Every year when we turn the page to a New Year, we enjoy the opportunity to reflect on the year that was. 2023 gave us a much-needed reprieve, in both equity and bond markets, after a challenging 2022. The S&P 500 rose nearly 25% in 2023 effectively reversing the 19% decline from the previous year. After a late Fed pivot, the Barclays (Bloomberg) Aggregate advanced 5.5% on the year, avoiding a third straight year of losses. Unlike its equity counterpart, the bond market still has some ground to make up in order to get back to all-time highs.
Before jumping into our 2024 outlook, here are a few themes that defined 2023:
Magnificent 7: The year was marked by a ferocious rally in a handful of stocks dubbed the Magnificent 7 (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms and Tesla) which returned, on average, more than 100% in 2023. Those seven stocks account for 70% of the total returns last year and their aggregate weight in the S&P 500 rose from 19% to 30%. Never in history has so much value been concentrated in such a small number of names. Indeed, the Magnificent 7 saw earnings grow well in excess of the rest of the market but not enough to keep pace with the meteoric rise in stock prices.
Interest Rate Volatility: In 2023, we experienced the highest interest rate volatility since the financial crisis. The intraday moves in bonds were often larger in magnitude than those in equity markets. This can lead to all sorts of unintended consequences: borrowers delay or cancel new issuances, lenders are forced to hedge more aggressively and more actively from the time they make a lending commitment to the time the loan is issued and eventually higher rates filter into earnings.
Bank Failures: In the spring of 2023, we witnessed the largest bank failures since the financial crisis. Interestingly it wasn’t cavalier lending practices that led to the failure of several banks in Q1 2023. Interest rate volatility and the speed and magnitude of the rise in interest rates blew holes in the balance sheets of lenders that were inundated with deposits during the pandemic. The flood of deposits were plowed into long term treasuries and government back MBS. With the meteoric rise in rates in 2022 and 2023, this caused treasuries and MBS to lose considerable value which several banks could not withstand.
In 2024 we expect the S&P 500 to return mid-single digits. This estimate is about half of the average calendar year return over the past decade. The reason we expect a modest return is because of how expensive stocks have become. When we started 2023 the S&P 500 was trading at 16.9x forward earnings compared to 19.7x today. While the benchmark index returned 24% in 2023, we expect earnings will have only increase by around 1% – 1.50%.. For 2024, consensus expects earnings to be up about 12%. In order for the Price-to-Earnings (PE) ratio to come back down, earnings need to grow faster than the index or in the case where earnings fall, earnings need to fall at a slower rate than the market declines. Interestingly, we looked at the last 15 years of returns (ex-pandemic) and when the PE was greater than 17x forward earnings the average 1-year return was 5%.
In Developed Markets outside the US, we expect high single digit returns. EAFE is trading at a much more attractive P/E Ratio than US stocks. At just 13.5x forward earnings, it is actually below average for the past decade. However, we think this is reflective of the benign earnings outlook and a lower allocation to higher P/E sectors such as Technology. Consensus expects EAFE earnings to be up less than 5% in 2024. While tactically we expect EAFE will do well in 2024, strategically, in the long-term, Europe and Japan continue to be regions we are structurally underweight due to poor demographics and burdensome debt levels.
Emerging Market (EM) equities, which have lagged their developed counterparts the last couple of years, should be poised for a stronger 2024. Compared to the S&P 500 which is trading well above the average of the past decade, Emerging Market equities are trading inline with historical valuations. Consensus expectations for EM EPS growth is 18%. We expect low double-digit equity returns in broad EM.
2023 ended the year with the 10-year benchmark treasury at 3.88%. Longer-term we expect the 10-year to head back to the Fed’s long-term target of 2.50%. Barring a recession, this will take time. With that in mind we expect the Fed to start lowering its short-term target later this year, and we expect the 10-year to end the year between 3.50-3.75%. That would deliver a Barclays (Bloomberg) Aggregate return of approximately 6.0% and a Municipal Bond Index return of 4.5%.
Corporate credit spreads, both in investment grade and high yield, have reversed most of the widening seen over the past two years. In 2024 we favor investment grade over high yield as lower credit quality issuers may find it difficult to rollover their debt at the highest interest costs in the past fifteen years.
We expect cash to return about 4.75% during 2024 even as the Fed starts to cut rates. Currently 1-year T-Bills yield 4.8%, compared to 5.35% for the 1-month T-Bill, reflecting the expectation of rate cuts throughout the year.
As always there are a number of risks to our outlook. There will always be risks we can’t see or risks that we miss, but these are the risks we feel are known:
China-Taiwan: Relations between China and the West have been strained over the last several years. The developed world has started to question China’s motives and looked to become less reliant on Chinese manufacturing and materials. However, to this point, direct conflict has been avoided. The Taiwan-China situation has the potential to force the United States and their allies to directly confront China in a way we have not yet experienced. As recently as a New Year’s speech, China’s Xi Jinping said reunification is inevitable. Taiwan’s recent election was an interest statement of how the Taiwanese people feel toward China. While the party that resists unification won the presidency, the candidate who won was not given a majority in the legislature. Policy experts view this as modestly positive because while the election did not bring the two parties closer to unification, it does not appear the election will provoke a response from China. That being said, we recognize it as a risk because the impact could be enormous regardless of the probability.
Resurgence of Inflation: The decline in interest rates late last year had many positive impacts on risk and lending markets. An unexpected return of inflation could again hit bond and stock markets. While most measures of inflation have been slowing, and specifically in the second half of last year those measures slowed more than the Fed had expected, wage inflation continues to run hotter than broader inflation. If higher wage inflation feeds through to the Fed’s preferred inflation measures, and the Fed feels like the committee needs to apply more significant brakes to an already slowing economy, the chances for a hard landing will increase considerably.
Credit Issues: It feels like we have been talking about risks in Commercial Real Estate (CRE) since the pandemic ended. While we have seen some significant write-downs of equity and defaults on loans backed by commercial properties, we have not seen contagion running through the banks from soured loans. Corporate default rates have picked up in the last year, however we’ve not seen anything resembling a crisis. If credit issues do pop up, it likely starts with a corporate default cycle that freezes lending as the market sorts through recovery values.
The views expressed in this newsletter represent the opinion of Custos Family Office, a Registered Investment Adviser. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment or services. The information provided herein is obtained from sources believed to be reliable, but no representation or warranty is made as to its accuracy or completeness. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. Investments are not a deposit of or guaranteed by a bank or any bank affiliate. Please notify Custos Family Office if there have been any changes to your financial situation or investment objectives or if you wish to impose or modify any reasonable restrictions on the management of your accounts through Custos Family Office.