2023: Extraordinary & 2024: A Return to Normal Monetary Policy

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com

Summary

• We have been predicting a soft economic landing where the Fed could tame inflation while avoiding hurting the labor markets and the economy, and that’s played out in 2023.
• 2024 will extend the gains from 2023, but the future will be volatile.
• 2024 will see inflation continuing toward its 2% target as owner-equivalent rent becomes less inflationary.
• Equity strategy will continue to overweight Information Technology, Consumer, and Industrial stocks. Still, we need to see earnings growth achieved through organic revenue gains, and just the cost-cutting that occurred in 2023.
• Bond strategy will continue investment in short-term U.S. Treasury Bills that yield around 5.4%. As the Fed reduces rates in 2024, these short-term yields will fall in lockstep, and we will begin locking in longer-term yields at attractive rates in both the U.S. Treasury and high-quality corporate and municipal bond markets.

2023: Against All Odds
In our January 1, 2023, Market Outlook, “How the U.S. Avoids Recession,” we argued that the investment markets in 2023 would rebound from a miserable 2022 on the back of a highly resilient labor force and consumer spending, helped by compensation gains that would begin to outpace lower inflation. Heading into 2023, our largest positions were in large, world-class technology firms with exceptionally low valuations, such as Nvidia (NVDA), Microsoft (MSFT), Alphabet (Google-GOOGL), Apple (AAPL), Tesla (TSLA), Meta (META), and Amazon (AMZN). The tremendous performance in 2023 of these stocks would earn them the Wall Street nickname of the “Magnificent 7”.
Our positions regarding the economy and the market were certainly not the prevailing market narrative then, and every major investment bank was forecasting a mild to severe recession in 2023.
In 2023, the S&P 500 was up 24.2%, and the Nasdaq Composite, with its heavy weighting in technology stocks, was up 43.4%.
It was an extraordinary year, especially given that the following occurred during the year:

• China’s COVID reopening was a relative bust.
• The Fed concluded a mini-banking crisis in March needed its intervention.
• The Federal Reserve raised rates four times in 2023, contributing to a collective 525 basis points of rate increases since the Fed started raising rates in March 2022, yet Q3 real GDP was up an astounding 4.9%.
• Israel went to war with Hamas following an October 7 terrorist attack by Hamas on Israeli citizens.
• The 30-year fixed mortgage rate topped 8.00%.
• The 10-year note yield, which started the year at 3.88%, hit 5.02% in mid‐October and ended the year at 3.88%.
• The “Magnificent 7” stocks accounted for roughly two‐thirds of the gain in the market‐cap weighted S&P 500.
• Despite a protracted inversion of the yield curve and 20 straight monthly declines in the Leading Economic Index, the recession many people saw coming never came.

This year’s exceptional market performance was due to the unexpectedly strong labor force, consumer spending, and wages that not only kept pace with inflation but are now above inflation, providing real compensation gains. In 2023, if you were not invested in the “Magnificent 7” stocks, you most likely did not outperform the market as these mega-cap technology stocks dominated and pushed the market cap-weighted indexes forward. An unexpected boost came from the high interest in stocks associated with artificial intelligence, which powered the market forward between March and July. Fortunately, our overweight position in Information Technology stocks benefitted from this heightened interest in this critically important technology.

Finally, the Federal Reserve pivoted in late October and, for the first time, spoke about rate reductions and their equal focus between inflation reduction and labor employment. The market cheered this shift in focus away from just inflation, sending the S&P 500 up 16% since Halloween.

As we enter 2024, the market valuation is not overextended and is trading at 19 times next year’s projected earnings. However, to be sustainable, continued market movements need to be based on growth in revenues and earnings rather than an increase in valuations. In 2024, with a resilient labor force and economy and the prospect of lower interest rates, we are looking forward to continued gains as the stock participation broadens beyond the large technology firms nicknamed the “Magnificent 7”. 2024: Good, but Volatile

Although we see a decent year ahead, the road will face shifting economic expectations, geopolitical concerns in Ukraine and the Middle East, and a U.S. election cycle that promises to be entertaining if you like watching dumpster fires. Stocks should follow fundamentals and earnings growth and less what the Federal Reserve says about the economy, which has been the only determinant of market direction for the past several years. We will return to a refreshing focus on company fundamentals and less on the Fed and monetary policy.

