As 2023 comes to a close, I wanted to take some time to reflect on the year that was and also take a look ahead to 2024. While we can't predict the future, there needs to be a baseline belief about what might lie ahead so that we establish a starting point for making investment decisions.
High inflation early in 2022 and rising interest rates drove fixed income (bond) returns and to an extent equity (stock) returns as well. Federal funds continued their rise from 2022, starting at 4.33% in January and finishing at 5.33% [1]. This was a negative for the bond markets and most especially so medium and longer duration bonds. The longer the term of the bond the more sensitive it is to rate changes in an inverse direction. As a result, more conservative investors again underperformed more aggressive investors in 2023, as they did in 2022. We also saw unexpectedly high equity returns. At the beginning of the year, many strategists were predicting a tough year for the markets in 2023 and that value stocks would outperform growth (a continuation of 2022). Both of these turned out to be wrong, and demonstrate the tendency to have recency bias, or the assumption that the most likely way forward is a continuation of what has been happening most recently. We saw generally low and declining volatility in 2023 [2], and this has been particularly true since October. This has led to increased risk taking, pushing equity investments further higher. Despite the more recent trend towards further breadth of the market and towards smaller stocks as rates have started to fall, large company stocks continued to outperform small company stocks in 2023.
My assumption right now is that rates have peaked. It’s possible that this still may mean that rates stay relatively high (higher for longer) but the Federal Reserve has indicated they expect 75 basis points of rate cuts in 2023. If this is true, I would expect fixed income to do much better than it has the last two years, and longer duration fixed income to even better. In addition, I believe all fixed income would be expected to do better than cash, with money market and CD rates expected to decline. I’m planning on 2024 being better for bonds than 2023 and not as good for stocks as 2023. This is straightforward given the potential for falling rates and outsized 2023 equity returns. Generally speaking, I think we should have tempered expectations for a lot of reasons. I expect increased volatility in markets relative to 2023. This could come from a recession in the first half or geopolitical events or of course the 2024 election. Key will be to look through it but that also requires you to have liquidity on hand. As in 2023, I believe higher quality larger stocks look attractive. Companies with free cash flow, low debt, good balance sheets and wide moats. This could help navigate both the recession scenario if it happens as well as the higher for longer scenario if it does. I think the higher for longer scenario as well as the A.I. boom favors active management (stock selection) over passive indexing.
Risks to the markets are always present and include inflation reaccelerating, geopolitical risks, election anxiety, recession risk and of course the biggest risks are those we have not even considered yet. Investors, especially those who need funds in the short term can prepare for this by raising cash when times are good. Also, as always, the key is not so much to predict where markets will go in the short term, but to be flexible enough in your beliefs and positioning so that you can respond to what markets are actually doing. And of course, looking through the noise and focusing on the long term has always been a winning strategy.
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