2023 proved to be another year in which risk assets demonstrated a surprising degree of resiliency, posting impressive returns despite a number of headwinds. During the first half of the year, major central banks around the world continued to tighten policy in a bid to fight inflation. At times, this stoked significant volatility- March, for example, saw a banking mini-crisis in the US, as well as the near-collapse of a major Swiss financial institution. The events of that month, though quickly contained, briefly raised questions about the level of risk taking within the financial system as a whole, especially in the face of rising rates. At the same time, though tighter policy appeared to be serving its purpose of getting inflation under control, there were signs, especially early in the year, that this policy was choking off economic activity. For many Wall Street commentators, a recession in 2023 was nearly considered a forgone conclusion.
Typically, an environment like this would have been more than enough to give investors pause, yet markets continued their ascent, accelerating further in the second half of this year. This was only briefly interrupted in the fall as investors considered whether the fight against inflation would require rates to remain elevated for longer than previously expected. This spurred volatility in equity and rates markets alike, with the US 10 Year Yield moving from roughly 4% at the beginning of August to nearly 5% by mid-October. Looking back on the past 30 years of 10-week changes in this benchmark interest rate, the upward move seen this fall certainly ranks as one of the more dramatic moves higher over the past three decades.
Yet as stunning as this rise in interest rates was, so too was its rapid decline. While the 10 Year Yield hit a post-pandemic high of 4.99% on 19 October, the yield ended the year at 3.88%- another dramatic move, albeit in the opposite direction. Given the role the cost of capital plays both in valuation and corporate decision-making, these developments bear watching. What’s more, the elevated volatility in interest rates we saw in late 2023 is rare, especially when matched with relatively benign levels of equity market volatility:
What drove the decline in interest rates at year’s end? Much of it, at least to start, was data driven. Inflation continued to tick downward, while employment and consumption data suggested that the economy, though perhaps slowing somewhat, was holding up relatively well in the face of higher interest rates. This led many to consider the possibility that the Federal Reserve, along with other central banks, may indeed be able to get inflation under control without tipping the global economy into a recession. The prospect of such a so-called “soft landing” drove markets higher in the final portion of the year. This sentiment was further buoyed by the speculation that such an outcome could even allow central banks to loosen monetary policy to a degree in the coming year.
This scenario was lent further credibility during the final meeting of the Federal Reserve in mid-December, as US central bank officials suggested that several rate cuts could be possible in 2024. While Fed Chair Jerome Powell was emphatic that the path of policy would clearly be data dependent, he expressed optimism about achieving an outcome in which the fight against inflation could see significantly less economic pain than some had previously expected. Though some ambiguity about the future remained, one thing was clear: the Fed’s tightening cycle, the most dramatic since the early 1980s, was likely coming to a close. Other central banks, namely the ECB and BoE, held their final meetings of the year soon after, and while perhaps not as sanguine as the US Fed, at the very least opted to leave rates unchanged. In wake of these meetings, markets priced monetary policy even easier than that suggested by central bank officials, driving a rally in risk assets around the world in the final weeks of the year.
Ultimately, the S&P 500 ended the year up 26.3%, the MSCI EAFE Index rose 18.9%, and the Bloomberg Aggregate Bond Index delivered a return of 5.5%. As of the 31 December, the S&P actually was within 0.6% of its all-time highs, likely an outcome few expected on 01 Jan 2023, ourselves included.
From our perspective, this was an interesting year in many regards. While markets were indeed resilient, as we have noted in the past, much of the return for the S&P 500 was driven by seven companies in the index, recently dubbed the “Magnificent 7”. If one were to strip out these seven businesses, the return on the S&P “493” for the year was 12.5%. While still impressive, it shows how much this small set of companies were responsible for a significant portion of U.S. equity market returns in 2023. Though (at least in the aggregate), a fine set of businesses from an operating perspective, their valuations, at nearly twice that of the S&P 500 on a price/earnings basis, require investors to place a good deal of faith in the prospects of a select few businesses that operate in dynamic, competitive spaces. While to the detriment of our performance in 2023, given these valuations, we chose not to own shares in these businesses.
