The 2023 Rollercoaster Ride
When reflecting on the calendar of events for 2023 and where we were heading into the year few people expected such a positive bounce back in the markets based on the economic headlines we would face. With all that the year brought – banks failing in the early part of the year, war concerns and higher-than-expected interest rates being persnickety since so many actually anticipated rates to start declining IN 2023. The year was a good reminder that markets often begin (or continue) their recovery while the economic data itself initially continues to get worse.
A Year That Tested All Predictions
Markets are forward-looking, so the news-of-the-day does impact markets, but it is more about how those changes impact the long-term trajectory of corporate profits that tends to be a bigger determinant over the long-term. And, profit margins across the S&P 500 remained strong despite some declines and remained above the levels they were for the 2000-2016 period. Companies heading into the year expected a recession and tougher economic times, so many adjusted their expenses accordingly to adapt. While there were meaningful struggles in pockets of the economy during the year, the better-than-expected economy proved a tailwind for many. Plus, positive developments in things like AI helped alleviate growth concerns.
Looking ahead, there are a few key goals that economists and markets are looking for including a return to 2% inflation, resumption of 2% GDP growth, avoiding a recession, and maintaining an unemployment rate below 4%. All of which seem like reasonable goals for the year given what we know now. While inflation has come down significantly over the last 18 months, it is important to remember that inflation is measured as a change in prices from one point to the next. So, when inflation happens, new (higher) levels of prices are established, so inflation “coming down” merely means the pace at which prices are increasing has moderated. So, we are seeing sustained higher prices in a lot of areas, and it would be unlikely for broad-based prices to actually decline from these newly established bases. There are components of the economy (namely technology) that can see asset price declines (ex. TVs and other electronics over the last 15 years), but it would be unprecedented for prices to revert back to the pre-COVID or early-COVID levels across housing, groceries, healthcare, and more.
Despite all of the economic and headline news that the year brought, many equity indexes concluded the year up double digits – including many international and emerging markets. When looking at things over a multi-year period of time, most U.S. public equities were still below the peaks previously achieved in 2021 and early 2022, so the U.S. is not out of the woods yet, but the year brought welcomed relief to the otherwise very challenging 2022. For fixed income investors, the U.S. fixed income markets narrowly avoided three unprecedented years of declines by rallying strongly in the final two months to officially turn positive for the year with mid-single digit returns.
The Fed indicated that they are likely to cut interest rates three times in 2024 for a total targeted reduction of about 0.75% (Source: Reuters). However, just a few weeks ago, market participants were aggressively pricing in six rate hikes, part of what helped propel bond and stock prices quickly higher through the end of December. Expectations at the start of the year already began to temper their expectations for rate cuts, so markets started to adjust back down. As a reminder, ‘Don’t Fight the Fed!’
Wishing you and yours a happy 2024. Read on as we discuss what may lie ahead for investors in the new year.
Why invest in markets when CDs are at 4-5%?
Investment and economic commentary is often focused on a point-in-time, and it tends to gloss over the long- term picture. It draws attention to things like what has happened this hour/day/week, a singular year-to-date figure, or one specific strategy. But, building – and retaining – wealth over time is about all the little decisions that are made along the way and whether decisions being made are potentially accretive to wealth creation.
This year was a classic example of risk and return which was a nice welcome from an otherwise turned-upside- down 2022 since many markets worked out from a classic risk/return framework during the year. Over the last two years, there were points in time where what most investors would agree as a more conservative positioning (i.e. typically a higher concentration in high quality fixed income / bonds) yielded worse short-term results than a more stock or growth focus. Generally over longer periods of time though, the more risk an investor assumes, the theoretically more return that it should command – otherwise, why take more risk? This mechanism can break down in the short-term as was evidenced in times of distress like the 18 month period of time that the Global Financial Crisis deteriorated from October 2007 through March of 2009 where the MORE risk someone took, the LESS return they got as markets continued their fall.
Certificates of Deposit (CD) at FDIC covered institutions soared past 5% for most offerings maturing in the next three years. The return on CDs earned during the 2023 year was easily tenfold the return of CDs per year over each of the years in the prior decade – or, another way of saying the return of CDs last year was equivalent to almost all ten prior years combined! But, even in the face of significantly higher (guaranteed) rates of returns that CDs offered, a well-constructed, balanced portfolio for what many consider as a traditional 60% stocks/ 40% fixed income experienced almost three times the return. Now, it should not be construed that these returns are directly comparable since investing of any kind involves risk, but it illustrates much of what we have discussed while the market was finding a bottom in October of 2022. At the market bottom on October 13, 2022, the going-rate for a two-year U.S. Treasury was approximately 4.5% (Source: St. Louis Fed). While we are not through the two year time frame, the annualized return for a high-quality, U.S. Treasury through December 31, 2023 was 3.5%. Since that time, a total world equity index (as measured by the MSCI All Country World Index – ACWI) was up an annualized 27%. Now, these two indicators are not directly comparable since the two year US Treasury had not experienced the downside like the stock indexes had that set the base for stocks to then rebound from the lows, but it speaks to the decisions we make as investors in real-time on whether a 4% “safe” return in October of 2022 is worth the uncertainty the market delivers. It is easy to say this with hindsight in the rearview mirror since there is nothing to say that things COULD have turned out differently. We could have entered a recession in early 2023 that propelled markets further, but that was staved off for now. What we learn from periods of time like this is that it is often a seemingly difficult decision to make in the short-term to consider such actions like rebalancing a portfolio (i.e. selling what has done better and buying what is relatively underpriced or lower valued), putting cash to work, or simply not selling beaten-up holdings for some when you do not have to be an active seller in that environment.
