Inflation Down, Stocks Up. Year in Review - 9/30/2023
Ongoing effects from Russia’s assault on Ukraine combined with strong consumer and governmental spending induced an inflationary spike that garnered most of the economic headlines. The Fed and other central banks struggled mightily against the inflation scourge. Data in 2023 displayed solid progress as the pace of price increases moderated, particularly in the energy sector. Expectations of an imminent recession were not realized; in fact, economic growth was quite strong in mid-2023. Investors could be forgiven for feeling confused as concerns oscillated throughout the year between runaway inflation and an economic downturn. Despite a hiccup during the 3rd quarter of 2023, stocks staged a significant rally. 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 satisfactory, Europe 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 additional inflationary pressures.
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 fuel to inflation. The Federal Reserve and European central banks continued raising 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 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. Only the real estate and utility sectors fell. These stocks were negatively impacted by rising interest rates. 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 – managed to produce gains, but far below those of the S&P 500. An additional hindrance to small and midcap stocks was the heavy weighting of financial stocks in those indices.
International stocks were a mixed bag. European stocks were surprisingly robust, while emerging markets struggled. China, which comprises roughly one-third of the emerging market index, persisted with its zero-covid stance until a sudden reversal at year-end. That policy - along 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 fell slightly, as tightened financial conditions spooked investors. Rising interest rates have hurt commercial real estate values. 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.
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 solid 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 negative. Small and mid-cap stocks lagged, while international equities were hindered by emerging markets. Real estate had a relatively poor year.
The Fixed Income Markets
The Fed raised interest rates dramatically as inflation reached levels not seen in decades. After a historically bad period in 2022, bond prices stabilized in the first half of 2023. However, long-term interest rates rose sharply in August and September, and this sent bond prices downwards. Mortgage rates hit levels not seen for fifteen years. The twelve-month period saw the overall bond market post a small gain of +0.6%. Cash and similar investments were a safe haven, and by June the rate of return from money markets actually exceeded the rate of inflation.