2023 Year in Review and 2024 Outlook
2023 was a year of resilience in the face of economic and market challenges. Despite a banking crisis, inflationary pressures, Fed tightening, weakening economic data, and stagnant corporate earnings, the Russell 3000 Index finished the year up 26%, with the MSCI ACWI-Ex-U.S. (International markets) Index up 15.6%. The bond market also ended the year in positive territory, with the Barclays Intermediate Gov/Corp Index up 5.2%. This marked the first positive year for fixed income since 2020.
On the economic front, a strong labor market and robust services sector led to preliminary U.S. economic growth of 2.6%, better than many economists had forecast. The U.S. equity market was once again driven by technology names, with the Russell 1000 Growth Index up 42.7%, while the Russell 1000 Value Index was up just 11.5%. The divergence between the largest tech companies and the rest of the market continues to widen, with the top 10 companies in the S&P 500 Index now accounting for roughly one-third of the market.
We were cautious heading into 2023. Despite indications of Fed easing in 2024 (with the market anticipating three rate cuts this year) and expectations for positive economic growth, we remain cautious and maintain our portfolio positioning heading into 2024. The labor market is softening, and federal deficit spending continues unabated. Additionally, consumer credit card debt is increasing, savings are depleting, and student loan payments have resumed. November 2023 marked the 20th consecutive month of negative leading economic indicators, the longest streak since 2007-2008. We believe the full effect of higher rates hasn't been experienced yet due to the inherent lag in monetary policy.
Our goal is to maintain a balanced perspective by considering the bullish and bearish economic and market arguments. In the following table, we outline both cases and conclude that the bear case's risks outweigh the bull case's enthusiasm.
History tells us that earnings ultimately drive equity prices. A combination of wage inflation, onshoring of manufacturing, elevated borrowing costs, and weaker consumer data could weigh on earnings and prove the current 11% earnings growth expectations to be overly optimistic. Technology stocks, which drove gains in 2023, may continue to carry equity markets in 2024. Still, multiples remain elevated, and concentrations are high.
Portfolio Positioning
In the equity portion of client portfolios, we maintain a slight value tilt vs. growth (55/45), which we believe lowers the concentration risks embedded in the U.S. market and improves the valuation profile of the portfolios. On the international side, we remain overweight active managers relative to the U.S., with 55% in active international equity strategies vs approximately 30% active domestic equity strategies. Given the larger opportunity set and lower concentration levels in non-U.S. markets, we are comfortable with this positioning and believe international managers have more opportunity to add relative value.
In the fixed income portion, we increased duration (longer maturities) in 2023, placing the segment between an intermediate and core structure. We maintained an intermediate focus for several years. But we saw an opportunity to add longer exposure as rates normalized in early/mid-2023. Despite lower inflation and signs of weakening economic data, treasury issuance will remain very elevated, over $1 trillion for the foreseeable future.
The bond market rallied at the end of 2023 on enthusiasm for a soft landing and lower inflation. Still, the market must absorb a heavy supply of new issues, particularly as the Fed is now in quantitative tightening (QT) mode. For this reason, we’re holding steady on adding additional duration to portfolios.
Economy - budget deficit creates long-term headwinds, forces Fed to pivot
Budget deficit spending continues to support economic growth. Federal borrowings are at levels typically seen during economic crises although economic growth remains positive. The trend of borrowing/spending at excessive levels since 2008 is unsustainable over the long-run and has the prospect of creating a budget crisis, especially now with borrowing rates well above levels seen over the past several years.
In our view, the Fed’s signaling of rate cuts in 2024 was not only in response to softer inflation and weaker economic data but also the recognition that higher interest rates and ballooning budget deficits could have serious implications for future growth. We believe the Fed was forced to become more “dovish” in the face of inflation well above its long-term objective, given unabated government spending. This pivot may ease some of the short-term pain for the Treasury, but without structural changes to fiscal spending, this problem will remain an issue for future economic growth.
Historically, economic growth has resulted in lower budget deficits (and even surpluses in the late 1990s) as tax collections increase during expansions. During recessions, when tax collections decline, fiscal, and monetary budget work in tandem to help aid the economy out of an economic downturn. The issue now is that deficit spending is increasing while the economy is in expansion. What happens if the U.S. enters an economic slowdown or recession? The government cannot continue doing what it’s done with rates around 4%. Normalized rates would exacerbate the budget problem with interest expense taking up a larger and larger portion of federal revenue.
Federal Budget Deficit
Source: Clearnomics, U.S. OMB
©2023 Clearnomics, Inc.