While it may mean forgoing returns in the short term, history suggests that what one pays for assets matters in the long term. Using the S&P 500 Information Technology Index as a rough proxy for high-tech growth, we found that buying such businesses at price/sales ratios above roughly 3.0x tends to result in underperformance versus the general index in the subsequent decade. The starkest example can be seen at the end of March 2000, when the Information Technology Index was trading at 7.0x Sales. In the 10 years from that point, this tech-heavy subindex would go on to underperform the S&P 500 by 7.3% annually. With the Information Technology Index trading at 7.65x as of the end of this past year, and the Magnificent 7 trading at 7.39x, we remain of the view that better entry points for these types of companies may exist in the future.
Though finding compelling long-term investments in equity markets remained difficult in 2023, we did leverage a significant opportunity this year in the fixed income sector. For the preponderance of the year, one has been able to generate a solid mid-single digit return in the space while taking minimal duration or credit risk. We took full advantage of this situation, allocating a significant portion of capital to such instruments. Though this meant owning a relatively unexciting collection of assets, given stretched valuations in both equity and credit, we felt this to be a prudent decision. Returns on the fixed income side were further enhanced through interest rate hedges, specifically an ETF that allowed us to benefit from the significant bounce in interest rates through the first three quarters of the year. We opportunistically trimmed this position amidst the spike in rates late this fall and will manage our remaining exposure according to our views on rates going forward. Overall, we felt the environment this year once again necessitated a defensive stance, even if this capped participation in market upside. However, unlike in past years, low-risk and risk-free assets offered reasonable compensation, making this decision at least somewhat easier.
As we look to the year ahead, however, we recognize that this opportunity to earn a risk-free return in the fixed income sector may diminish to some extent, as central banks seek to lower interest rates in 2024. So far, the US economy has proven quite resilient in the face of higher rates, but we do wonder whether that will remain the case. While there has been a good deal of excitement over looser policy, we would note that the Fed’s most recent “dot plot” only implied a median reduction in rates of 0.75% next year. While this is not insignificant, it is certainly higher than what the economy has dealt with for most of the post-GFC era. Given the time lag at which interest rate policy can impact the economy, we may find ourselves in a situation where, even with rate cuts, monetary policy remains too restrictive, and economic data deteriorates before the central bank can react quickly enough. Simply put, some fear there is a risk that in the face of cooling inflation, the Fed has already “done too much”.
While this is certainly unsettling enough, there is also the possibility that the decision to lower rates may be premature. Recent improvements in consumer confidence surveys, along with elevated spending during the recent holiday season, suggest that households still have ample buying power, or at the very least, ample access to credit. Behavior by corporates appears similarly self-assured, if credit issuance and dealmaking volumes in the latter part of the year are any indication. Simply put, through a number of market channels, looser monetary policy could reinvigorate demand, bringing inflation back with it.
The Bloomberg U.S. Financial Conditions Index draws data from the U.S. money, bond and equity markets to gauge the availability and cost of credit in the U.S. When the index is positive, the financing environment is accommodative, and when it is negative, the environment is restrictive. When the Fed began raising rates last year, the index fell into negative territory rather dramatically, and stayed there for most of 2022. However, conditions have improved noticeably this year, recently rising to levels last seen before the hiking cycle began. Most likely, this is the market pricing in expectations of easier monetary policy. What concerns us about this situation is that, during this recent inflationary bout, increasingly looser financial conditions tended to precede accelerating inflation:
To be clear, we recognize that there are plenty of reasons why this relationship may not hold. However, we do worry that the Federal Reserve, along with other central banks around the world, may ultimately find themselves cutting rates only for inflation to reaccelerate once again, drawing out this battle even longer. As we have noted in the past, such a scenario arose in the late 1970s/early 1980s. While central bankers have expressed a desire to avoid repeating this mistake, we question how that desire reconciles with their hopes to avoid engineering a potentially unnecessary recession.
