The year 2023 began with high levels of inflation and a predicted (at least according to popular opinion) recession. The year finished with a much reduced rate of inflation and solid economic growth. To many, a soft landing was an elusive goal. They were right. There was no landing of any kind, as the economy expanded at a robust 3.1% in 2023.
Interest rates peaked in 2023. While the Fed raised its target rate of interest four times during the year, the last raise was at the end of July, and the discussion has shifted to rate cuts. Meanwhile, the 10 year U.S. Treasury rate, though above its level a year ago, is far off its peak that was reached in mid-October. Likewise, the average 30-year mortgage rate rose during the year but has fallen from over 8% in mid-October to just below 7% currently.
To place this in context, the Fed had been raising interest rates to stem inflation. Businesses borrow funds to fund growth and consumers borrow money to spend, particularly in the housing and auto sectors. Higher interest rates tend to lead to reduced economic activity. This in turn reduces pressures on prices.
As bond prices are inversely correlated with interest rates, higher rates lead to lower bond prices in 2023. But interest rates are also generally inversely correlated with valuations in equity markets. There is a cost to waiting for the future when investors can achieve higher rates of interest on their money. Yet stock markets in the U.S. were generally up in 2023. The S&P 500 returned 26.29% in 2023, the tech heavy NASDAQ index returned 44.70%, and the broader NY Stock Exchange Composite Index returned a more modest 13.92%.
How do we explain this. First, there was perhaps an overreaction in 2022 when stocks fell significantly in the face of rising inflation and interest rates. When the bottom didn’t fall out in 2023 and inflation became more muted, the stock market rebounded. And while stocks clearly performed well, 2023 was another year of “Big Tech”.
The S&P 500 is a capitalization weighted index meaning each stock’s contribution to the index’s total return is a function of its relative market value. Bigger stocks have a bigger impact. The so called “Magnificent 7”, Apple, Microsoft, Alphabet, Amazon, NVIDIA, Tesla, and Meta, account for just under 30% of the market value of the S&P 500. To understand the impact they had on the S&P 500’s returns in 2023, we can compare the index’s return to an index where those same 500 stocks are weighted equally. That equal weighted index returned 13.84% in 2023, almost 50% lower than the cap weighted return.
In addition to the rebound from a dismal 2022 when large tech stocks generally underperformed the market, 2023’s performance by this sector was boosted by the latest investment theme – artificial intelligence (AI). While AI is having a real impact on our lives and the economy, the fact is AI has been a work in progress for several years. It is not new. It is perhaps reaching a critical mass where it is more widely deployed. Expect AI to add to GDP as it helps improve productivity, thereby offsetting some of the issues we have in this country with labor shortages. This will be an obvious benefit for those who can harness the technology. But it won’t just be the technology companies. Those traditional businesses that master its use, such as retailers who can better control their inventory or manufacturers who can better optimize output will benefit as well.
But beyond AI, what is instore for us in 2024? The obvious big issue is the U.S. general election. Our usual advice to investors is to ignore the election as it pertains to one’s investments. But, we suspect there will be more volatility this year than in past election cycles. That does not mean get out of the market and wait for better opportunities. Timing the market is generally a fool’s game. It does mean if you do have cash on the sideline AND the markets fall out of fears of the election’s outcome, that may actually be an opportunity to invest.
Another factor is the trend of interest rates. We think many are too aggressive with their bets on the speed of interest rate declines. Nonetheless, lower rates can do much to help grow the economy. We think one of the most remarkable aspects of 2023 is that the economy grew at the rate it did, even though the housing markets seized up. It is estimated that housing related activity, including moving, furniture purchases, etc., accounts for nearly 20% of economic activity in this country. Imagine the growth possibilities for the economy if falling mortgage rates result in a reinvigoration of the housing markets. The same is true for business investment. Lower rates should spark increased capital expenditures and industrial production.
Of course, with this there is a potential dark side to this potential growth. Inflation may be reignited. There are other concerns. Global tensions can result in various outcomes. Currently, many shippers are avoiding the Red Sea. While this is less of an issue for the U.S., it has a larger impact for Europe. At the same time, water levels are low in the Panama Canal. At a minimum, these issues can result in inefficiencies, shortages, and higher prices.
Another issue is the U.S. consumer who has been the lynchpin of economic growth in 2023. Still, it seems that job growth has peaked, and consumers may become more wary. We don’t want to overstate this, as the job market is still strong by historic standards. It just bears watching.
Finally, we are concerned about the level of U.S. debt and the need to refinance. We are dependent on international sources to fund our debt, and interest payments are taking up an increasing chunk of our government’s budget. If international markets fail to support our spending, and even if they do, the U.S. government could be forced to scale back spending, increase taxes, and / or inflate our way out of debt situation. As we don’t have space to cover all the ramifications here, suffice it to say that some of this may be good and some may be bad in the long run. But in either case, the shorter term disruptions could be very problematic for the economy and markets.
Not to leave our readers with a negative tone, it is important that we believe the negatives above are risks and temper an overall positive outlook. We believe 2024 will bring continued economic growth, and gradually easing interest rates – with some blips along the way. This should lead to overall positive returns in the equity markets in 2024. Additionally, we think the returns will be more even across various sectors and not concentrated nearly exclusively among the big tech companies. Despite all the fears and all that needs to be fixed in the world, investment opportunities can be found.
Past performance does not guarantee future results. Pinnacle Capital Management is an SEC Registered Investment Advisor and proud member of the Pinnacle Family of Companies, an organization designed to provide a full range of financial solutions to individuals, businesses, and institutions. For more information on our member companies, visit PinnacleHoldingCo.com. Opinions are our own and do not constitute financial advice. Talk to your financial professional for any advice specific to your situation.