December marked another significant month in a historic two-month rally to conclude 2023. While the month’s returns did not surpass November returns, it came close. The period saw robust jobs data and continued softening inflation statistics, while the Federal Reserve Open Markets Committee (FOMC) delivered the biggest gift to investors. It was the “pivot” of the year, as the FOMC signaled the end of tightening monetary policy, indicating that inflation was under control and that monetary easing would be the focal point for 2024. Notably, the dot plots from FOMC members suggested three interest rate decreases in 2024, while markets have priced in substantially more than that. Consequently, interest rates and risk premium spreads experienced a sharp decline, propelling equity markets to reach new record levels.
Nearly all sectors of the S&P experienced significant gains last month, except for the energy index, which remained slightly negative due to the fluctuating news from the Middle East. Notably, real estate emerged as the top performing sector in the S&P, recording a +8.70% increase, while the usually dominant information technology sector lagged with a +3.83% gain. Interestingly, real estate stocks exhibited remarkable strength, rallying over 22% in the last two months, driven by the impactful move in interest rates.
The Nasdaq maintained its position as the frontrunner, rising +5.62%, followed by the Dow Jones Industrial Average (DJIA), which posted a gain of +4.93%, and the S&P 500, which recorded a +4.53% increase.
For the full year 2023, the Nasdaq concluded the year with an impressive gain of 44.7%, the S&P 500 also had a strong year, finishing up 26.26%, while the DJIA posted a solid gain of 16.18%.
Sector-wise, information technology led the way with an outstanding +57.84% increase. Communication services closely followed, concluding the year with a +55.80% gain. However, the energy sector experienced a decline, finishing with performance of -1.42%, while utilities ended the year down -7.08%. These figures provide a snapshot of the diverse performance across different sectors in the financial landscape throughout 2023.
In our November commentary, we discussed how the downward shift in interest rates prevented broad investment grade indices from experiencing an unprecedented occurrence of three consecutive years with negative bond returns. The trend continued in December, with numerous fixed income sectors not only turning positive, but also surpassing the high returns of cash and money market indices for the entire year. Credit sectors and riskier bonds continued to outperform risk-free assets.
Specifically in December, investment grade corporate bonds recorded an increase of +4.34%, while municipal bonds saw a rise of +2.32%. The Bloomberg Aggregate Bond Index rose +3.83%. Equity-correlated markets also experienced significant gains, as high yield posted a +4.03% gain, and emerging market debt returned +4.20%. Preferred and hybrid bonds rose by +2.48% as financial institutions continued to stabilize. Towards the end of the year, markets began to normalize post-Christmas, with new issue markets largely closing, and interest rate volatility showing signs of slowing down.
For the full year of 2023, the US Aggregate Bond Index returned +5.53%. Within this, AAA bonds returned +4.36% and Baa bonds recorded +9.40% return. Government bonds returned +5.83%, corporate debt returned +8.52%, and the securitized market returned +5.08%. The broad municipal index returned +6.40%. Preferred and hybrid debt exhibited strong performance with a return of +9.84%. Emerging market bonds returned +9.63%, and global high yield recorded an impressive return of +14.04%.
Mirroring the trend observed in November, interest rates experienced a rapid decline last month. Starting around the time of the Federal Reserve’s announcement on December 13th, coupled with the release of inflation data, the yield curve consistently shifted lower throughout the holiday week, pausing just before the New Year. Rates decreased approximately 43-48 basis points across various maturities, this movement exhibited a much more parallel shift than was seen in November.
The downward trajectory was evident not only in long-term bonds, but also in short-term Treasury bills. The 1-year US T-Bill fell from 5.12% to 4.76%. The US benchmark 2-year note stood at 4.25% yield to end the month, and the US 10-year note experienced a notable 45 basis point decrease, ending the year with a yield of 3.88%.
Remarkably, the short end of the yield curve finished the year slightly lower in yield than the previous year. In contrast, the longer end remained virtually unchanged for the year, despite the considerable volatility encountered through the year. The US 10-Year note demonstrated a range from 3.31% in early April, influenced by the banking crisis of March 2023, to a peak of 4.99% on October 19th, reflecting investor uncertainty regarding the extent of the Federal Open Market Committee’s rate tightening measures. This nuanced movement emphasizes the intricacies and challenges within the interest rate landscape during the year.
In December, market attention was dominated by what is being termed the new “Fed pivot of 2024”. While the market expected the Federal Open Market (FOMC) to maintain its pause on December 13th, the Fed surprised by stating that it would carefully consider multiple factors before “any” further tightening. Furthermore, several FOMC members predicted multiple policy easings in 2024, as indicated in their “dot-plot” estimates. Chairman Powell reinforced this stance in his speech, contributing to clear market direction. Following the FOMC meeting, both the European Central Bank and the Bank of England adopted decisions with “less dovish” language, placing them on a more “wait and see” trajectory.
In the realm of inflation, data in the United States continued to show signs of abatement. Although still above Fed targets, the year-over-year rate of change in both Core CPI with a year-over-year (YoY) of 4.0% and Core PPI with a YoY of 2.0% have considerably decreased in the last 12 months (Core CPI YoY was 6% and Core PPI YoY was 6.2% in November 2022). The QoQ Core Personal Consumption Expenditures (PCE) Price Index fell to 2%, slightly less than expected at 2.3%. Additionally, the YoY Core PCE Deflator dropped to 3.2% in November from 3.4%. Unit Labor Cost Estimates also decreased for the third quarter, and inflation surveys indicated a trend of about 3%.
Economic data continued to show relative strength last month. With inflation inching closer to the desired range, there’s a growing sentiment that the FOMC may shift its dual mandate to scrutinize economic data more closely.
Jobs data exceeded expectations slightly, leading to a decline in the unemployment rate to 3.7%. Job openings, however, continue to trend lower. Retail sales remained robust during the holiday season, while manufacturing data showed a decline, the service sector remains strong. The housing sector experienced an upturn last month, potentially influenced by a decline in mortgage rates for the first time in months.
As the new year begins, the market landscape is notably different from the start of the fourth quarter. The economy, though robust, exhibits signs of potential employment slowdowns. The Federal Reserve, has taken a well-deserved victory lap on taming inflation, and is now contemplating a shift in strategy, potentially easing off the monetary tightening measures implemented over the past two year. Investors are gaining confidence in the prospect of a soft landing, navigating the unique post-pandemic period.
However, the global risk landscape has heightened, with concerns arising from geopolitical tensions in Russia and the Israel-Gaza War. Additionally, the United States is gearing up for an election year that appears to be more divisive than the last. In such a complex environment, asset allocation decisions will be crucial, especially as certain markets have experienced significant moves higher.
Wish cash and fixed income markets now offering higher yields and risk markets coming off historic total returns, there is a growing rationale to reassess safer fixed income allocations. Investors, for the first time in years, are considering extending bond duration and adopting a more active approach. Many strategists draw parallels to the late 1990s, highlighting similarities in significant risk movements and a higher rate environment.
The key question on many minds is whether the Federal Reserve can successfully engineer a soft landing, and how long the economy can sustain its resilience. Comparisons to the late 1990s provide historical context for the challenges and opportunities that may lie ahead. As investors navigate this dynamic landscape, thoughtful and strategic decision-making will be imperative in shaping successful investment outcomes in the coming year.