By J Keith Buchanan, CFA – Senior Portfolio Manager
All the chatter centered around budget deficits, a government shutdown, and union strikes. Fresh off of a Fitch Ratings downgrade US from AAA to AA+ in the summer due to high and growing debt burden and erosion of governance, government officials seemed to be operating from one crisis to the next crisis. While a federal government shutdown was eventually averted, the resolution would trigger the ouster of the Speaker of the House for the first time ever and put Capitol Hill’s dysfunction on full display. The bond vigilantes were beginning to impose their will on the bond market, and stakeholders, investors and politicians alike, were scrambling for answers. Crude oil also surged in the 3rd quarter from $70 to above $90 per barrel reviving inflationary fears pervasive in the year prior compared to the disinflationary hopes of 2023. In many ways, entering the 4th quarter of 2023 felt uncomfortably familiar to the year prior. If 2022 was the year the market nervously asked the Fed “how much higher?”, then fall 2023 the market asked, with very similar anxiety, “for how much longer?”
October brought more of the same. Interest rates careened to generational highs as the market pondered the reflexivity of higher interest rates. If individuals, homeowners, corporations, and governments cannot afford to service their debt at these rates, should interest rates ultimately go higher as the realization and resulting ramifications ripple through the markets? The daunting possibility that the answer was growing closer to “yes” with every basis point move higher in interest rates added a level of panic that drove the 10-year Treasury rate to 5% later in October. The United Auto Workers launched a strike against the big three North American automakers, bringing about additional disruption and uncertainty.
And in early November, the dam seemingly broke on each of those mounting risks in short order. The UAW started striking deals with manufacturers in the last week of October, ending an impasse that began several weeks prior and dominated business and mainstream news headlines. The next week, Federal Reserve Chair Jerome Powell hinted that they may be done raising rates after twenty months and 525 basis points of monetary tightening.
Two days later, the nonfarm payrolls report showed that October hiring and wage growth cooled, giving additional hope that inflation was headed in the right direction and that the Fed wouldn’t need to stay so restrictive for much longer. And right before our eyes, “higher-for-longer” morphed into “higher-for not-much-longer” – animal spirits were unleashed. Equity markets jolted back to near all-time highs along with bond markets which rallied from a 5% to below 4% yield on the 10-year Treasury.
So here we are starting the first quarter of 2024 with renewed hopes and optimism that the risks which plagued risk assets in the summer of 2023 are behind us. However, the catalysts that bond vigilantes latched onto are still lurking in the shadows. Our elected officials on Capitol Hill are not any more functional than they were three months ago. And our federal debt continues to grow ever larger. Inflation continues to show signs of slowing toward the Fed’s 2% target, but Fed speakers often remind the market of historical occurrences of resurges of inflation, and this last mile of inflation seems to be trickier than the earlier phases.
So, while we applaud the returns of the fourth quarter, we look back to the dark beginning of the quarter, appreciate how abruptly the story changed, and we look forward to a new year of new opportunities and challenges while remaining diligently aware of the ever-present risks, some of which we experienced in 2023, and unforeseen problems that will undoubtedly arise.
FOURTH QUARTER 2023 REVIEW
The United States equity market, as broadly measured by the Russell 3000 Index, was up 12.07% in the fourth quarter. Over the quarter, every sector besides energy (down -6.35%), posted positive returns. real estate led the way, gaining 18.83% and was followed by the technology sector, up 17.71%, as measured by the S&P Select Services Index family. Small Cap Value, as measured by the Russell 2000 Value, was a standout over the quarter, up 15.26%. This was followed by Mid Cap Growth, up 14.55% as measured by the Russell Mid Cap Growth index. The greatest dispersion between style classes was seen in large cap, where the Russell 1000 Value was up 9.50% over the quarter, compared to the Russell 1000 Growth, up 14.16 %. International markets underperformed US markets over the quarter, with the MSCI All Country World Index ex USA up 9.75% compared to the S&P 500 which was up 11.69%. Over the quarter, we saw yields on the long end of the curve fall and the Bloomberg Long Term US Treasury TR index rise 12.70%.
As of today, the S&P 500 is reporting a -0.1% year over-year decline in earnings. At this early stage, only 6% of the companies have reported and 76% had actual EPS above estimates, which is slightly below the 5-year average of 77% and above the 10-year average of 74%. Additionally, companies are reporting revenues that are 0.6% above estimates, which is below the 5-year average of 2.0%, and below the 10-year average of 1.3%. Five of the eleven sectors are expected to report year-over-year earnings growth this quarter, led by communication services, utilities and consumer discretionary. The consumer staples sector is expected to have flat year-over-year earnings growth. Alternatively, the remaining five sectors are expecting to report a year-over-year decline in earnings led by the energy, materials and healthcare sectors.
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