Coming into 2024, global financial markets are at an inflection point. U.S. 10-year Treasury rates have fallen from the 5.0% October 2023 peak to just under 4.0%.1 Stocks have rallied aggressively, with U.S. equity market indices close to or, in the case of the Dow Jones Industrial average, at all-time highs. Fear of a looming recession in early 2023 has been replaced by optimism the Federal Reserve has beaten inflation and engineered a rare “soft landing” for the economy.
In their December meeting, the Fed penciled in three rate cuts in 2024, but left the door open to raising rates again if necessary. Financial markets reacted to the changing Fed sentiment with strong fourth quarter rallies across many market segments. The S&P 500 index gained 11.7%, the Bloomberg U.S. Aggregate Bond index rallied 6.8% and gold posted a 10.2% return.1
Economic demand and inflation data are both expected to soften in 2024. However, market expectations are quite high. Based on current interest rates, bond investors are expecting six rate cuts this year with the first cut beginning in March.2 Overzealous investors have driven interest rates too low. We expect the Fed to follow their forecast delivering three cuts in the second half of 2024. Markets have consistently overestimated the Fed’s rate decisions since the tightening cycle began. This time is no different.
Equity markets advanced on the heels of falling interest rates as P/E multiples expanded. The S&P 500 index is trading at 19.9 times forward 12-month earnings estimates, up from 16.7 times in January 2023.3 This is well above its long-term average of 15.6 times. The S&P 500 index returned 26% last year. Over 75% of that return was due to multiple expansion. Clearly, bad news on the economic front and/or rising interest rates will hurt equity market returns. We expect muted return for stocks in the first half of 2024.
Magnificent Seven
The term FAANG was coined in 2013. The acronym described five companies whose outsized returns were powering most of the S&P 500 Index’s return. Companies included were Meta Platforms (formerly Facebook), Amazon, Apple, Netflix, and Google.
Today the group is called the Magnificent Seven and is made up of, META, AMZN, AAPL, GOOGL, MSFT, TSLA, and NVDA. As a group, these stocks were up 76% in 2023. Conversely, the remaining 493 companies only managed a 13% return.4 It is interesting to note that this outsized performance in 2023 was reversed in 2022 as these stocks significantly underperformed. Over the last two years, the performance difference is 2%.4
The performance and concentration of the S&P 500 has been compared to the dotcom trend in the late 90’s. But the duration of the Magnificent Seven trend, and their impact on performance may be closer aligned with the “Nifty Fifty” stocks of the 1950’s and 60’s. This group of companies were believed to be the best companies in the U.S. Their fundamentals and management teams were never questioned. Investors believed nothing could go wrong and there was no price too high for their shares. In 1972, these stocks traded at P/E ratio of 42x while the overall S&P 500 was trading at 19x. In 1973 and 1974, inflation rose rapidly, a recession hit, the overall market declined, and the Nifty Fifty stocks underperformed sharply.5
Inflation
A sharp and broad-based slide in core inflation during the second half of 2023 provided investors greater confidence that inflation would soon be returning to the Fed’s target rate of 2%. Much of the slide was the result of repairing broken global supply chains. However, the core goods prices deflation trend has played out. In fact, air and shipping freight costs have moved higher in recent months. While it’s doubtful this is the start of a trend higher, it is likely the current phase of goods price deflation has ended.6
Inflation in services-based sectors of the economy remains stubbornly high. Economic reports point to strength primarily in core services categories, where inflation can be particularly “sticky,” or hard to slow. Services price inflation has been a concern for the Fed because it is closely tied to the labor market and wages. Service-based inflation along with strong labor markets may restrain the Fed from cutting rates until the latter half of 2024.
Inflation measured by the Consumer Price Index (CPI) has fallen steadily from its 9.1% peak in 2022 to the 3% range but since June of 2023 the CPI has remained at 3% or higher. Is this the “last mile” in the Fed’s inflation fight? In October 2023 Chairman Powell noted: “…the record suggests that a sustainable return to our 2 percent inflation goal is likely to require a period of below-trend growth and some further softening in labor market conditions.”7 Inflation has trended lower but with resilient labor markets and a steady economy we believe it will take longer for inflation to reach the Fed’s 2% target.
A New Market Paradigm
In 2004, Fed Chairman Ben Bernanke spoke about “The Great Moderation”, a name given to a period of a significant decline in the variability of both economic output and inflation. This period began in the mid-1980s where inflation had peaked at 13.5%. Bernanke gave three explanations for the dramatic trend, structural change, improved macroeconomic policies, and good luck. Not surprisingly, Bernanke’s speech focused on the impact of macroeconomic policies.
The end of the Great Moderation introduces an era of volatility in economic growth and inflation. This global paradigm shift will usher in a new regime of higher bond yields. Rapidly rising fiscal debt, de-globalization, demographic changes, investment in climate change mitigation and adaptation, are forces which begin to put upward pressure on yields in the coming decade. The recent rise in global interest rates that drove U.S Treasury 10-Year Note yields to 5.0% may be early evidence of this trend change.
In the chart above, U.S. 10-year Treasury rates fell from a peak of 15.8% in 1980 to 0.54% in 2020. Also pictured is the rapid rise to 5% in 2023.
Fixed Income Portfolio Allocations
With yields above 5%, investors poured a record $1.4 trillion into money market funds in 2023.8 While the yields provided comfort and safety, short-term rates will fall when the Fed begins cutting rates. Though intermediate-term bond yields have retreated from their cycle highs in October, investors can still take advantage of today’s yields by extending duration in their portfolios.
