2023 turned out to be a good year for stock and bond investors, although the paths to achieving returns differed. The S&P 500 Index began the year positively before pulling back in March when Silicon Valley Bank, among others, ran into trouble. It then rallied through the end of July before correcting after bond yields rose to multi-year highs. The Ten-Year Treasury Note briefly touched five percent, up from less than three and a half percent in early May. Stocks went on a broad-based rally over the last nine weeks of 2023 with the S&P 500 up each week.
Bond prices also rose to start the year, but fell over the summer and early fall. While the Bloomberg Aggregate Index (“the Agg”) and the Bloomberg Intermediate Index finished the year up more than five percent, there was a substantial part of the year where investors would have been better off in cash. The Agg was down as recently as October despite the strong first quarter performance. As with stocks, bond prices rallied sharply in the fourth quarter to end up more than five percent.
The S&P 500 Index ended the year up 24.23%. However, the gains were concentrated in the information technology, communication services and consumer discretionary sectors which each rose over forty percent. The “defensive” consumer staples and utilities sectors fell in 2023. The energy sector also declined along with oil prices despite an increase in geopolitical concerns. More sectors took part in the strong fourth quarter rally. Five S&P 500 sectors outperformed the index, and three of the fourth quarter laggards combine to make up less than ten percent of the Index’s market capitalization. In other words, the rally broadened out in the fourth quarter.
Large capitalization equities outperformed small and mid-capitalization stocks, although the S&P Midcap 400 and Russell 2000 rose 14.45% and 15.09%, respectively, in 2023. The S&P 500 also outperformed international stocks. While the MSCI EAFE was up 15.03% for the year, the MSCI Emerging Markets Index only increased 7.04%. However, China dragged down the Emerging Markets Index. The MSCI Emerging Markets Ex China Index was up approximately twenty percent.
Bond investors suffered through historically bad returns in 2021 and 2022. 2023 may have been a transition year. Inflation looks to have peaked and is coming down faster than most market watchers expected. Investors in most fixed income sub-asset classes earned at least five percent for the year. Investors in higher risk debt categories such as high-yield bonds and emerging market debt earned more than ten percent.
Treasury Bill yields rose approximately one percent in 2023 thanks to four Federal Reserve Rate hikes. The intermediate and long-end of the Treasury curve followed the Fed Funds rate higher before falling in the fourth quarter. The curve is now deeply inverted. Short term Treasuries yield materially more than the long end of the curve. Intermediate Treasury securities saw their yields jump over one percent last summer before ending the year close to where they started. The Thirty-Year Treasury Bond nudged up slightly from 3.96% to 4.03% after getting as high as 5.10% in October.
It was another good year for gold. The yellow metal rose 11.60% in the fourth quarter and 13.10% for the year. On the other hand, 2023 was not as good a year for oil. Oil prices fell 10.73% in 2023 despite the continuing war in the Ukraine. In fact, oil prices fell 21.08% in the fourth quarter despite the turmoil in the Middle East. The CRB BLS Commodity Index also fell in 2023, consistent with broad inflationary pressures waning.
A Strong Year for Equities
2022 saw equity markets correct, bonds sell off and most market technology and growth companies enter bear markets, while energy and value outperformed. 2023 saw markets return to the post-GFC trends with technology, internet and consumer discretionary stocks outperforming while value stocks lagged. Artificial intelligence, strong economic growth, and reasonable valuations to start the year combined to drive the S&P 500 higher. Most bull markets have at least one big theme, and in 2023, that theme was AI. Stocks that were generating rapid growth in their AI offerings did well, while stocks that were presumed AI winners who did not see enough revenue acceleration lagged at times. The fourth quarter saw stock market gains broaden to underperforming sectors and smaller stocks.
Looking Ahead for Equities
2024 could be a different story. The information technology and communication services sectors both jumped more than fifty percent in 2023 and their valuations reflect this. NPP does not believe that large technology companies are in a bubble, but it is hard to argue that they are cheap. The risk of a recession is elevated, and it is likely some or all of them will pull back if a recession occurs. NPP thinks it makes sense to trim your winners in favor of other high-quality companies that have not performed as well. This does not mean the tech leaders should be sold in their entirety. Their balance sheets remain fortress-like, and they should outgrow the economy in the long run. We are still positive on large cap tech. However, taking a little bit of the gains off the table may make sense after a fantastic 2023.
Investor positioning could be another headwind in 2024. Sentiment has improved and equity exposure has jumped since the end of 2022. This does not mean equities are due for a bad year. However, there is less cash on the sideline and the likelihood of gains as strong as 2023 is low.
