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Quarterly Review and Outlook: December 2023

"Don't Worry Baby"

Loyd Johnson Photo

By Loyd Johnson, Chief Investment Officer
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A Look Back

The band that epitomized the 60’s surf scene, The Beach Boys, released “Don’t Worry Baby” in 1964 as part of their Shut Down Volume 2 album. Lead vocalist, Brian Wilson considered the song one of his defining performances and later referred to “Don’t Worry Baby” as perhaps the Beach Boys’ finest record. It reached #2 on the Billboard Adult Contemporary Chart and was featured in the 2006 film Déjàvu starring Denzel Washington. I heard it recently, and the title, along with the next line of, “everything will turn out alright”, reminded me a bit of today’s economic situation. Over the last half of 2023, the discussion here in the U.S. about our economy and the likelihood (and severity) of a recession has shifted. From the higher inflation numbers in the summer of 2022, throughout last year, the overall financial situation has quietly, and moderately improved. With that, many have predicted, wished, or hoped for a scenario to play out that we playfully call the “Goldilocks” outcome. Like the famous story of the three bears, where Goldilocks prefers her porridge neither too hot or too cold, but rather, “just right” …the Federal Reserve has been trying to navigate the nooks and crannies of the system to bring down inflation by increasing short-term interest rates, while not putting such a damper on demand that might send us into a more serious and prolonged economic downturn. Historically, the process of trying to get things “just right” has not been extremely successful…and for many reasons. Mainly, the Fed is using one main tool, short-term rates, in an effort to control a variable (inflation in this case) that has many contributing factors affecting it. It’s been compared to using a sledge hammer to drive home a nail…might get the job done, but it also might not look particularly pretty.

The fourth quarter of 2023, and as a result, the entire year was just outstanding from an investment return standpoint. In the quarter, large-cap U.S. stocks were up nearly 12%, and finished the year over 26% higher, or 2 ½ times more than the long-term historical average of around 10%. Importantly, Core Bonds, as shown by the Bloomberg Aggregate, were positive by 6.82% in the quarter, bringing the full year performance to + 5.53%. We bold the word positive because it has been tough sledding in bond-land for the last couple years as the Fed aggressively raised those short-term rates. Other major asset classes also performed well for the year, with only Commodities showing a negative return in the table above. After such a disappointing 2022, the title song above proved accurate for 2023...

The chart below is an interesting one. It’s looking at the most significant headlines that affected markets in 2023. It shows the return of the MSCI All Country World Index, which is a pretty good barometer of global stock performance. Stocks were fast off the blocks to start the year with returns of nearly 10% after just six weeks. Then we had three significant bank failures here in the U.S. that precipitated a downturn into April. We grinded through the rest of the summer as the Fed continued to raise the Fed funds rate to its highest level in twenty years. We reached a low point in late October after the war in Gaza broke out…but then a funny thing happened. Stocks and bonds both staged one of the more aggressive run-ups we’ve seen…ever…in the last two months of the year. Just another reminder of why investment discipline is so important. You’ve gotta be in it, to win it

We probably shouldn’t talk about 2023 without mentioning the “Magnificent 7” stocks (Microsoft, Amazon, Meta, Apple, Alphabet, Nvidia, Tesla) that really drove overall performance. Those seven had an average increase of 111%, and the gain comprised over 75% of the S&P 500’s total return of 26%. That’s a lot of return for a handful of stocks! This chart asks, “is it likely to continue?”. Historically, the climb has been more enjoyable than when you get to the mountaintop...

We believe that it would be much healthier for the overall market if the drivers of return were not so concentrated in a few names. If you held every other name in the 500 stock index except those seven, your return for the year would have been around 10% versus the 26% that we got.

We continue to show and update the asset class returns because a chart like this visually shows how different major asset classes perform over time…and the real ability to flow in and out of favor from year to year. Most importantly, the white Asset Allocation box shows what a diversified, less-risky portfolio with a 55% stock allocation has done. By definition, it will never be the best…or worst. It tends to capture a good chunk of return in a healthy year like 2023, while helping to mitigate risk in years like 2022. Indeed, as Investment managers, our holy grail is always striving to deliver the highest return with the least amount of risk!

A Look Forward

The look forward sure is tougher than the look back, but it is almost always what clients are most interested in. So let’s dive in. The Fed, and their manipulation of short-term rates, has really been the main catalyst of market moves over the last several years. That was the case when they took the Fed Funds rate to zero in March of 2020 and stocks subsequently rallied over 70% from the lows. It was also the case when they embarked on their restrictive, rate-increasing policies to fight rising inflation in 2022, as stocks and bonds dropped precipitously. We believe their language issued from the meetings in late 2023 was also a major contributor to the rise in the last two months of the year, as it was perceived by most as a sign that the long-awaited pivot from rising rates was finally here…or at least near. Forward futures markets currently expect the Fed to lower rates a total of seven times in 2024, for a total of 1.75%. That would put the Fed Funds rate at around 3.5% versus the current 5.25%. We believe that is aggressive, and expect the Fed to be more measured. In my own personal experience over the last 37 years, I believe the one thing that the Fed would want to avoid is making the pivot to start lowering rates and then having to re-pivot because of conflicting economic data that surprises…like renewed, higher inflation…lower-than-expected unemployment numbers, more-robust GDP growth, etc. Certainly there are always enough geo-political events out there that could have an impact. We remain concerned that the war in Gaza could have additional tolls in both lives and global political unrest. Certainly, the fundamentals that are supposed to usually drive markets should come to the forefront again. Are companies profitable? Are consumers spending? Can the average family afford their mortgages, and maybe go out to eat now and then?

We end with a couple of charts that help make the case for at least a “softer” landing. The first shows just how much money has poured into money market funds over the last several years, as investors took advantage of these higher rates. The $5.9 trillion number is over $1 trillion more than the peak made in the Covid year of 2020 with all of the various government subsidies. In plain words, there is money to spend, should investors so decide.

The last chart above shows the six economic variables that the NBER looks at in making a recession determination. Unlike April of 2020 and other points along the way, none are flashing red. We know that some of these indicators can change quickly, but for now, the sky is not falling. Currently, we are fairly neutral in our overall asset allocation. Without further information, it is likely that stocks respond favorably to rate cuts, and bonds, in particular, will do well in a falling rate environment. But, big picture…the Beach Boys got it right…everything will turn out right...

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