The Economy
The economy maintained its trajectory of growth with slowing inflation. In fact, inflation slowed enough that the Federal Reserve kept the Federal Funds rate level during its two Q4 meetings. This prompted a strong rally in risk assets as markets applauded the likely end to the Fed’s current rate hike cycle, possible rate cuts in 2024 and the improved potential for a legitimate soft landing for the economy.
The Fed’s primary inflation gauge, the Personal Consumption Expenditures Index (PCE), cooled in November, following gains in October that were softer than expected. Annual headline price increases slowed to their lowest level in 33 months. Much of the slowdown was influenced by lower energy and food prices. Personal income growth stayed steady at 4.6% year over year and retail gas prices fell nearly 20% over the quarter, providing consumers with additional support as they entered the holiday season. Consumers responded as retail sales rose 3% over the twelve-month period ending November 30. In particular, consumers indulged more than expected as food services and drinking establishment sales rose 11% from November 2022. Consumer sentiment ended 2023 on a high note.
Manufacturing data continued to be mixed. Durable goods orders rose 5.4% in November, following a decline of 5.1% in October. Core capital goods orders rose 0.8%, following a 0.6% decline in October. Outside of the core goods measurement, transportation was particularly strong, with commercial aircraft orders soaring. In addition, orders for motor vehicles and parts jumped following the end of the UAW strike. However, expectations for deflated consumer spending could slow manufacturing revenues in 2024.
Real estate data was noisy over the quarter due to the dramatic rise in mortgage rates over the past two years. The 30-year fixed rate mortgage rose from an average of 2.7% in January 2021 to a recent high of 7.8% at the beginning of the quarter. However, that rate witnessed a dramatic drop to below 6.65% by the end of the year, raising confidence among home builders and sellers that 2024 could see a rise in activity.
Globally, the Eurozone and U.K. continue to be hawkish on inflation but have kept key policy rates steady over the fourth quarter. In contrast to the Fed, both Central Banks are not entertaining plans for rate cuts in the near future. The U.K., in particular, saw wages grow more than 7% in the third quarter, versus 4% in the U.S. and Eurozone. China continues to wrestle with deflation, including its steepest decline in consumer prices in November since the height of the pandemic (Nov. 2020). The drop in consumer demand has been driven by a sharp decline in property prices and household wealth. But, concerns about continued easing by their Central Bank and the disparity between Chinese and U.S. interest rates eased as the U.S. signaled an end to its hiking cycle.
Markets
Equities and other risk assets experienced a significant swing in the quarter. The S&P 500 went on a 15% run from late October through the holidays. To add to the good news, markets broadened from just the biggest stocks, like the Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla). Small capitalization stocks, as measured by the Russell 2000, were up 25% in that period. Despite the strong quarter from small cap stocks, large cap U.S. equities still dramatically outperformed smaller asset classes for the year. The Russell 1000 Growth (+14%) significantly outperformed the Russell 1000 Value (+10%) over the quarter and returned nearly 4 times that index over the year. Over the quarter, the Real Estate sector (+19%) and Information Technology sector (+18%) led the S&P 500, with the Energy sector the only negative sector. For the year, the Information Technology (+56%) and Communication Services (+53%) sectors led the way, with the Consumer Staples sector (-0.8%) being the worst performer.
In the S&P 500, earnings estimates are in line to show the second consecutive quarter of year over year earnings growth. However, more companies issued negative earnings guidance than positive for the quarter. As of December 15, the forward 12 month Price/Earnings ratio for the index was 19.3 which is above both the 5-year average (18.8) and the 10-year average (17.6).
Globally, Developed International Markets (10.4%) outperformed Emerging Markets (8%) for the quarter and maintained a lead for the year (18% vs. 10%, respectively). The primary reason for the disparity is China, as Chinese equities experienced both a negative quarter and year.
Fixed Income assets also experienced a significant turn, with the 10-year U.S. Treasury yield rising to above 5% in October but dropping to below 4% by the end of the quarter. Investors moved out of cash into longer durations and broader credit risk in anticipation of lower yields in the future. Corporate yield spreads dropped to their lowest level since February 2018. Despite getting within 16 basis points of eliminating the inversion, the 2-10 year spread inversion ended the quarter near where it started.
Looking Forward
One question that keeps coming up is ‘why don’t people feel better about an economy that seems to be doing well?’ The bottom line is that price inflation remains fresh in consumers’ minds as they were used to a low inflation regime before the pandemic hit. For the 20 years ending 2019, the Consumer Price Index averaged just over 2%. The CPI rose 8% in 2022 with food prices rising nearly 10%. While inflation has been slowing, prices have not returned to those 2019 levels. Because of historically low unemployment, increases in wages, the recovery of equity prices and better returns on savings, consumers are still strong, despite paying higher prices for food, shelter, mortgages and consumer loans than they did in 2019. However, in order to have a level of deflation that returns us to previous price levels, the economy would have to significantly retract, with massive reductions in demand, mostly driven by significant job loss and reductions in wages. While we see the job market moderating as the demand and supply of labor comes more into balance, a return to normal full-employment levels shouldn’t drastically stall the economy. High interest rates for a sustained period of time will likely be needed to further tame inflation unless there is a dramatic rise in unemployment as employed consumers typically continue to spend.
In the meantime, the 500 basis points of Fed hikes are having an effect on the economy and market participants are expecting the Fed to eventually relieve some of that pressure with rate cuts in 2024. This will likely cause more cash to come off the sidelines into both fixed income and equities. However, the timing and size of those cuts will be in question as inflation has been particularly sticky during this cycle and economists expect the last leg to the Fed’s 2% inflation target to be the toughest. In addition, the rapid drop in longer term treasury rates since late October might keep the Fed in ‘pause’ mode.
Finally, the dramatic late quarter run by the equity market may present questions about valuations and short-term volatility in the first quarter of the new year. Sustained strength from the consumer and corporate earnings would allow for a positive start to the year.