VWG Wealth Management 2023 4th Quarter & Year-End Review

By VWG Wealth Management on January 10, 2024

Executive Summary

• Measures of U.S. inflation softened in November, triggering the Federal Reserve to indicate its monumental monetary tightening regime was peaking.  Their revised projections, released in December, showed the potential for three Fed funds interest rate reductions over the coming year.
• Bond markets responded with enthusiasm after a painful October in which the yield of the 10-year U.S. Treasury touched 5.02%.  After a very rocky year marked by rapidly changing narratives and sentiment, it closed flat for the year at 3.88%. 
• Emerging from deeply negative sentiment, U.S. stocks advanced relentlessly over the last seven weeks of the year.  Large U.S. stocks as measured by the S&P 500 Index, gained 11.6% in the quarter to end the year up 26.1%.  Small U.S. stocks finally began to show signs of life.  International stocks also enjoyed a solid 4^th quarter.
• Many economists now believe that the Federal Reserve’s ‘heavy lifting’ has been done and “the economy is through the worst of the credit tightening.”  
•  VWG is optimistic that a less restrictive monetary environment can further support businesses and strategies seeking to create and grow long-term value.  The future is bright for those actively initiating and adopting technological innovation.
• However, we don’t believe that an ‘all clear’ signal has been issued by the Fed.  Extremely complex and challenging issues remain for the economy, markets, monetary policy, and geopolitics.  Periodic episodes of uncertainty and volatility will surely emerge.
• Long-term investors should remain disciplined, holding balanced and diversified portfolios.  Adequate levels of cash and short-term liquid instruments should be maintained to help protect against unexpected events and emergencies, and to take advantage of future opportunities.  As always, thoughtful financial planning and reviews should drive portfolio allocations and investment decisions.

Review of the Markets

Encouraging data pointing to subsiding inflationary pressures strongly propelled bond markets in the fourth quarter.  Core PCE (personal consumption expenditures) inflation for November increased 1.9% on a six-month basis, below the Federal Reserve’s target for the first time in over three years.  Bond yields began sliding steadily (with prices rising) in November.  Then came December’s Federal Open Market Committee (FOMC) announcement.  While keeping rates unchanged, they lowered their 2024 year-end rate estimate and their 2024 and 2025 PCE estimates.  Chairman Jerome Powell said that “we believe we are either at or near the peak for the (rate increase) cycle,” and that the Fed “has already started discussing the topic of dialing back policy restraint.”  Bond yields moved even lower as market participants began projecting a series of rate cuts to be made in 2024.

The yield of the 10-year U.S. Treasury Note finished at 3.88%, flat for the year after touching 5.02% in October.  The yield of the 2-year Treasury finished at 4.25%, 0.17% lower for the year.  The Bloomberg U.S. Bond Aggregate Index returned 5.6% for the year.  Despite this rebound, long-term bond investors are still licking their wounds after this extremely difficult tightening cycle.  The annualized 3-year return of the benchmark U.S. bond index is negative 3.4%, one of its worst stretches ever.

High yield bonds produced stelar returns as corporate earnings and balance sheets remained relatively stable.  The Bloomberg Barclays High Yield Bond Index increased 7.1% in the quarter, and 12.4% for the year.  The S&P Municipal Bond Index gained 6.7% for the quarter and 5.5% for the year.  

Overseas bonds also performed well as much of the world displayed slowing growth and softening inflation. 

Fueled by the moves in the bond market and the promise of easing financial conditions, stocks rallied sharply.  Following October’s third consecutive monthly loss, the U.S. benchmark S&P 500 index gained 11.6% for the quarter.  2023’s 26.1% return was a welcome reprise after 2022’s 18.1% loss.  U.S. small stocks rebounded strongly.  The benchmark Russell 2000’s fourth quarter return was 13.9%, its first quarter of outperformance against the S&P 500 in three years.

The 4^th quarter bond market reversal and expectations for 2024 rate cuts put pressure on the U.S. dollar.  The U.S. dollar index (DXY), a measure of the value of the U.S. dollar relative to a basket of foreign currencies, fell 4.6% in the quarter and posted its first decline since 2020.  This, along with changing economic sentiment, helped support international equities.  The MSCI EAFE index increased 10.7% in the quarter, posting a positive 18.4% for the year.  The MSCI Emerging Markets index gained 8.9% for the year due to its positive 8.0% quarter. 

