2023 in review: A surprisingly strong year for equities
Q4 and 2023 at a glance
Markets rallied strongly to end the year as investors grew more confident that continued easing in inflation would mark the peak of the current interest rate increase cycle.
- Equity markets gains were highly concentrated in a handful of US large cap tech stocks and artificial intelligence related companies for most of the year, but market leadership broadened out in the fourth quarter.
- While the Fed stopped raising short-term policy rates after July, longer-term rates fluctuated in the second half of the year – rising in the third quarter and peaking in October on “higher rates for longer” concerns, then falling steadily in November and December on a perceived “Fed pivot” to potentially lowering rates earlier than previously expected in 2024.
- The “soft landing” scenario for the economy looked increasingly likely by the end of the year as economic activity remained strong, buoyed by continued low unemployment, solid consumer spending and rising corporate earnings.
The outlook for 2024 largely depends on achieving this soft-landing, with any broad weakness in the economy likely to trigger a sell off in risk assets.
A surprisingly strong year for equities
Equity markets rallied strongly to end the year, with all major indices posting double digit returns in 2023 and the Dow reaching record highs.1
- The NASDAQ was by far the market leader in 2023, but the winners broadened substantially in the final quarter.2
- Small cap stocks, which had lagged other segments and remained in negative territory for much of 2023, posted significant gains to end the year.3
Sector leadership for the year was also relatively concentrated with record spreads between the top and bottom performers:4
- Technology stocks led for most of the year, rising 16.92% in Q4 and over 56% in 2023.
- Consumer Discretionary and Communications Services were the next strongest sectors, up over 10% in Q4 and over 40% for the year.
- Real Estate stocks jumped 17.66% in Q4, pushing the full year returns up to over 8%.
- Defensive sectors (healthcare, utilities and consumer staples) rose during the quarter but remain flat or negative for the year.
- Energy stocks continued to reverse course on falling oil prices, dropping 7.8% for the quarter and off 4.8% for the year.
- International equities, both developed and international, were the weakest performers in the fourth quarter, but were up over 10% for the year.5
Source: S&P Dow Jones Indices6, NASDAQ7
Source: S&P Dow Jones Indices8
The Fed held policy rates steady after July, but longer-term rates fell sharply in November and December, boosting fixed income returns across the board.9
- All fixed income segments were up over 4% for the year.10
- Short duration fixed income returns were the strongest for most of the year, but trailed longer maturity bonds in Q4.11
- Non-US bonds, especially Emerging Market Debt, rallied in the final quarter.12
- Global high yield and US preferred stock posted the year’s highest returns.13
Source: S&P Dow Jones Indices
2023: A focus on inflation and interest rates…
At the start of 2023, investor focus was squarely on the Fed’s battle with persistently high inflation. Not surprising given that inflation was running above 6% from a year earlier at the end of 2022 and the Fed was continuing to push up short term interest rates. In hindsight, we can see that inflation peaked between June and September of 2022 for the broad and core ex food and energy indices, respectively. Still, the level of inflation, while retreating, remained well above the Fed’s stated 2% target. The downward trend in inflation continued as 2023 progressed with the core Personal Consumption Expenditures less food and energy price index, the Fed’s preferred gauge of inflation, up 3.2% in November from a year earlier, down over a percentage point since this past summer.14 Inflation Including food and energy is now at just 2.6% from a year earlier, the lowest level since March 2021.15
Source: U.S. Bureau of Economic Analysis
The progress on inflation has led investors to conclude that the Fed is finished with interest rate increases for now, supported by Fed Chair Powell’s comments on December 13th that they “believe that our policy rate is likely at or near its peak for this tightening cycle”.16 To be sure, Powell continues to hedge those expectations to allow room for further increases if inflation reverses course, but many feel that December marked a “Fed Pivot” in policy and that reduction in rates is coming in 2024. In fact, in their December summary of economic projections, 17 of 19 Fed policy makers expected lower rates by the end of 2024.17 The interest rate path for much of the year was far less certain than it feels now. While the Fed kept shorter term rates steady in the second half of the year, longer term rates rose steadily starting in August before peaking in October as investors tried to understand the implications of a “higher for longer” rate posture. After October, rates fell notably with the 10-year Treasury yield ending the year 3.79% after topping 5% in October.18
Source: Board of Governors of the Federal Reserve System
…and the likelihood of a recession or “soft-landing”
Amidst the gyrations of inflation and interest rates, the US economy kept chugging along. At the start of the year, most forecasters expected at least a mild recession during 2023. That never occurred despite a debt ceiling standoff, a regional banking crisis and warning signs from the Leading Economic Indicators index and inverted yield curve measures (when short term interest rates are higher than longer term rates) that have historically predicted recessions.19,20 Labor markets remained tight with the unemployment rate in November at 3.7%, up just 0.2% from the start of the year.21 Third quarter GDP was revised upwards to a robust 5.2% annual rate, up from close to 2% in the first and second quarters.22 Expectations for the final quarter of 2023 are more muted, but growth for the year will still come in far higher than forecasted at the start of the year.23 The strong growth has been fueled by still accelerating consumer spending which was up 5.4% in November from a year earlier.24
The solid pace of economic activity has helped keep corporate earnings growing for most of this year. The growth in profits has in turn bolstered stock prices as the two tend to move in parallel. In 2022, the decline in earnings began early in the year and equity prices declined as well. Earnings bottomed out in the first quarter of 2023 and have grown steadily since then and are forecast to continue increasing at a modest pace into 2024.25 That trajectory for earnings would provide support for stock returns although the magnitude and volatility of those returns in the short-term is always challenging to predict.
Source: Standard and Poors, Robert Shiller. Earnings are actual reported through Q3 2023 and consensus forecasts from Capital IQ through Q2 2024.
Looking ahead, the biggest risk to continued positive returns to risk assets is a change in the economic outlook. It is apparent that investors have priced in a “soft landing” for the economy and no further interest rate increases (and indeed several rate decreases) in 2024. If this scenario plays out, then risk assets should enjoy a supportive environment. Many of the segments of the market that struggled in relative terms in 2023 – small cap and value stocks, international equities, longer duration fixed income – could see revaluations that boost their relative performance. The key metric to watch on the path of the economy in 2024 seems to have shifted from inflation measures and Fed interest rate comments to the pace of consumer spending. Continued strength in the months ahead and we achieve the “soft landing”, but any noticeable weakness and prices for risk assets will have to adjust downwards with the currently undervalued, but economically sensitive, segments likely faring the worst.
25 S&P Dow Jones Indices