It is not to say that everything will recover back to previous highs quickly – Japan’s public stock market, the Nikkei 225, took 20 years to finally come back to the prior highs – but a careful evaluation of an investor’s goals, resources, and cash flows is important to line up long-term objectives with long-term assets that tend to perform better particularly following periods of distress where markets have dropped (even if just modestly at 5-10%).
Before 2023 began, most people were not only expecting interest rate pauses, but many had expected rates to start declining at some point during the year. But, as recently as October, payroll reports for September were more positive than many expected, and some were estimating that could mean even further rate hikes for the Fed from their July meeting (Source: Bloomberg). By the end of the year, it seemed like we had officially reached the “Fed pause” with little weighting placed on any further rate hikes. Markets had started to quickly move on and investors overshot in the other direction to begin pricing in up to six potential rate decreases in 2024. A consistent theme is that markets tend to over adjust in the short-term for both positive and negative directions, but they tend to under adjust for the long-term when looking at things through a five to ten year lens.
It is important to keep in mind that while many expect lower interest rates to be a boon for the economy, much of the time when interest rates decrease, it is a result of tougher economic times and a struggling economy that needs the stimulation that lower rates often provides. So, lower-than- expected rates may not bode well for the economy or markets if we do slowly creep toward an eventual recession. For now, the recession can continues to be kicked down the road. We may, however, be in a cycle that sees pockets or sectors of the economy that experience their own mini- recessionary environment (i.e. the technology sector rout of the last 18 months).
An otherwise silver-lining that has cropped up the last couple months is that 30 year mortgage rates have dropped back down by about 1% from where they were in November to the mid-6%. Lower mortgage costs can help keep more dollars in consumers’ pockets, and it can also potentially allow consumers to refinance their debt to lower cost levels. Although mortgage rates have indeed crept back down, they are simply back to the levels they were over the summer. And, most consumers are not purchasing a home or acquiring other long-term debt on a regular basis, so there is a swath of homeowners that are locked in at rates of the pre-COVID environment that are below 4%, where higher rates have done little other than to deter moving and acquiring a new mortgage. However, a reduction in interest rates could help support the real estate market if rates continue to decrease into the new year. Many consumers face credit card rates which have ticked up in the last year, but they hardly saw any benefit from a decade of low interest rates with most credit cards remaining in the 15-25%/APY range, so interest rate movements both up and down have had little impact on those rates.
Difficult times may continue to lie ahead for commercial real estate. We have talked about it for several years now, but the push-pull of work from home policies with employers and employees creates strains on commercial real estate as companies continue to adapt office spaces. Much of the commercial real estate debt does require refinancing every few years, so higher rates over the last couple years could put additional pressure and headwinds on an otherwise challenged market. Time itself can be the catalyst that allows things to adjust, but it could bring about some near-term pain as refinancing activity occurs over the next 18 months. And, to the extent that significant renovations or capital improvements are needed to repurpose a space that otherwise used to have office employees, additional capital (or opportunities for some) may be required.
Investing requires patience, discipline and thought. Times such as the last several years remind us that even the best of plans get tested, and we question the status quo.
An important aspect for decisions an investor makes along the way on whether to sell (or not) – followed by what to buy (or not) can pave the way for the next five to ten years – even if conditions deteriorate further before they improve. But, by creating and following discipline, it helps encourage those decisions that are hardest to make in the moment and when the time comes – the adage of buy low, sell high. Buying low often translates to purchasing investments that have been beaten up, or simply “not selling”, as that is equally as viable an option sometimes. There has not existed a “right” time to invest other than “now” particularly when building a portfolio that is rooted in diversification, low expenses, and tax efficiency. If we reflect on each time the U.S. equity markets have dislocated (whether 10%, 20%, or 30%+), each has offered a compelling long-term opportunity for those willing to ride out any near-term volatility. It’s far easier to say that when looking at historical charts, but it often feels very different when you are actively going through the environment since there is usually a barrage of negative news that causes the markets to dip like that – be it temporary political uncertainty, war, energy shocks, recessions, or natural disasters.
It can be very difficult to separate out a cheap asset that could recover from one that is cheap-for- a-reason, but the focus can shift to strategies that may be able to generate wealth for years to come vs. speculating on trying to make a quick buck. When speculating, markets can be most humbling if the positive scenario is anything but.
While reflecting on the past is not helpful through a lens of regret on “what one should have done”, it is nonetheless a helpful reminder of the decisions (or reactions) we can choose to make in the current environment that can help tilt the tides toward more potential positive outcomes. While
U.S. equity markets are near historic highs, so are profit margins, and so the underlying forces driving corporate profitability and revenue remain strong. We live in a dynamic environment, so as new information is priced into markets (some bad, some good) we all attempt to adapt to those changes. And, it’s those changes we make on a personal level that add up to create significant opportunity for the next decade.
May 2024 bring you and yours a great year ahead!