Gold also benefitted from the decline in the U.S. dollar.  The NYMEX Gold continuous futures contract increased 13.4% to an all-time closing high.  Crude oil was weaker for the year amidst Mideast geopolitical uncertainties, concerns about an anemic China recovery, and rising non-OPEC output.  The NYMEX West Texas Intermediate Crude Oil continuous futures contract fell 10.7%, bolstering a growing disinflationary market narrative.

2023’s ‘Ping Pong’ Narratives

2023 was a year of dizzying ‘ping pong’ narratives and sentiment.  It’s difficult to look back without feeling a touch of nausea.  Coming off October 2022 lows, the year started with consensus expectations for an immediate recession.  From there we moved to ‘higher (rates) for longer,’ and then to a ‘deflationary crunch,’ spurred by the Silicon Valley Bank and Signature Bank failures.  The unveiling of the GPT4 AI large language model moved the narrative to expectations of a ‘productivity miracle.’  This was dampened by persistent growth and inflation which forced the Fed to increase rates ‘even higher for longer.’  November’s PCE reading reversed the narrative to ‘easing,’ and then December’s FOMC meeting commentary led to ‘weakening growth, deflation, and expectations for Fed easing in 2024.

Perhaps what was most significant about 2023 is what DID NOT occur:

• The recession expected by the middle of the year did not emerge.  Perversely, GDP accelerated to an above-trend pace.
• Massive Federal Reserve monetary tightening did not markedly pressure the record low level of unemployment, or the health of the U.S. consumer.
• The steepest bond market selloff in 50 years, and a mini-banking crisis, did not crush U.S. stocks, or the U.S. housing market.
• Corporate earnings in most industry sectors did not significantly weaken.
• Violence in the middle east and the escalation of conflicts around the globe did not adversely affect energy prices.

Looking Forward

Goldman Sachs’ chief economist Jan Hatzius, and many other notable experts, believes that the Fed is mostly done with their heavy lifting, and “the economy is through the worst of the credit tightening.”  Backing this claim, Goldman’s U.S. Financial Conditions Index’s eased in November by its largest monthly amount recorded in the past four decades.  Stock and bond markets have embraced this theme by advancing relentlessly for the last seven weeks of the year.  They now appear to be pricing in a soft economic landing in which inflation slowly recedes toward target levels while the economy remains sound.  Remarkably, some observers even project a return to pre-covid economic and monetary conditions.

VWG agrees that the odds of ‘worst case’ economic scenarios posed over the past 18 months appear to have considerably diminished.  The promise of new business formation and technological innovation across many disciplines is great.  We see many bright opportunities for strategies, businesses and entrepreneurs seeking to create and build value over the coming years. 

However, investor discipline, balance, and diversification is called for.  It is too early to declare that the fight against inflation has been soundly won.  Strategas’ chief economist Don Rissmiller points out that “history suggests that once inflation gets going, a second waive tends to build over the next several years.”  In the U.S., this notably occurred after the 1910, 1939, and 1972 surges.

It is also possible that markets are already pricing in an overly optimistic ‘goldilocks’ conclusion.  Option experts calculate that short-term interest rates are now pricing in seven rate cuts by the Fed by the end of 2024.  This is twice as aggressive as the Fed’s own projections in their ‘dot plot.’  Bob Elliott, former head of research at Bridgewater Associates, writes that “getting 6-7 cuts next year would require a substantial collapse in economic conditions that is unlikely given the current economic momentum.” Even with three rate cuts in 2024, Rissmiller believes that “monetary policy will be tight, and lag effects from 2023’s tightening will still be in effect.”

Corporate earnings growth, the ultimate long-term driver for stock prices, are far from certain despite a Wall Street consensus expectation for 11% in 2024.  Inflation has benefitted some companies and industries whose top line revenues rose more quickly than their costs.  This may partly reverse if pricing power comes under pressure while some costs, particularly wages, remain sticky.  The increased costs of refinancing corporate debt could also pressure earnings. 

VWG does not believe that periods of quickly changing economic narratives and market sentiment have ceased.  Nor do we believe that the Fed has given investors an ‘all clear’ signal.  Historically, there has been quite a wide range of stock market outcomes (which include some significant losses) after the last Fed rate increase in a rate cycle:

Source:  Charles Schwab, Bloomberg, Federal Reserve, period 1929-2019

With its swift reversal from its adamant stance that “rates will remain higher for longer” the Federal Reserve’s message may have sent a “confusing message” to market participants.  Former President of the Federal Reserve Bank of New York William Dudley sees this pivot as a “big gamble.”  Noted economist Mohamed El-Erian views this “confusion as a failure (of the Fed) to reduce its deterministic, unhealthy influence on asset prices.”  We doubt that this back-and-forth dialogue between the Fed has quietly concluded.