Extending duration while yields are high will provide strong, longer-term income streams. We anticipate intermediate- to longer-maturity yields will decline modestly, creating attractive return opportunities across higher-quality fixed income segments. We began extending duration in November and December 2023 using high-quality investment grade bonds including U.S. Treasury, municipal, investment-grade corporate, investment grade mortgage, and asset-backed bonds. This strategy shift was funded with cash and short-term bonds. Prior to this shift, our portfolios were carrying higher levels of shorter duration fixed income to protect them during rising interest rates.
Credit-based fixed income assets performed very well in 2023 with returns for high yield bonds and bank loans above 13%. Coming into the year, recession fears pushed values lower. But the improving economic outlook throughout 2023 provided a strong tail wind for credit-based strategies. We are analyzing current economic trends and credit conditions. If these conditions deteriorate, moving these strategies into higher quality bonds will be warranted.
Equity Portfolio Allocations
Equity markets are likely to remain challenged as investors transition to a regime of higher trend inflation and interest rates. Discussions regarding Fed policy will shift to how specific companies can navigate elevated inflation, higher capital cost and slower growth. The share of S&P 500 market returns explained by company-specific factors versus macroeconomic factors is 30% above the 20-year average.9
Concentrated equity market leadership, led by the Magnificent Seven, increases risk. Stretched valuations produced by strong performance, leaves these tech giants vulnerable to mean reversion where periods of above-average performance are followed by subpar returns. In October of 2022, FAANG stocks were down -48.6% versus the S&P 500 decline of -21.4%.10 We believe concentrated tech leadership begins to diminish and performance dispersion across and within sectors increases, favoring disciplined, fundamental approach to stock selection that actively managed strategies provide. This environment also increases the need for broader diversification.
Portfolio equity exposures are underweight their long-term strategic allocations by 10%. This allocation was moved to hedged equity strategies in the alternatives portfolio. Hedged equity strategies helped protect portfolio returns during equity market drawdowns.
Our equity allocations are focused on US large and mid-cap stocks with underweight exposures to US small-cap, foreign large cap and diversified emerging markets. Equity market weakness would provide opportunity to increase exposure to US small-cap and foreign large cap as valuations are substantially lower in both segments. Further, increased market volatility provides opportunity to increase overall equity exposure up to the long-term strategic exposure.
Alternatives
Alternative investment strategies are used to either reduce portfolio risk or enhance portfolio income and returns. The hedge equity strategy is an example of an alternative strategy designed to reduce equity market risk. We have additional investments in real estate and alternative income strategies designed to deliver higher levels of income. With higher interest rates, their importance diminishes and could be moved back to fixed income to secure strong income levels for longer periods.
Summary
Financial markets are linked to long-term economic cycles that change slowly over time. As we move into 2024, signs of change, such as higher inflation and interest rates along with de-globalization, have presented evidence that the long-term economic cycle is changing. This change has implications for portfolio construction and allocation.
Higher interest rates allow bond portfolios to provide longer-term, more consistent income streams. For equity markets, allocation of capital and returns on that capital grow in importance at the expense of growth at any cost mentality.
We focus on the long-term when managing investment portfolios by allocating to a broad set of asset classes in equity, fixed income, and alternative market segments. Asset allocations are adjusted based on changing market conditions with the goal of reducing portfolio risk or enhancing portfolio returns.
Equity market conditions look to be challenging in the first half of 2024. Portfolios have extended duration and higher interest rates will provide some cushion. We’ve identified the opportunities and challenges ahead and will execute as conditions dictate.
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Footnotes:
- Morningstar Direct
- CME FedWatch probabilities
- “S&P 500 returned 26% in 2023”, David J. Kostin, US Weekly Kickstart, Goldman Sachs Portfolio Strategy Research, January 2, 2024
- “Concentrating on Market Concentration”, SAS Market Strategy, Goldman Sachs Asset Management, January 2024
- “Equity Duration & Inflation: Lessons from the Nifty Fifty”, Sean Stannard-Stockton, CFA, Intrinsic Investing, Ensemble Capital
- “Not so fast: Global core CPI to rise to 3% in 1H24”, Bruce Kasman, Global Data Watch, JPMorgan Global Economics Research, January 4, 2024
- “December 2023 Fed Meeting: Rates Stay Put”, Luke Conway, JPMorgan Wealth Management, December 14, 2023
- “5% yield set to drive record $1.4 trillion to money market funds in 2023”, Matthew Fox, Business Insider, November 10, 2023
- “Embracing New Realities”, Asset Management Outlook 2024, Goldman Sachs Asset Management
- FAANG Portfolio; Portfolio Labs
Index Definitions:
S&P 500 Index – The S&P 500 Index (Standard & Poor’s 500 Index) is a market-capitalization-weighted index of the 500 largest U.S. public-ly traded companies by market value, the index is widely regarded as the best single gauge of large-cap U.S. equities. The index is unman-aged and cannot be purchased directly by investors.
US Treasury 10-year note – A 10-year treasury note is a debt obligation issued by the United States government that matures in 10 years. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.
Fed Funds rate – The interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. The federal funds rate is generally only applicable to the most creditworthy institutions when they borrow and lend overnight funds to each other.
Bloomberg Barclays US Aggregate Bond Index – The Bloomberg Barclays U.S. Aggregate Bond Index is an index of U.S dollar-denominated, investment-grade U.S. corporate government and mortgage-backed securities. The index is unmanaged and cannot be purchased directly by investors.
Consumer Price Index (CPI) – is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
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