The U.S.' ballooning interest burden is creating problems. This year, the interest expense will become the largest federal expenditure, surpassing military spending, with debt-to-GDP expected to reach close to 125%, the highest level in over 50 years. Interest expense has doubled in just nineteen months. On November 10, 2023, Moody's lowered the U.S. debt rating from AAA to AAA with a negative outlook, citing the interest burden as the primary reason. During 2024, the interest burden is expected to surpass $1 trillion for the first time in history.
Source: Treasury, BEA
Given the interest burden and the Fed's quantitative easing, deficit spending is likely not a viable policy option should we enter a recession or slowdown.
Economic Growth
Economic growth is expected to slow but remain positive in 2024. In its latest report, the OECD (Organization for Economic Cooperation and Development) projects the global economy to grow by 2.8% in 2024 and 3.0% in 2025. Like domestic corporate earnings forecasts, we believe these projections are overly optimistic and that U.S. economic growth is slowing, which will be evident when the first quarter GDP data is released in April 2024.
Source: OECD Economic Outlook, November 2023
U.S. Equities–low risk premium warrants caution
Fiscal and monetary stimulus measures following the Great Recession, including record-low interest rates, drove the bull market of 2009-2021 and created a compelling equity risk premium (ERP). The ERP, which compares the forward P/E of the S&P 500 Index to the 10-year Treasury yield, is a broad measure used to gauge the value of stocks relative to bonds. The ERP is like a "snapshot" of surface valuations. However, historically, a higher ERP was linked to long stretches of strong equity performance.
The ERP matters because equity investors expect compensation for assuming the additional risk of holding equities in their portfolio. The spread between stock and bond returns must be positive to encourage investors to take the added risk, which has been the case for the past twelve years. With the 10-year Treasury rate between 1-2% for the better part of the last decade, the ERP was consistently positive, averaging 3% during this period.
The chart below reflects that the ERP was only slightly positive at the end of September 2023, with the 10-year yield approaching 5%. With the massive bond rally at the end of 2023, where yields declined from 5% to 3.8%, the ERP is positive again, but not near the levels the market enjoyed since 2009. To get back to comparable levels, the forward P/E multiple on the S&P 500 Index would need to fall to approximately 15x earnings vs. the current 19x. We believe the lower ERP could hamper equity returns unless rates continue declining or earnings surprise to the upside.
Equity Risk Premium
Source: Bloomberg, DoubleLine
Equity Risk Premium is measured by the S&P 500's 12-month forward earnings yield (1/PE) minus the U.S. 10-year Treasury Yield.
Technology–how much longer can this continue?
The top 10 companies in the S&P 500 Index account for 28% of the index's value and have an average P/E multiple of roughly 27x earnings. In addition, the top 5 companies account for 23% of the index, with an average forward P/E of approximately 30x.
Source: Morningstar. Top 5 holdings determined using the SPDR S&P 500 EFT Trust. Data as of 12/31/2023.
As technology goes, so goes the market. Tech stocks must continue to move higher for the broader markets to see meaningful gains in 2024. In 2023, the top 5 names accounted for 45% of the market's gains, with the top 10 accounting for 59%. However, a greater contribution from lower market capitalization companies is needed to generate more sustainable market gains.
Fixed Income - how do bonds respond to an economic slowdown and elevated inflation?
Government debt is priced based on inflation expectations and economic growth. During slowdowns and recessions, interest rates typically decline as low or negative growth leads to lower inflation and money supply. The current environment is unique. Leading economic indicators are weakening, projecting slower growth while inflation remains above the Fed's long-term objective. It is an interesting environment for the bond market, as what worked over the past 40 years may not work going forward. While we believe rates have peaked, how bonds will behave in this unusual environment is uncertain.
Takeaways
A lot must "go right" for 2023's surprising results to carry over to 2024. For example, a soft landing and earnings growth for the S&P 500 Index constituents could propel equities. However, economic headwinds are building, and signs of recession are strengthening. Following the Fed Chairman's comments at the end of 2023, the market is pricing in 3 rate cuts this year, which seems unlikely, barring a deep economic slowdown. Should a slowdown or recession occur, 11% earnings growth could prove difficult, and a repeat of 2023's equity market performance seems unlikely.
We believe investors should temper near-term return expectations for the reasons mentioned in this paper. Since 2013, the Russell 3000 Index has risen 11.8% annually over each trailing 10-year period, while the MSCI ACWI-Ex U.S. Index and the Intermediate Gov/Corp Bond Index have gained only 4.0% and 1.7%, respectively. In our view, a mid-to-high single digit U.S. equity return is a reasonable return expectation over the next 3-5 years, and we anticipate that fixed income returns will play a larger role in balanced portfolios.