Credit Markets Driving a “Sea Change”

VWG espouses the observations of Oaktree’s Howard Marks in his memo “Sea Change.”  The ‘free money,’ zero-interest rate (ZIRP) and quantitative easing policies of global central banks in the fifteen years following the great financial crisis (GFC) are over.  It should now be clear to central bankers that there are limits to financial stimulus and manipulation, that if persistently exceeded will threaten economic stability.   

Regardless of the level of the federal funds short-term interest rate, there are significant factors that could keep longer-term interest rates from falling further:

• Enormous U.S. Treasury issuance to finance and refinance the federal debt (increased supply).
• Reduced demand by foreign central banks, as they move to marginally diversify their reserves.

• Growing concerns over U.S. fiscal imbalances.  The federal deficit has surged to $1.7 trillion in fiscal 2023 which is 6.3% of our gross domestic product.  This is astounding for a period of economic expansion.  The federal debt now stands at $34 trillion, nearly equaling the size of the U.S. annual economic output. 
• Possibility of a regime change in Japan’s monetary policy which could further reduce foreign demand for U.S. debt.  Japan’s decades of ‘yield curve control’ has created a huge global ‘carry trade,’ where the inexpensive Yen is used to finance and leverage purchase of higher yielding non-Yen denominated securities. 
• Overall, the appetite of ‘rate agnostic’ credit buyers has been marginally reduced.

If this “Sea Change” thesis of higher long-term interest rates proves correct, it will have important implications for markets and investors.  Long bonds will not be the best hedge against stock market risk.  Corporate earnings and cash flow multiples are likely to trend lower.  Financing costs for unprofitable companies will be higher.  Opportunities in actively managed high yield bonds will expand.  Overleveraged countries with unfavorable demographics will find it difficult to grow their way out of debt.

Portfolio Positioning

Despite an easing Federal Reserve monetary policy, we don’t expect a respite from many complicated and confusing cross currents facing investors.  The global geopolitical tensions and over 60 countries holding regional, legislative, and presidential elections this year add to the mix.  Periodic bouts of volatility will inevitably emerge.  

VWG recommends moderately positioned, well diversified portfolios.  The cornerstone of these are the ownership of quality companies and the implementation of differentiated strategies that can persistently grow and create value.  Investments that can generate dependable cash flows independent of gyrations in the bond market are highly coveted.  A weaker U.S. dollar suggests that some exposure to quality international stocks should be included.  Investment grade taxable and tax-free bonds are also a part of diversified portfolios although we continue to prefer short and intermediate-term maturities.  Ample levels of cash and liquid instruments should be maintained to help cushion unexpected personal and market events, and to fund future opportunities.  Carefully considered financial planning should drive custom allocations to assets dedicated to living needs, emergency needs, and to long-term appreciation, aspirational, and legacy goals. Those assets should be invested appropriately, considering expected liquidity needs, timeline, required rate of return, and acceptable levels of risk and volatility.

VWG is deeply honored for the opportunity to serve you and your families.  We fully accept the  responsibility of helping you plan, protect, and fund your future needs, goals, and dreams.  We thank you for your trust, and we are dedicated to continue working hard to earn it in the coming year. 

Best wishes to all for a very healthy and deeply fulfilling 2024!  We’ll look forward to speaking with you soon!

Regards,

VWG Wealth Management

Suzanne, Ashley, Rashmi, Kay, Brandi, Lynette, Ona, Michelle, Lilly, Ryan, Ryan, Ryan, Justin, Elana, John, Rick and Jeff

Who we are

* All stated index returns are as of 12/31/2023 unless otherwise indicated.

* Index Data and Charts Sourced from FactSet Research, Morningstar, Bloomberg, U.S. Federal Reserve, Bespoke Investment Group, Charles Schwab, and Goldman Sachs Global Investment Research.

VWG Wealth Management is a team of investment professionals registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC.  Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.

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This document was created for informational purposes only; the opinions expressed are solely those of VWG Wealth Management, and do not represent those of Hightower Advisors, LLC, or any of its affiliates.