2023 Q4 Investment Commentary

2023 Defies Predictions

2023 began the year with most economists predicting the economy would fall into a recession and the majority of investment strategists expecting stock markets to struggle. Defying these pessimistic forecasts, the economy grew at a 2.6% real rate (6% in nominal terms) and the S&P 500 earned a total return of 26%. The forecasts were not just off by a small margin, they were not even in the ballpark. The economy enters 2024 in remarkable shape. The unemployment rate remains at an historically low level and the labor participation rate continues to grow. Inflation, which has been at the forefront of our economic issues for the last three years, appears to have been tamed. Time will tell if inflation remains low, but for now, Federal Reserve policymakers appear to have accomplished their goal and the economy has clearly shifted into a disinflationary environment. Note that disinflation is not the same as deflation.

We believe the best measure of inflation is the Personal Consumption Expenditure Index (PCE). It decelerated to an annualized rate of only +1.9% in December and is running +3.1% year over year. Inflation indicators are signaling a further deceleration in 2024, which is good news for the economy and financial markets. Positive inflation trends have prompted the Federal Reserve to announce they do not plan any more rate increases and are instead signaling rate cuts in the foreseeable future. This is welcome news for home buyers and small businesses. We continue to have an upbeat view on the economy but also know the future is unpredictable and events can occur that could shift economic winds. It is still possible that the economy has not fully felt the entire effect of higher rates and economic activity could potentially slow. Yet strength in nearly every stock market around the world is encouraging and is probably signaling the “soft landing” scenario everyone has been hoping for.

Fed’s Policy Sparks Year-End Surge

The Fed’s policy change ignited a broad year end rally across the entire market spectrum. The S&P 500 rose 14% in the final 8 weeks of the year and ended the fourth quarter +11% on the way to the 26% return mentioned at the outset of this letter. Small-cap stocks fared even better during the quarter, rallying by nearly 15%, and they finished the year up +17%. International and emerging market stocks increased 10% and 8%, respectively, during the quarter and earned double-digit returns for the year. Equity markets have effectively recovered most of the value lost in 2022. Even with the volatility and all the chaos around the world, stockholders continue to create wealth. Over the last 5 years, the S&P 500 has compounded 15% annually, while small stocks gained 10% and foreign stocks rose by almost 9% annualized. It has been more rewarding to be a business owner than a business lender.

Stock Markets Soar Despite Pessimism

If stock prices are a reliable forward-looking indicator, then the long-term outlook for the economy is bright. Nearly every stock market in the world is at an all-time or 52-week high. Despite the year end buying surge, many investment strategists remain skeptical about the prospects for stocks. It begs the question, why are people so pessimistic and concerned about the stock market with record low unemployment and stock markets at 52-week highs? Stock markets are known to “climb a wall of worry”. Without question, geopolitical issues and the expanding risk of war and conflict are serious concerns. There is also a lot of social and technological change occurring that tends to cause anxiety among the investing public. And there is an election this year, which as usual will be a heated and contentious process. Most of the country will fear the consequences of “the other candidate” getting elected. The first half of election years are often choppy and directionless. Considering how hot stocks entered 2024, it is reasonable to expect markets to cool down and consolidate their recent outsized gains. Historically, election years have produced positive outcomes for stocks, rising 83% of the time since 1928. Taking a historical perspective one step further, whenever the stock market rises by more than 20% in a pre-election year (2023), election years have been positive 100% of the time. Of course, there are no guarantees and precedents can be broken, but this is an important fact to know and surely encourages one to stay invested. There is still an incredible amount of liquidity in the US economy. There is roughly $6 trillion stashed in money market funds and a large amount of savings from the pandemic still sits on consumer balance sheets. This is an incredible amount of money that could eventually be spent or invested.

Bond Market’s 2023 Turnaround

The final eight weeks of 2023 saved the bond market from experiencing its third consecutive down year. The Bloomberg US Aggregate bond index produced a total return of 5.5%, led by corporate bonds earning 8.4%. The fact that corporations are performing better than Treasuries is an encouraging sign for the economy. The 10-year Treasury ended the year yielding 3.85%, only a tick above where it began in 2023. While the Fed has set expectations of lowering short-term interest rates, there is no indication that they prefer lower long-term rates, and they thus plan to continue shrinking their balance by the strategy known as quantitative tightening.

The last few years are prime examples of why people with a plan tend to achieve much better results than those without one. Without a plan, a person is more likely to make decisions based on their own feelings and hunches or, heaven forbid, listen to the strategists’ predictions. Our financial planning process blends expectations with reality, matches a person’s liabilities with their assets, and understands that risks, while unpredictable, can be mitigated through a suitable asset allocation.

Final Thoughts

We are optimistic about the outlook for the economy and equity markets over the rest of this decade. There will, unquestionably, be ups and downs and potentially even a recession. There is an incredible need to replace, improve, and expand our country’s infrastructure. The need for adequate housing, secure supply chains, and a reliable electrical grid are just a few examples of areas that critically need investment. Governments don’t have the financial capacity to make these investments on their own. Therefore, it will be the responsibility of private enterprise to satisfy these needs. The combination of manufacturing onshoring, technological innovation and a motivated workforce will drive productivity and growth in the economy.

All of us at The Watchman Group wish you and your family a happy, healthy, and prosperous New Year! We work for you and are here to serve. If you feel your goals or objectives have changed, please contact us for a review of your investment portfolio or financial plan.

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