Finally, as we enter 2024, the VIX, a measure of market volatility, is extremely low, which happens during periods of investor overconfidence. Although we expect decent earnings results, the market is undoubtedly not positioned for any downside surprises, and negative information will certainly be met with declines in the market. Interest Rates & Inflation

The remaining inflationary factor is owner-equivalent rent (OER), or what your home would rent for in the open rental market. However, with stabilizing real estate prices due primarily to high mortgage rates, the reduction in OER has been the primary factor in recent reductions in the overall inflation rates. If you do the math, continued reductions in OER should continue reducing inflation to 2.3%-2.5% by the end of 2024. Accordingly, to keep the real interest rate at 2%, the Federal Reserve will need to reduce the Federal Funds Rate into the 4.25%-4.5% range, which would need four equal rate reductions of 0.25% each. I call these measured moves “calibration cuts” in that the Fed calibrates the real interest rate around 2%. Any cuts that would move the real interest rate below 2% indicate that the Federal Reserve has become worried about the economy. Of course, this would not be well received by the market. Yield Curve & Bond Strategy

The current U.S. Treasury Yield Curve has been an odd duck for 2023. As you can see below, the best current yields are found on Treasury Bills maturing within the next four months. After that point, yields fall and settle in the 3.8% range between 5 and 10 years. The yields then rise between 10 and 20 years to a maximum of 4.1% and then fall to 3.9% for the 30-year Treasury Bond.

During 2023, we were heavily invested in short-term Treasury Bills at their attractive yield of around 5.5% for most of the year. The short-term Treasury Bills move in lockstep with changes in the Federal Funds Rate presently between 5.25%-5.50%, and as the Federal Reserve begins to reduce interest rates in 2024, we should see the short end of the curve drop along with the Fed Funds Rate reductions.

By the end of 2024, we should see a very flat yield curve with short-term rates in the 4.25%-4.5% range and intermediate and longer-term rates in a similar range. As the year progresses and we see steadily improving economic conditions, we will move away from short-term Treasury Bills to lock in longer-term yields later in 2024. Until then, we will continue to take what the market gives us: risk-free bond returns in the 5.4% range.

The Magnificent 7 Seven large technology firms powered the market forward in 2023, namely, Nvidia (NVDA), Microsoft (MSFT), Alphabet (GOOGL), Meta (Meta), Tesla (TSLA), Apple (AAPL), and Amazon (AMZN). As you know, we owned them all for 2023, and many market forecasters have opined that this performance is unsustainable. We do not believe these core stocks in our portfolios will have the same level of outperformance in 2024. Still, each exhibits sustainable free cash flow returns well more than their firm’s cost of capital, strong balance sheets, competitive moats around their core businesses, vast and growing profit margins, and management teams with a record of success. Although we will take some of our winnings from these positions to widen our breadth of stock ownership in 2024, we firmly believe these companies represent the sustainable winners in their respective business lines.

Much has been written about Nvidia (NVDA) and its enormous returns during 2023 based on its dominant position in semiconductor chips fueling the artificial intelligence boom. Its stock is up 233% this year, but what has yet to be said about the firm is that it grew its earnings by 268% during 2023. In essence, Nvidia is about the same valuation at the end of 2023 as when the year began.

Sector Overweights for 2024 We will remain overweight in Information Technology, Consumer, and Industrial stocks, benefiting from the vast infrastructure and semiconductor manufacturing spending bills just now entering the economy. Many believe that 2024 will see a rough start, and most of the returns occur later in the year based primarily on the massive run-up in the market during the last several months of 2023. We never attempt to time the markets in this way, and the returns could continue into the new year depending on the pace of rate cuts and the evolving economic outlook.