Bonds Rebound in 2023
2023 was an interesting year for bond investors. Investors who owned the Agg earned 5.53% for the year, but the returns were not linear. The Index jumped almost four percent through February 2nd, but was down 3.44% through October 19th when the Ten-Year Treasury neared five percent. Just when things looked bad for long-term bond investors, the investing backdrop changed. The Fed’s mantra of higher for longer disappeared as the inflation data improved and the labor market loosened a bit. The Ten-Year Treasury closed the year at 3.88%, compared to 3.87% on December 31st, 2022. Investment grade and non-investment grade credit investors also did well in 2023 outperforming the Agg in 2023.
We think the risk skews positively for investment-grade bond investors in 2024. Interest rates exceed inflation with inflation trending lower. Investors worried about inflation risks throughout the majority of 2023. Now, recession risks are a bigger fear. A recession will cause the Federal Reserve to cut short-term interest rates, while yields are likely to fall for most Treasury durations. Even in a soft landing the Fed will likely cut rates due to soaring real yields and greater worries about a somewhat looser labor market. Bond investors should favor quality in 2024. NPP believes that bond investors should earn at least their coupon 2023 as inflation fades from the headlines.
Economic Data Diverges from Consumer Confidence Indicators
GDP growth was strong, labor markets remained tight although they have loosened, while inflation data improved in 2023. In other words, the economy performed well last year. Nevertheless, soft data such as consumer confidence data and future expectations have lagged. Why has this happened? There are a couple potential causes of this. The employment data is still historically strong, but the average person is struggling with higher prices despite a steep drop in the rate of change. Even if the annual inflation rate comes down to the Federal Reserve’s two percent target, the level is above trend after the two-year bump in the inflation rate. Other potential causes of the lagging confidence data and weak survey data could be psychological. COVID took a huge toll on the country. It is possible there are still lingering effects that dampen confidence. Moreover, the United States is ideologically split, and partisanship runs high. This too may have contributed to the decline in consumer confidence.
There is another possibility. Reported data sometimes stays strong until a recession or slowdown hits. There is a chance weak confidence data is sensing a recession around the corner. However, several indicators have ticked up recently. Confidence was falling the last two years despite an economy that continued to grow and create jobs as higher inflation took a toll. NPP thinks that lingering effects caused by the step up in price levels was the main reason for this divergence, but there were certainly other factors in play.
The outlook for the economy in 2024 is mixed. There are good reasons why a recession is being predicted by forecasters, but the case for a soft landing is also reasonable. There are several indicators or risks that point to an elevated chance of recession. Commercial real estate, specifically office real estate, could be a problem for the economy in 2024. Consumer credit card delinquencies are rising and any uptick in unemployment could worsen the problem. Overseas, Europe and China have weakened due to a variety of factors. Additionally, domestic indicators including the LEI, M2 growth, and an inverted yield curve point to an elevated risk of recession. However, these and other indicators have predicted an imminent recession that has yet to materialize.
There are several reasons the recession that so many people, including NPP, predicted did not occur in 2023. The government has run extremely large deficits since COVID began. The excess spending has likely helped the economy in the short run while leaving more debt on the government’s balance sheet. While the economy avoided recession last year, many industries did not. Housing starts contracted from 2022 highs, but they may have bottomed. Semiconductors moved from not enough, to a glut and back as overordering transitioned into high demand created by AI. In short, some of the industries that often foretell a recession have already experienced one. M2 (a measure of money supply) has been contracting since July 2022, but the absolute level remains above its long-term trend. Despite a drop in M2, high home and stock prices have buffered consumer comfort amongst asset owners. More importantly, the slightly looser labor market remains historically tight. If consumers are employed, the likelihood of a recession is low even if confidence lags.
NPP does not have a strong conviction regarding whether a recession will occur in 2024. We do not think a mild recession is something to fear or make major adjustments for. What we are watching, and are always on the lookout for, are major economic excesses or signs of financial market stress. As of now, we agree with consensus that if a recession occurs next year, it is likely to be mild. For all the pessimism on the economy, NPP does not think it is time to become overly cautious. Focusing on what can go wrong ignores what can go right. Artificial intelligence could be a game changer for the economy even if that is already priced into current stock prices. AI could lead to a step up in productivity growth which would likely lead to faster economic growth, higher incomes, and accordingly, higher corporate revenues and earnings. This would be bullish for equities.
The S&P 500 is less than a percent from its prior closing high reached on January 3rd, 2022. Valuations are full at the index level, but many stocks are reasonable after experiencing bear markets. We think the market rally will broaden in 2024, but that the percentage gains in 2024 will be significantly less than 2023 with more market volatility. Investors should remain focused on quality and earnings but should diversify their holdings if they are too concentrated in recent winners. Large cap tech should be a long-term winner, but the chance of a pause is higher than normal in 2024 after a phenomenal 2023. NPP believes that bond investors are set up for another good year. We expect inflation to continue to fall, and growth to slow. Historically, this is a favorable outlook for investment grade credit. In sum, we think investors should tilt slightly toward safer assets such as cash, investment-grade debt, and gold.