As 2023 draws to a close, let’s review the stock and bond markets’ performance and the economic factors that will shape them in 2024. Investors were rewarded if they re-filled their equity allocations at the end of 2022. The S&P 500 experienced near double-digit growth through the first three quarters after declining 18% in 2022. The bond market is likely to provide investors with flat to slightly negative returns in 2023. If bond returns end up negative, it would be an unprecedented three years in a row of losses. The traditional 60/40 allocation bounced back in 2023 after its second worst year (2022) in the past 50 years. The question investors are asking: Will the “inevitable” recession finally come in 2024? We think the possibility exists, but it is not a certainty.
Interest rates climbed higher in 2023, led by sharp increases in longer duration bonds. The Federal Reserve appears to be near the end of the current rate hiking cycle. The market is undecided on whether the next Fed move is an increase or a cut in interest rates. Interest rates on longer maturing bonds have breached 15-year highs and offer investors an opportunity to lock in relatively attractive forward expected returns. There are now plenty of options for the 40% in the 60/40 portfolio.
There is less certainty in the direction of the stock market. Prices follow earnings over the long-term. However, there are periods where prices overshoot or undershoot earnings. Inflation and interest rates are other factors impacting prices. In 2023, inflation has continued its downward trajectory; however, longer term interest rates rose more than forecasted. Earnings have been better than expected (or better than “feared” for the bearish crowd). For the first time in decades, interest rates have led bonds to become a viable alternative to stocks. The sustained elevated rates force the math to change on what is a “fair” price to pay for stock earnings. It is our belief that this valuation reset between bonds and stocks continues to be a driver of uncertainty on where the stock market is headed.
What about inflation and worries of recession? It appears the market has moved on from its worrying about inflation. Consumer Price Index has remained under 4% since May and remains largely driven by services and shelter. Home prices remain elevated, even amidst near 8% mortgage rates. New home construction remains well below 2006 levels (1 million fewer homes being built). We are building the same number of homes as we averaged in the 1960-70s (just before the baby boomers were buying their first homes) yet the United States has a population that is twice as large. There was an accompanying spike in new home building to accommodate demand from baby boomers; however, there has not been the same response for the 70 million millennials looking to buy a home. With record low selling of existing homes, housing is likely to remain an issue that needs to be addressed.
On the recession front, Chair Powell has slightly opened the door to the possibility of a “soft landing” but continues to deliver the message the Fed will keep monetary policy restrictive until inflation is vanquished for good. Wage growth has slowed throughout the year, which has been good for the Fed. Employment is up over 2 million jobs. This was not supposed to happen since the Fed indicated they expected 2 million people to lose their jobs as a result of interest rate increases. The Fed must be surprised at how well the economy has absorbed 5.25% of interest rate increases over the last 18 months. In fact, 3rd quarter GDP came in at 4.9%, the highest growth since 2014 (outside of the post-Covid bounce back, which was abnormal). We continue to believe businesses and households can adapt to higher rates, given enough time.
Despite these worries, your financial goals should remain the most important factor to consider when looking at your investments. If you are just beginning to invest or are in your prime earning years, you should embrace the opportunity to buy stocks at lower prices. If you are in retirement, your bonds are finally offering yield. When working with clients in or close to retirement, we point to their total cash and bond investments as the next X years of spending. This ballast is different for each client, but important in maintaining a large enough equity allocation to support those later years of retirement. Bottom line, now is the time to review, not abandon or drastically alter your asset allocation.
Andrew Messerschmidt, CFA, is an Investment Officer at Cedar Rapids Bank & Trust. His direct line is (319) 743-7136.