The economy: Two factors have been driving the macroeconomic landscape through 2023: interest rates and inflation. In 2022, The Federal Reserve began a rate hiking campaign to combat rising inflation. This year, they continued the hikes in the spring, but have left rates unchanged since July. The chart below suggests the Fed has been succeeding in its battle as the CPI (a measure of inflation) has been slowing. This does not mean prices are lower, just that they are growing at a slower rate. This has been felt by consumers in myriad of ways, especially at the grocery stores where the average bill is up 20% from 2020. Consumers have also seen wages increase by 20% from 2020, but nearly all the wage growth has been eroded by inflation. Although inflation is slowing, higher rates add pressure on consumers in different areas. The elevated interest rates have manifested most visibly in the mortgage and auto industry, as rates on loans are nearly double what they were less than two years ago.
A key metric to watch next year that closely relates to interest rates will be the Unemployment rate. In the event of a weak labor market, the Fed may feel they have slowed the economy enough and could lower interest rates sooner than the market previously expected. This has historically been the case.
Stocks: The equity portion of client portfolios is up very nicely throughout the year, driven by Big Tech stocks leading gains in the first half of the year fueled by hype surrounding Artificial Intelligence. Companies like Nvidia, who are key players in the AI space, saw a surge in their stock prices. In fact, 7 stocks have been coined the “Magnificent 7” due to their drastic outperformance this year as evidenced below. Due to the returns coming from large components of the S&P500 the market overall is up, but the breadth of gains is very weak, with the S&P493 being nearly flat. Due to this, outperformance came from undisciplined, overconcentrated portfolios, which we do not believe in. Recently, a slew of positive economic data in November sparked the best month for stocks (+9.1%) since 2020. The driver of this rally is the expectation that interest rates will be lowered quicker and sooner in 2024, than the market previously expected.
Bonds: In the bond market, we have outperformed our benchmark throughout the year due to our strategy favoring short-term high-quality bonds. The story with bonds is simple: there are finally opportunities. After years of TINA (There Is No Alternative) to stocks, the rise in interest rates created many opportunities for investors. For the first time in over a decade, bonds may be more favorable than stocks (Argus Research).
For much of the year it was unclear how much higher interest rates would go. Our strategy this year has been to buy high grade bonds with attractive yields, and many we purchased at a steep discount, taking advantage of the fear in the market. Now that the market has caught up with us and expects rates to come down early next year, the yields on bonds have fallen causing prices to increase. The 20-year U.S. Treasury bond yield fell sharply in November, which rallied the price of the bonds 7.8%, the best month in nearly 4 years.
For bonds, the relationship between yield and price is inverse, so when rates increase the price drops, and when rates drop the price increases. So, the expectation of the Fed cutting interest rates in 2024 has been the catalyst behind the rally in both stocks and bonds in the second half of the year.
