January 2024 Market Commentary

January 17, 2024

• Markets enjoyed a strong finish to the year driven by increased optimism that the Fed has completed its current rate hike cycle.
• Fed’s updated projections now show three rate cuts in 2024, up from prior forecast of one.
• Consumer spending remained strong during the holiday season helping allay concerns about impending economic slowdown.
• Returns: S&P 500 up 4.4%. Bloomberg US Aggregate Bond index up 3.8%.

Christmas, and the arrival of Santa, can be measured in a number of ways. For children, it is measured by the number of presents under the tree. For retailers, it is measured in sales and profits. And for investors, it is measured by returns. December often witnesses a “Santa Clause” rally in which stocks enjoy relatively strong performance during the last week of the year. In 2023, the traditional Santa rally largely failed to materialize. That doesn’t mean that Santa didn’t come though, he just came early, in the form of the S&P 500 gaining 13.4% between November 1st and December 22nd. That helped cap the S&P 500’s best year since 2021. More importantly, it helped soothe investors’ frazzled nerves following 2022 when the stock market experienced its worst year since 2008 and the bond market experienced its worst year of record.

As expected, the Federal Reserve left interest rates unchanged at its December meeting. Given that the decision was largely a foregone conclusion, investors were more interested in the Fed’s revised “dot plot” projections showing policy makers’ updated forecasts for the Fed Funds rate in 2024. Like a kid receiving a much sought-after toy, investors were excited to find that the Fed now expects to cut rates by a total of 0.75% in 2024, up from the prior forecast of 0.25%. Investors treated the Fed’s updated forecast as a “floor” on the number of possible rate cuts in 2024, with current market expectations anticipating a total of six (6) 0.25% rate cuts, lowering the Fed Funds rate to 3.75-4.00% by the end of 2024.

One of the biggest upside surprises in 2023 was the resilience of labor markets and the consumer, which are inextricably linked. Though nonfarm payrolls added just 173K jobs in November, below the average 231K jobs/month added between January and October, the gains were largely in line with pre-pandemic levels which saw the economy add an average of 190K and 163K jobs/month in 2018 and 2019, respectively. With employers continuing to add jobs at a healthy rate and weekly jobless claims not showing any meaningful signs of upward pressure, the labor market appears poised to enter 2024 still in solid shape. That in turn should continue to support positive consumer spending, benefitting the broader economy.

Throughout its rate hike cycle, the Fed has stressed the lagged, cumulative impacts stemming from higher rates. Many economists at the start of 2023 expected those impacts to quickly result in slower economic activity, reduced hiring, and higher unemployment. While arguably all three of those occurred, they did not to the level that was widely expected. Key to the economy’s resilience in 2023 was the ongoing strength of the consumer which consistently surprised to the upside. As measured within GDP, consumer spending increased on average by 2.6% in each of the first three quarters of 2023, compared to full-year growth of 2.5% in 2022 and 2.0% and 2.7% in 2019 and 2018, respectively. With consumer spending accounting for ~70% of all economic activity, stronger-than-expected spending over the course of the year helped the economy avoid recession.

Though the unanticipated strength of consumer spending was certainly welcome, other data suggests that the cumulative effects of the Fed’s rate hikes are increasing. Much was made about wage increases in the immediate aftermath of the pandemic, and for a while those wage increases really did help, as real wage growth outpaced inflation. However, by early 2021, even as nominal wage growth remained strong, real wage growth (i.e. nominal wage growth less inflation) turned negative as inflation soared. In fact, real wage growth was negative for 25 consecutive months, from April 2021 until May 2023, when real wage growth finally turned positive again as inflation receded.

Based on the data it appears that rather than reigning in spending to offset the effects of negative real wage growth, consumers instead drew down on savings, and ran up their credit card balances. In February 2020, just prior to the pandemic, the personal savings rate stood at 8.5%. By the end of 2022, following significant pandemic-induced distortions in 2020 and 2021, the rate had fallen to 3.4%. And while it has recovered some since then, it ended November at 4.1%, less than half of what it was prior to the pandemic. At the same time, total credit card debt, which stood at $930B at the end of 2019, surpassed $1.0T for the first time on record in 2Q23 before ending 3Q23 at $1.08T.

