Energy and food prices moderated during 2023, and these helped to drive down headline inflation readings significantly. Expectations of an imminent recession were not realized; in fact, economic growth was quite strong throughout the year. Investors could be forgiven for feeling confused as concerns oscillated throughout the year between persistent inflation and an economic downturn. For better or worse, predictions around Federal Reserve actions drove much of the activity in the financial markets. Despite a hiccup during the 3rd quarter, stocks staged a significant rally, particularly late in the year when the markets began to anticipate rate cuts in 2024. AI mania captured the imagination of society and the markets. The collapse of several mid-sized banks had no long-term impact.
Major Economic Events
The post-pandemic global economic recovery decelerated. Most central banks tightened policy and that depressed economic activity a bit. Although top-line growth in the US was robust, Europe and Japan flirted with recession. The German economy has become very reliant on exports to China, and thus stagnated as demand there was lackluster. China’s abandonment of its zero-covid policy failed to generate significant momentum.
Employment worldwide was strong, and wages rose. Even as the supply chain snafus slowly resolved themselves, spending on services such as travel soared, providing additional inflationary impetus. The Federal Reserve and European central banks raised rates. Commodity price pressures eased, which, in concert with the impact of higher interest rates, had inflation in a downward trajectory as the year drew to a close. So-called “core inflation” (overall inflation excluding food and energy) remained uncomfortably high.
The Equity Markets
After being pummeled for most of 2022, stocks embarked on a rally that began late that year. The surge continued into 2023 and, despite taking a pause in August and September, equity markets surged and ended with significant gains. Technology stocks were the standouts, as investor exuberance over the potential of artificial intelligence combined with what was already a favorable regulatory/competitive environment. Among market sectors, only utility stocks dropped. Health care stocks struggled as provisions in recent legislation threaten pharmaceutical firms’ profitability. Financials took a hit in early 2023 as several mid-size banks collapsed suddenly. The more economically sensitive parts of the market – small and midcap stocks –ended the year with gains below those of the S&P 500, despite a surge late in the year.
International stocks recorded gains, but lacking any tech stock standouts, lagged the US. European stocks were surprisingly robust, while emerging markets struggled. China, which comprises roughly one-third of the emerging market index, fared poorly. Erratic leadership policies including a government assault on its home-grown technology firms as well as a crackdown on property firms - took a toll on Chinese equities. Any signs of relief from these restrictive policies have been greeted with relief from investors, although the capricious nature of Chinese authorities continues to be a threat, as does the economic hostilities between the US and China. China’s attempts to present a welcoming attitude towards investment and dynamism have been thwarted by heavy-handed government actions.
REITs prices leapt higher as investors began to anticipate Fed cuts in 2024. A powerful 4th quarter rally was more than enough to wipe out losses from earlier in the year. Although this asset class continues to broaden and includes much more than the traditional office and apartment properties, the rise in work-from-home employment has had a drastic effect on office valuations and this appears to be a structural, rather than cyclical, change. It appears that this asset class has become more dependent on the (predicted) path of Federal Reserve policy than actual economic results.
Natural resource prices rose and fell along with the economic outlook. When recession fears became prominent, oil prices fell. Energy stocks ended the twelve-month period with small gains. Alternative energy stocks, although seemingly well-positioned for the long-term, endured a relatively poor period, wounded by lengthened paths to profitability, tightening financial conditions, and continued reliance on fossil fuels.
Overall, the effects of diversification from the traditional S&P 500 index were quite negative. Small and mid-cap stocks lagged, while international equities were hindered by emerging markets. Real estate and natural resource gains lagged the broad market.
The Fixed Income Markets
After a historically bad period in 2022, bond prices stabilized in the first half of 2023. Interest rates rose in August and September, before tumbling down as investors began to sense economic weakness and a likelihood of Fed easing. As always, bond prices move inversely to interest rates, and the 4th quarter rally was enough to lift the overall bond market to a respectable gain. The twelve-month period saw the overall bond market post a small gain of +5.6%. Inflation decreased and demand for inflation-protected bonds waned. Cash and similar investments were a safe haven from volatility; by June the rate of return from money markets actually exceeded the rate of inflation.