Q4 2023 Market Update

From your Investment Strategy Team:
​​2023 was the best terrible year in recent history. While sentiment remained depressed throughout
the year, markets ignored the noise and went on a year-end run that rivals anything we have seen in the last decade. Overall, the year provided many important lessons in investing, with clear examples of why timing markets and letting emotions dictate decisions is rarely a good idea. In the short term, we remain cautiously optimistic about the prospects for 2024, even as we expect somewhat choppy returns. In the long term, many of the macro themes we have previously hit on (innovation, uncertain geopolitics, aging demographics, and higher inflation) remain in play and could once again impact markets.

​Encouragingly, the fourth quarter saw market returns broaden beyond the technology behemoths that accounted for so much of the returns during the first three quarters. US small-cap stocks were up 14.03% in Q4, leading the way, while international equities and domestic bond markets were also higher. We believe the broadening out of returns can continue in 2024, and despite the big run, domestic small caps remain one of our highest conviction ideas. If markets continue to do well, we should see a meaningful uptick in both M&A (mergers and acquisitions) and IPO activity as private companies look to access capital by going public. For nearly two years, rising rates and market turmoil led to frozen capital markets, but it appears that there was an uptick in activity during the last quarter. More corporate activity should be a tailwind for smaller companies, and there is more room to run in the months ahead. We have maintained a healthy weighting to small and mid-cap stocks in our allocations, and as the year progresses, if our outlook appears to be correct, we may look to increase our allocation in this area. For the time being, we continue to prioritize maintaining
a neutral risk stance with broadly diversified equity exposure and higher quality fixed income holdings.

Of course, we cannot talk about last year without mentioning the continuing pace of innovation, highlighted by AI, but also including areas such as quantum computing, biotechnology, and pharmaceuticals. While the jury is still out regarding the ultimate impact of AI, the potential remains massive. Like the internet, artificial intelligence has the potential to permeate any and every industry and become a ubiquitous part of our lives. We are still in the very early stages, and the leading companies in this area will drive a new wave of wealth creation. Quantum computing is AI's lesser-known sibling, but could also be hugely impactful. The ability of quantum computers to process large amounts of data at much faster speeds could aid in many fields and is perfect for modeling complex simulations, optimization, and logistics. In theory, quantum computers could help to develop more advanced battery technologies or aid in the discovery of more effective drug treatments to combat any number of diseases.

Along those lines, a somewhat under-the-radar story from 2023 was the explosion of GLP-1 drugs. These treatments were created to help those with Type-2 Diabetes, but some of these drugs have been found to aid with obesity and addiction and also could be positive for heart health. The increasing use of the drugs led to a selloff in consumer staple stocks and parts of healthcare, as investors theorized that reduced obesity and compulsive eating would lead to less snack food consumption and fewer healthcare needs, such as joint replacements and various surgeries. Somewhat comically, it even led one analyst to upgrade airline stocks, as the prospect of lighter individuals would reduce fuel costs for airlines.

As with anything new and exciting, the hype can get out of control, but the real-life application of these innovations is inspiring and not something that should be overlooked.

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Looking ahead, the Fed very much remains a focus for investors. Since the onset of the hiking cycle in early 2022, investors have had an acute focus on the central bank, and for the entirety of this time, investors have been overly optimistic about their inflation and rate expectations. The so-called Fed pivot happened in Q4, setting the stage for the end of this hiking cycle and eventual rate cuts. Markets quickly went overboard, projecting six rate cuts by early 2025. Those expectations have come down slightly, and outside of an economic downturn, we do not anticipate the Fed being quite so accommodative. Based on history, the Fed understands there is no need to rush and cut rates, only to see inflation reappear and have to hike aggressively again. However, as inflation does slow, the Fed will shift focus from fighting inflation to managing the business cycle, where employment data is likely to take center stage. The labor market has cooled somewhat from the frantic post-pandemic hiring pace, but wage growth remains robust, and barring some big shifts, current demographic trends have the jobs market in a structural deficit for the foreseeable future. There are simply more retirees than there are people to replace them currently. Looking out over the next 5-10 years we are facing a growing labor shortage, which is supportive of higher wages and stickier inflation. It is also one of the reasons why we believe that the AI impact will be real, as productivity gains are one of the few things that could save us from having too few available workers. As they say, necessity is the mother of invention.

Finally, we have arrived at the recession watch portion of our commentary. For more than a year we have had the threat of recession hanging over our heads, but one has yet to materialize, at least officially. With recessions, we usually have bear markets, and so the prospect of one has in part held stocks back from doing as well as they otherwise might have. Now we have to ask ourselves, could the worst be over? Remember, we did have two consecutive quarters of negative GDP growth in 2022, and S&P 500 earnings growth was negative for three straight quarters before turning positive in Q3 of last year. The manufacturing side of the economy has been shrinking for a year, partly due to the outsized gains that took place during Covid, and partly due to expectations for an economic downturn. Any prudence on the part of companies will eventually lead to better outcomes. Additionally, with inflation and possibly interest rates coming down, input and capital costs are likely to fall, leading to improved margins and ultimately better earnings. This is part of the reason why earnings are expected to grow around 10% this year.

In our view, things started to turn in the final months of last year. Q3 earnings and GDP growth were better than expected. The S&P 500 bottomed at the end of October and the run that took place after is far more reminiscent of something we typically see in the early stages of a bull market, rather than the average bear market rally. Even manufacturing data and other cyclical economic readings seem to be bottoming and setting the stage to rebound. No one can predict the future, and it is still possible that the economy will experience a recession in 2024, but in our opinion, those odds went down during the last quarter. In some sense, this period reminds us of 2010/2011, when after the initial jump off the bottom in 2009, investors were still uncertain of the economy and stocks. Those were the days of Eurozone debt worries and a hangover from the financial crisis of 2008. These days markets have rallied from the 2022 lows but we are all still grappling with the inflationary aftereffects of Covid and the outlook remains uncertain. We may be in that in-between period where markets are transitioning from bear to bull, but no one wants to get too optimistic just yet. We continue to prioritize broadly diversified equity exposure and higher quality fixed income.

However things end up playing out, it should be another interesting year. If we are right, there will be more good news than bad. Most of us are invested for the long term, and as last year demonstrated, getting caught up in the short-term news cycle can be harmful in different ways. The best thing we can do in more uncertain periods is to keep an even keel and stay on top of any new developments. Thank you and please feel free to reach out with any questions or concerns.