The concern is that having depleted savings, many consumers are effectively continuing to finance their spending with credit cards at a time when the average credit card rate has risen to a new record of ~25%, depending on the source. In a sign of how tenuous this strategy can be, the rate at which households are becoming delinquent on their credit cards is now at its highest level since 2011. Nonetheless, consumers forged ahead during the all-important holiday-shopping season. According to Mastercard, holiday shopping between Nov. 1 and Dec. 24, including both online and in-store sales, increased 3.1% in total from the same period in 2022. So, while the cumulative effects of the Fed’s rate hikes may be growing, they don’t appear to have reached a tipping point, thus far. With the Fed now expecting to cut rates in 2024, whether consumers can, or are willing to, continue financing their spending with credit cards may become a matter of timing. While history is not on the Fed’s side with respect to engineering a soft landing, if the Fed begins to cut rates before consumers cut spending, then perhaps a soft landing can be achieved.

Increased investor optimism surrounding the idea that the Fed has reached the end of its current rate hike cycle continued to propel equity markets in December. For the month, large caps (S&P 500) gained 4.4%, boosting full year returns to 24.2%. Small caps, which tend to be more interest rate, and economically sensitive, enjoyed their best month in over three years jumping 12.1% to bring full year gains to 15.1%. International markets also enjoyed solid returns with developed (MSCI EAFE) and emerging (MSCI EM) markets gaining 5.2% and 3.7%, respectively, to bring full year returns to 15.0% and 7.0%.

Fixed income markets surged for a second consecutive month, with the Bloomberg US Aggregate (“Agg”) Bond index, the broadest measure of the US bond market gaining 3.8%, its second-best month since 1995, trailing only November 2023. For the year, the Agg enjoyed its best year since 2020, gaining 5.5%. A continued decline in yields, after hitting multi-decade highs in October, was the primary driver of December’s performance. The rally was initially triggered by the ADP employment report that showed businesses added fewer jobs than expected in November. Employment has been a driving force behind the economy’s sustained strength in 2023, so a signal that employment might be slowing reinforced fixed income enthusiasm from the prior month. A stronger November employment report, released days later, however, showed that the perceived employment slowdown may have been premature, causing the decline in yields to reverse and back up again. The following week saw the Fed concede that they expect more rate cuts in 2024 than previously forecasted. Though their projections showed a minor increase in anticipated cuts, the market took the information and ran with it, pricing in as many as six rate cuts in 2024, beginning in March. Some Fed members subsequently suggested that the market may have gotten ahead of itself and implied that cuts will come later in the year and not to the degree currently assumed. The market has ceded little ground, as economic releases continue to signal further slowing ahead, which would only reinforce their assumptions and continue to facilitate the fixed income rally.

As December’s rally continued, municipal bonds closed the year with yields at lows last seen in April, overall finishing the year lower by 18 to 37 basis points across the curve. Treasuries were mixed on the year, with 2- to 7-year Treasury bonds seeing yields drop overall, while shorter bonds still saw significant yield increases and longer bonds saw minor increases. At the outset of 2023, the near unanimous consensus was that the economy would enter recession before year end. That proved erroneous, as stronger-than-expected hiring and continued consumer spending buoyed the economy. Entering 2024, investors are now optimistic that the Fed will buck historical precedent and achieve an elusive “soft landing.” Investors, however, should not become too sanguine as inflation, while headed in the right direction, remains well above the Fed’s longer-term target of 2%, pressure on the consumer continues to build, and geopolitical tensions remain high. The arrival of the US presidential election could also prove to be a wild card. In addition, the stock market’s strong 2023 performance has pushed valuations back above longer-term averages, from which future returns tend to be more muted. For equity markets to move sustainably higher in 2024, earnings growth will have to accelerate, which in turn will be dependent upon how economic growth unfolds. In short, while 2023 proved to be a pleasant surprise, investors should not naively assume that 2024 will automatically be smooth sailing.

From all of us at First Western, we wish you and yours a happy and healthy 2024.

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Information and research contained herein do not represent a recommendation of investment advice to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment, and it does not constitute an offer or solicitation to buy or sell any securities. It is not possible to invest directly in an index. There is no assurance that investment products based on the index will accurately track index performance or provide positive investment returns. Past performance is not a guarantee of future results. These materials have been prepared solely for informational purposes based upon information generally available to the public from sources believed to be reliable. The views and opinions expressed in this publication are subject to change, at any time, without advance notice or warning.