs of capital, most U.S. companies saw the bottom in operating margins, and began reporting improving earnings. Looking forward, we expect solid, continued economic improvement in 2024.

Real GDP growth for Q3 came in above 5%— a strong reading for any period, let alone after 15 months of the Fed attempting to slow the economy. While Q4 growth is trending lower, full-year 2023 real GDP is estimated at 2.5%— well above its pre-Covid average of 2.1%. This level does not signal an impending slowdown, and, in fact, we see 2024 growth at a similar level. If any weakness from the restrictive impact of high rates appears, we expect the Fed to react quickly, cutting interest rates to support economic growth.

Even more fundamental to our economic outlook, we have seen inflation steadily decline this year— as has every other global economy that experienced a pandemic-related spike in inflation. At the latest reading, inflation has dropped to just over 3% (4% excluding food and energy). This is down from over 6% in February, yet still well above the Fed’s 2% target. Since supply chains have fully eased and the energy price spike has fully reversed, we do not expect easy future declines in the inflation rate. China’s economic struggles have also helped keep global inflation stable, as China’s strength often defines the pace of global growth. For inflation to move lower, it will likely require higher U.S. productivity and/or lower wage growth. Still, 3-4% inflation with 4% wage growth sets a solid foundation for future U.S. economic growth in which workers, savers, and investors can prosper.

The continued decline in inflation has coincided with a sharp rally in the bond market, pushing yields lower. After 10-year Treasury bond yields briefly touched multi-decade highs of 5% this fall, bond yields across maturities came down meaningfully. The decline strengthened as the latest comments from our Federal Reserve increased investors’ confidence that interest rates will start to come down in 2024. After the historic decline in bond prices in 2022, the recent rally is moving bond yields of all maturities back to levels consistent with a future of normalized economic growth. We do not see long-term rates returning to the past decade’s 1-2% levels, and this is good news for savers and income investors.

Despite investors sharing their feelings of uncertainty throughout this year, the S&P 500 is now up over 20%. Adjusting for the outsized influence of a few over-weighted stocks, even the equal-weighted S&P 500 index is up over 10% this year, building back wealth for most portfolios. Investors are just starting to embrace the strong year-end rally and now worry the market might be overheated. We are not overly concerned. See below how different industries within the market have done so far this year:

Is it surprising that four market sectors have yet to earn a positive return in 2023? While your portfolio has benefitted from owning Apple, Microsoft, Nvidia, Netflix, and Amazon this year, we have also been buying attractive investments in Health Care, Financials, and Consumer Staples— areas of the market that have not participated as strongly in the market’s strength and we believe have attractive appreciation potential into 2024.

We remain optimistic about the health of this economic expansion. We’re heading into an election year, which tends to cause short-term market volatility as campaign rhetoric is digested into potential fiscal policy changes. Yet despite this potential headwind, we believe broader market participation is on the horizon as potential interest rate cuts comes into play. As always, we will take advantage of any long-term opportunities that arise in the equity markets and lock in attractive yields in the bond markets for clients who need fixed income exposure.

We wish you a happy, healthy, and prosperous 2024!

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