Further complicating an already muddled situation are a number of other external factors, not the least of which being geopolitics. In addition to the ongoing war in Ukraine, October saw the outbreak of violence in the Middle East. While hostilities have generally been contained for now, the peripheral involvement of a number of regional and global powers raises the risk this situation spirals into a larger conflict. Such a scenario, especially in this corner of the globe, could easily impact commodity prices or further disrupt global supply chains. As the year begins, we feel developments in the region bear watching. Politics will also likely be top of mind for investors in 2024, with 40-plus national elections set to occur globally this year, covering roughly 40% of the world’s population and a similar proportion of GDP. While many of these contests will be watched closely, it goes without saying that the US presidential election will be top among them, and shifting views on its outcome could easily impact global markets.
At the same time, we will be vigilant for clarity around the trajectory of global growth, as it relates to the state of major economies around the world. Though the US has shown a great deal of resiliency, the Eurozone, the United Kingdom, and China all appear to be struggling to find their way out of economic doldrums. Despite higher interest rates, other emerging economies like India and Mexico continue to enjoy accelerated growth, likely beneficiaries of a new, more fractious era of globalization. General uncertainties aside, it is our hope that this asynchronous state of growth widens the investment opportunity set in 2024, regardless of what may be in store.
Indeed, with a wide range of possible outcomes for the year ahead, we would once again emphasize our intention to move deliberately in allocating capital. We have identified a number of investments across asset classes and geographies that we believe have the potential to create significant value over the long term. This year, for example, small and mid-cap equities in the US significantly underperformed their larger counterparts, resulting in discounts unseen since the beginning of the pandemic, and before that, the early 2000s:
Many have attributed this discount to a combination of both higher interest rates and inflation, as many of these smaller businesses have taken on significant leverage in recent years yet lack the scale to make up for rising costs. While this may be true in some cases, we believe there are just as many smaller businesses with solid balance sheets and demonstrable competitive advantages likely worth owning in the near future. Though markets are currently enamored with the Magnificent 7 at seemingly any price, we believe a shift in sentiment could easily act as a catalyst for the value of smaller businesses, as the discount becomes more apparent.
We see a similar opportunity in smaller businesses on the other side of the Atlantic as well. While we have discussed the opportunity in Europe in the past, the discount in this region versus large cap U.S. equities has only grown further this year, again to a level not seen since the early 2000s.
Many investors have bemoaned the lack of dynamism in Europe and write off the region’s bourses as collections of nothing but shrinking “Old Economy” businesses. Our work suggests this might be somewhat of an overgeneralization, and in recent years have gotten to know a number of well-run businesses in segments like industrial technology, mobility, and raw materials. Much like the opportunity in small and medium-sized businesses in the U.S., we believe that as investors move further afield in search for reasonably priced assets, this discount may also revert to the mean.
Our team is quite excited about these kinds of opportunities, and the value they may create, but we must emphasize that value is to no small extent predicated on the price paid for those assets. As such, it is our intention to be opportunistic, taking advantage wherever markets allow. Surprises both to the upside and downside could stoke volatility this year, potentially allowing us to deploy more capital in risk assets versus the recent past.
Regardless of what may lie ahead, we would yet again highlight that communication with you, our clients, is incredibly important in times like these. If you are of the belief that your financial situation or investment objectives have changed in some way, we encourage you to inform us so that we may reposition your portfolio accordingly. Similarly, we always welcome the chance to discuss with you the potential opportunities we are currently seeing, or our general view on markets in the year ahead- do not hesitate to get in touch.
As always, we greatly appreciate your support and the trust that you put in our team. We look forward to working together in the year ahead, and wish you and your loved ones a happy, healthy, and prosperous 2024.