Happy New Year 2024!
My, what a difference three months can make. From the beginning of Q4 to where we sit now, we have seen quite a few changes as it relates to the Fed, interest rates, and the overall sentiments of the market. 2023 turned out to be a recovery year for assets and the economy after a big negative year overall in 2022. In our opinion, this was the surprise of the year as many economists were forecasting recession at the start of the year. Here is a snapshot of performances for various major indexes in 2023:
US Core Bond Index
Source: Morningstar, 1/3/24.
Since the beginning of Q4, we’ve seen yields fall precipitously from around 5% on the 10 year Treasury, to just below 4%. This has come from a change in guidance from the Fed on interest rate policy, not from the Fed actually changing their short term rate targets. While they have not completely closed the door on raising rates, they have signaled they may be complete and are anticipating the lowering of rates in 2024. While the market may turn out to be overreading this guidance a bit, it seems to us safe to say that we have likely seen the last rate hike of this cycle.
If the Fed does, in fact, turn towards lowering rates, this will create a tailwind in the equity and fixed income markets. While there can be downturns within a low rate environment, the lowering of rates and an overall lower rate environment in general will help drive asset prices. While this would seem to signal a more risk on approach, there are still some caution signs in the short term. There are still a number of economists predicting a slowdown for the overall economy in the coming year. For some, the prospect of rates being lowered during the year would be to combat the coming slowdown. We’re still seeing a contraction in the overall money supply (recessionary) and certain signals such as yield curve inversion (recessionary) are still flashing. The job market has cooled a bit, and many areas that looked to be growth drivers (particularly in green energy) are struggling to adapt to higher interest rates.
On top of all this, we are entering another pivotal election year. The two parties still remain far apart as it comes to economic policy, and based on current polls the race appears to be a tossup. This is particularly true in the area of regulation and tax policies. The outcome of the election will have large implications on how much regulation the federal government is churning out over the next few years, as well as on tax policy, as a number of reforms implemented during the 2017 tax code rewrite will be expiring during the next administration. Finally, there are also large implications as it relates to the geopolitical landscape. With wars currently being waged between Russia-Ukraine, Israel-Hamas, Iran’s proxies throughout the middle east, and China ramping up its threats on Taiwan, American leadership will be playing a large role. The parties no longer leave politics at the water’s edge, so-to-speak, and this is another area of divergence depending on what the American people choose in November.
All of that being said, this is an opportunity to reevaluate portfolios. At a minimum, evaluating fixed income portfolios is key. With the prospect of further rate increases seemingly being lowered by the day, we are looking at taking on more duration and longer time horizons for our fixed income positions. Should the lowering of rates come to fruition, longer maturity bonds will perform better than shorter maturity bonds, all else being equal.
Lower rates also bring easier money conditions to a number of equity sectors. We also saw over the past decade the effect low rates can have on growth categories. These consistently outperformed value during previous low rate environments. That being said, we are not eliminating value positions entirely, and with the prospects of an economic slowdown still looming, we believe it is prudent to maintain caution as we get more data through the first half of the year.
Federal Reserve Policy. The Fed maintained its current Fed funds rate at 5.25% - 5.50% during the quarter. They signaled possibly done with hikes, and potentially three cuts in 2024 based on current dot plot.
Economic Growth – GDP. GDP grew at 2.2% in Q1 2023, 2.1% in Q2 2023, and 4.9% in Q3 of 2023 based on the 3rd estimate. Q4 GDP is projected to come in softer with many predicting growth of around 2%.
Labor Markets. Unemployment ticked down slightly to 3.7% during Q4 while the Labor Force Participation rate ticked down to 62.5%. Job openings continue to outnumber job seekers, but the amount of job openings has continued to come in below the post pandemic peak of above 10 million, with the latest figure at 8.8 million as of November. We’ve continued to see growth in jobs, but at a slower monthly average of gains.
Inflation. Inflation has improved substantially in the last year, but still runs higher than the Fed’s target. Headline CPI is 3.1% year-over-year in November. The Fed’s preferred gauge (Core PCE) is 3.2% year-over-year. Continued improvement here has led to the market perception that rate hikes are likely done.
Consumer Sentiment & Spending. Personal consumption and retail sales have maintained positive trajectories, although they are largely flat in real terms over the previous two years. Consumer sentiment dramatically improved over the final weeks of the year according to the U of MI index which ended the year at 69.7, up from 59.8 in the previous year. This is the first real improvement in this outlook since inflation took off.
Housing & Real Estate. Real estate markets are still experiencing headwinds, although there is excitement that we worst may be past if rates continue to come down. With rates still higher than what people are used to, it will take a good reason for those who have existing mortgages in the 2-3% range to move to a home with a higher mortgage. This is showing in sales of existing homes which are down year-over-year compared with new home sales which are positive year-over-year. Home sales are being led by new development in the single-family space as builders try to bring on more supply.
Business Investment & Manufacturing. While manufacturing has been in contraction for some time as the economy reorients back towards services, there has been a large uptick in spending on manufacturing facilities. Spending on facilities will continue to be a highlight in the coming quarters. Outside of manufacturing, a number of companies are starting to become more cautious with hiring, as well as expectations about future consumer spending on their products. A number of companies in areas considered “green” energy are starting to struggle with economic viability given the current interest rate environment. This is something to watch as the federal government has been deploying large resources and has put great focus on during the present administration.
Global Economy. The global economy is seeing improvement on the inflation front, which is a welcome sign. However, China as the world’s number two economy is struggling to maintain growth. The war between Russia-Ukraine is still raging, and continues to look more like a proxy war between the Russia-China-Iran axis and the West consisting of America, Europe, and their allies. In addition, we’ve seen the middle east explode into war between Israel-Hamas and Iran’s proxies causing trouble and advancing attacks across a number of countries in the middle east. China also continues to increase their threats on Taiwan, and recent reporting states that China’s president directly told President Biden they plan to take back Taiwan and it is just a matter of when, not if. This all speaks to continued challenges on the global economic front for some time to come.