February Investment Comments
Last year the market rebounded from what was a challenging 2022. Investor sentiment going into 2023 was decidedly negative, as the Federal Reserve’s aggressive rate hiking campaign to quell inflation led market participants to broadly anticipate a recession that still has not arrived. Instead, the economy proved more resilient than many expected while the Federal Reserve’s campaign against inflation showed progress. Falling inflation coupled with the anticipation of easier Fed policy has raised investors’ spirits heading into 2024. The possibility of inflation returning to more normal levels while the economy remains healthy has increased hopes for a “soft landing,” something that historically has been difficult to achieve.
Recent data on inflation has been encouraging, trending toward the Federal Reserve’s customary 2% target. The consumer price index for December showed headline inflation increased 3.4% on an annual basis, an acceleration from 3.1% growth the prior month. That is the wrong direction, but in more encouraging news, the core consumer price index, which excludes volatile food and energy prices, fell to a 3.9% annual increase in December, a modest tick lower from 4.0% growth in November. The Fed’s preferred inflation measure, the core PCE price index, rose 3.2% in November versus the prior year, down from 3.4% in October. Notably, the November PCE inflation data took the core six-month annualized rate of inflation down to 1.9%.
While inflation has rightly attracted the bulk of attention over the past couple of years, the Federal Reserve maintains a dual mandate of both price stability and full employment. With inflation trending towards target levels, it appears the Fed is transitioning to more evenly considering both parts of its mandate by weighing the risks to the labor market as the economy slows.
So far, the data continues to highlight the resilience of the labor market. The Labor Department reported the U.S. economy added 216,000 jobs in December, up from 173,000 jobs added in November and ahead of expectations. However, job additions for October and November were revised lower by a combined 71,000. For all of 2023 the U.S. added 2.7 million jobs, down from 4.8 million a year ago but representative of a robust labor market and ahead of pre-pandemic years. The unemployment rate in December remained at 3.7%, up slightly from the start of the year but hardly a sign of a labor market that has softened meaningfully. The Fed’s outlook is for the unemployment rate to tick up to 4.1% by year end, with real GDP growth slowing from 2.6% in 2023 to 1.4% in 2024.
Other measurements of the labor environment remain historically strong but are weakening. Job openings at the end of November were 8.8 million, down from a high reading of 12.0 million openings in March 2022. Job quits data is probably a better indicator of the employment market, as employees don’t typically choose to leave their jobs without feeling confident in finding another position. In November, the quits rate was down to 2.2%, the lowest reading since September 2020.
Given the progress on inflation and a shift by the Fed to more equally weight both sides of its dual mandate, expectations from market participants are that the Fed not only finished its tightening cycle last July but that it will be easing policy over the coming year. Expectations according to the CME’s FedWatch Tool currently reflect six rate cuts of 0.25% in 2024, with the first cut occurring in March.
Market participants believe the Fed will lower interest rates in step with falling inflation so that inflation-adjusted rates stay constant. The concern is that leaving rates unchanged as inflation declines could result in an unnecessarily restrictive environment, serving as a headwind to growth. The 10-year real rate, which reflects the stated yield on Treasury bonds less the rate of inflation, is currently about 1.7%, down slightly from recent highs but still nearly the highest level for real rates since 2007. Provided inflation continues to cooperate, it makes sense to go ahead with rate cuts over the coming year to keep real rates from being overly restrictive.
Federal Reserve Chair Powell’s commentary following the Fed’s meeting in mid-December was more dovish than many expected and added fuel to the year-end rally in stocks. The Fed will get one more look at its preferred measure of inflation before its next meeting at the end of January. In the press conference following that meeting, where rates are expected to remain unchanged, market participants will be listening carefully to see if Powell says anything to change the expected trajectory of rate cuts. The Fed’s own view of only three one-quarter point rate cuts this year has done little to dissuade the market from believing twice that many rate reductions are in the cards.
At a company level, more robust earnings growth is expected in 2024. Following essentially no earnings growth for companies in the S&P 500 in 2023, the consensus forecast for the coming year is for earnings to advance nearly 12%. Indicative of upbeat investor sentiment, the S&P 500 currently possesses a forward P/E multiple of approximately 19.5x, elevated relative to historical levels but more closely aligned with “reasonable” than “euphoric.”
There is a general expectation over the coming year that market leadership needs to broaden out from the “Magnificent Seven,” which drove returns in 2023 as each member of that vaunted group returned at least 49%. The relative outperformance of the Magnificent Seven meant that group accounted for nearly 30% of the total market capitalization of the S&P 500 at year-end, up from the low 20% range at the end of 2022. In 2023, 72% of stocks in the S&P 500 underperformed the index, representing the second-highest percentage since 1980. It is difficult to see how this can persist, and there are some signs recently that things may be changing. Since the market’s recent low at the end of October, the Russell 2000, representative of smaller capitalization companies, as well as the equal-weighted S&P 500, have outperformed the traditional market cap weighted S&P 500.
The contrast to the backdrop a year ago is hard for investors to ignore. Gloom has been replaced with a fair amount of optimism in the form of expectations for easier Fed policy and robust earnings growth. While history suggests long-term optimism remains appropriate, rosy expectations entering 2024 leave a fair amount of room for potential disappointment. Add to this an uncertain geopolitical backdrop with active wars and meaningful elections across the globe, and 2024 looks to be an interesting year in the markets. Maintaining an eye on the long term while staying invested in growing, profitable, reasonably-valued companies remains a sensible recipe for success.
James Skubik, CFA