2023 will be remembered as a year of several plot lines. The year started with economists calling for a recession; by summer, the consensus shifted to the “higher for longer” (higher inflation and interest rates for longer period) catch phrase; but by November, the temperature changed to cooling inflation, rate cuts and a “soft landing” scenario. The early anticipated recession did not materialize; in fact, just the opposite occurred with the S&P 500 Index up 26.29% for the year, leveraging gains from a concentrated group of mega-cap tech stocks (“Magnificent Seven”).
Stepping back and looking from a historical perspective, a key driver of returns was accommodative monetary policy — the same tool to deal with every equity market downturn over the past 20 years. Consider the dot.com bubble bust, the 2008 Global Financial Crisis, the European banking crisis and the COVID-19 pandemic. Investors became fixed on cheap and, in some cases, almost free money (i.e. with negative nominal and real interest rates). While low-cost capital provided fuel for economic growth, the unintended consequence was market excess and over-inflated asset values on a global scale… none of which were healthy for long-term capital market stability.
But it certainly boosted residential property in Hong Kong, office buildings in San Francisco, 30-year fixed bonds and growth stock prices as evidenced by the booming S&P 500. Companies with limited near-term earnings but high expected growth rates (resulting in longer-dated cash flows) were the biggest beneficiaries. But “time might be up” for growth stocks…
The single biggest influence on equity markets this past year was the unprecedented speed at which interest rates rose. The markets whipsawed in the fourth quarter, as the Fed signaled rate cuts in the second half of 2024; we expect an environment of modest rate cuts by the end of 2024, targeting real interest rates at levels around 0.5% for short-term maturities to upwards of 2.0% for 20- and 30-year bonds. If inflation moderates, nominal rates should follow.
However, there are risks to decelerating inflation, namely wage inflation, shipping interruptions, duplicate supply chains and other cost pressures that companies must either pass through or suffer margin pressures that will not be good for equity valuations. Based on our dialogue with management teams worldwide, it appears moderating prices have been helped by destocking. As inventory reductions turn to rebuilding, it is possible supply chains will tighten up and prices may start to trend up again.
Regardless of the near-term rate challenges, we suspect that the Fed and other central banks will keep rates at more stabilized levels especially in real, after-inflation terms, departing from the ill-advised period of artificially low rates. While the timing of interest rate cuts is uncertain, the Fed had penciled in three rate cuts for 2024 in its last meeting. More appropriately priced cost of capital has far-reaching implications and is particularly beneficial for value stocks. In simple terms, when the cost of capital is no longer zero, it matters what you pay for things.
In 2024, we anticipate that the Fed (and other central banks) will begin lowering rates in small increments, but we will not see a return of artificially low rates. Rates will be a determining factor in driving equity returns in 2024; not all equity returns will be equal, with specific parts of the investment spectrum showing more promise than others. In fact, we have seen a rolling wave of in- and out-of- favor sectors and industries. Companies are adjusting to the “new normal”, with supply chain constraints, pricing/inflation balance, consumption trends, labor dynamics and post-pandemic routines.
High-flying tech stocks led the way in 2023, while defensive sectors languished. 2024 might see a reversal of those fortunes. We see opportunity in a number of areas, some cyclical and some defensive. If the U.S. decisively avoids a recession and manages the “soft landing” scenario, then any number of rate-sensitive cyclicals can take the lead. And we have found value investing picks throughout. A few examples:
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