January 17, 2024

As we welcome a new year, we take stock of 2023 and consider what the year ahead might hold in store. Last year was a good year for investors and the U.S. economy. The economy grew, bonds offered positive real returns (beat inflation), and stocks soared. However, a general backdrop of unease, characterized by a seesaw stock market and out-of-sync economy, cast a shadow over these welcome results.

Going into 2023, an economic downturn was almost taken as given. Yet, despite the Federal Reserve’s sharp, anti-inflation interest rate hikes, the economy performed much more strongly than economists expected. How did forecasters get it wrong when they predicted we’d be in a recession by now? A partial explanation is that the economy has been functioning abnormally since Covid. The pandemic caused exceptional disruptions to everyday life and business, the ramifications of which were largely mitigated by extraordinary government efforts. The government continues to be more involved in supporting the economy and the financial markets than they have traditionally, making it harder for economists to make sense of things. While traditional indicators pointed towards an imminent recession, strong consumer spending—the largest contributor to GDP—helped the economy defy difficult conditions.

Will the delayed effects of the Fed’s tightening cycle push the U.S. into a recession? Notably, cracks are beginning to show in the U.S. consumer. Large household reserves, along with a resilient labor market, have supported consumer spending thus far. However, household savings are returning to pre-pandemic levels. While consumer spending supported the economy in 2023, many retailers have reported more cautious spending—although demand for services and experiences remains strong. With excess savings from the pandemic exhausted on the lower end of the income spectrum, consumer credit quality also appears to be declining, as evidenced by increasing credit card and auto loan delinquency rates.

After reaching a 50-year high of 9.1% in June 2022, headline CPI cooled to 3.1% in November 2023. With inflation nearing its 2% target, the Fed appears confident that inflation is under control. Short-term interest rates may have reached their peak. Indeed, the market expects the Fed to reverse course and begin cutting rates in mid-2024. However, once the inflation genie is out of the bottle, it’s hard to get it back in. While we are happy inflation has moderated, we are mindful that inflation came in three waves throughout the 1970s and 1980s.

Bond markets were volatile in 2023. The yield on the 10-year U.S. Treasury rose almost 170 bps (1.7%) from early April to late October, then declined by more than 100 bps in less than two months in response to expectations for a soft landing and an end to rate hikes. While muted from October highs, current fixed income yields still offer investors good income and total return opportunities. Because the Fed appears near the end of its tightening cycle, we are considering longer-term bonds to lock in yields.

After a difficult year for investors in 2022, U.S. equities rallied in 2023, with the S&P 500 Index returning 26.3% on a total return basis (including dividends). The stock market has seesawed over the past few years. Based on price movement only, the S&P 500 went from a decline of -25% (measured from a peak on January 3, 2022 through a market low on October 12, 2022) to a 33% gain from the October 2022 low through the end of 2023. For retirees, keep in mind that 2023’s strong finish will result in larger required minimum distributions in 2024 as IRA balances have been pushed higher (the 2024 RMD is based on the account balance on December 31, 2023). Last year’s strong performance was highly concentrated, with the “Magnificent Seven” accounting for most of the gains. While valuations for the seven largest stocks are especially overextended, our research team’s work suggests there are very few good buying opportunities—a bellwether that the overall market is overvalued. When stock prices are disconnected from business fundamentals, active management can provide the advantage of identifying companies with sustainable, high-quality earnings that are underappreciated by the market.

Finally, investors are keenly aware that 2024 is an election year. While volatility may pick up heading into election day, markets have historically tended to rise in presidential election years, with the S&P 500 recording positive returns in 20 out of the 24 election years since 1928. Apart from limited anticipated impacts on portfolios, remember that major provisions of the 2017 Tax Cuts and Jobs Act are set to expire in two years, including the halving of the estate tax exclusion. 2024 is a good time to begin preparing for potential tax code changes.

The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.

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