In 2023 markets reversed their 2022 performance with strong gains across both stocks and bonds. The S&P 500, Dow, and Nasdaq all generated exceptional returns last year: 26.3%, 16.2%, and 44.7% respectively (with reinvested dividends). The S&P has come full circle and is now only a fraction of a percentage point below the all-time high from exactly two years ago. The US 10-Year Treasury yield climbed as high as 5% in October before falling to end the year around 3.9%, pushing bond prices higher in the process. International stocks also performed well, with developed markets returning 18.9% and emerging markets 10.3%. What drove these results and how could they impact investors in 2024?
Perhaps the key lesson of 2023 for most of us is that news headlines and economic events don’t always impact markets in obvious ways. Last year’s positive returns occurred despite historic challenges including the worst banking crisis since 2008, rapid Fed rate hikes, debt ceilings and budget battles in Washington, the ongoing war in Ukraine, the conflict in the Middle East, cracks in China’s economy, and many more. If you had shared these headlines with an investor at the start of 2023, they would probably have assumed there would be a worsening bear market or a deep recession.
Why isn’t this what happened? At the risk of oversimplifying, the key factor driving markets the past few years has been inflation. High inflation affects all parts of the markets and economy, key among which was the Fed’s program to raise interest rates. In 2022 the Fed’s response to inflation slowed growth, hurt corporate profits, dampened consumer spending, and acted as a drag on bond returns. Yet in 2023 many of these effects reversed as inflation rates improved.
The headline Consumer Price Index, for instance, jumped 9.1% in June 2022 on a year-over-year basis but grew only 3.1% this past November. Unfortunately for consumers and retirees, this does not mean that prices will fall back to pre-pandemic levels – only that they will rise more slowly. For markets, however, what matters is that the rate of change is slowing and that core inflation could gradually approach the Fed’s 2% long-run target.
As a likely result, the recession that was anticipated by markets a year ago has not yet occurred. While many still expect economic growth to slow this year, it’s not unreasonable to suggest that the Fed could achieve a so-called “soft landing” in which inflation stabilizes without causing a recession. This is why both markets and Fed forecasts show that they could begin to cut policy rates by the middle of the year.
What does this mean for the year ahead? If 2022 was characterized by the worstinflation shock in 40 years, leading to a bear market in stocks and bonds, 2023 saw many of these factors turn around. These trends could continue if the Fed does begin to ease monetary policy. Of course, much is still uncertain. After all, markets never move up in a straight line. And even the best years’ experience short-term pullbacks.
All that said, the past year has shown us how important it is not to assume that market prognosticators, whose job it is to capture attention, always have it right. Making investment decisions based on a belief that we know exactly how the future will unfold is almost never a successful investment strategy. Rather than think we can predict exactly what will happen, we need to plan for a range of possible outcomes, always being mindful of contingency plans and alternatives. Below are five key insights into the current market environment that are likely to impact markets’ behavior and outcomes in 2024.
1. Many asset classes performed exceptionally well in 2023
Strong economic growth and falling rates propelled many asset classes higher last year. Stocks reversed most of their losses from the previous year, and bonds bounced back as interest rates fell in the final months of the year. Technology stocks, especially those related to artificial intelligence, helped to drive market returns as well, pushing the Nasdaq to a nearly 45% return. While the so-called “Magnificent 7” doubled in value, other sectors also began to perform better as market conditions improved.
Most importantly, there are signs that earnings growth is recovering. Earnings-per-share for the S&P 500 are expected to have been flat in 2023, but Wall Street consensus estimates suggest that they could grow by double digits each of the next two years. While this will depend on the path of economic growth, any increase in earnings will help to improve stock market valuations overall.
2. Bonds have rebounded as interest rates have stabilized
Bonds had a much improved year in 2023, with interest rates rising through October then falling on positive inflation data. While bonds have not completely recovered from their 2022 losses after a historic spike in inflation, recent performance shows that bonds are still an important asset class that can help to balance stocks in diversified portfolios. This is true across many sectors, including high yield, investment grade, government bonds, and more.
3. The Fed is expected to cut rates in 2024
Improving inflation coupled with a historically strong job market have helped the Fed toachieve its policy objectives. While it’s too early to declare victory, many expect the Fed to begin cutting rates in 2024. The Fed’s own projections suggest they could lower rates by 75 basis points by the end of the year. Market-based expectations are much more aggressive and are expecting twice as many cuts. Only time will tell whether the Fed will be as aggressive in as the market expects them to be in cutting rates.
4. The economy has been remarkably strong
The economy has been stronger than many expected over the past twelve months. GDP grew by 4.9% in the third quarter, one of the fastest rates in recent years. Consumer spending helped, as did a rebound in business investment. Unemployment remained extremely low, at 3.7%. And while monthly job gains have slowed somewhat, the labor market is still far stronger than most economists predicted.
5. The most important lesson for investors is understand the market is unpredictable
While the past twelve months have been positive for investment portfolios, investors should not become complacent. Volatility in the stock market is both normal and expected, with even the best years experiencing short-term swings. Rather than trying to predict exactly when these pullbacks will occur, it’s more important for investors to hold portfolios that can withstand unforeseen events. The past few years are a reminder that expecting the unexpected is the best way for investors to achieve their long-term financial goals.
