By Wayne Yi, CFA
In a final sprint to the end of the year, the S&P 500 climbed out of its 2022 hole, returning about 26% to close out 2023. This was an impressive return, in the face of an additional 100 basis point rise in interest rates to 5.5% this past year, and a plethora of other events that could have taken the market in a more negative direction: regional bank failures that required a Fed bail-out, a potential government default, further escalation of international conflicts, and generally weaker economies in Europe and China. It has been another demonstration of American exceptionalism this year.The interest rate hiking cycle appears to be coming to an end, as inflation has been on a steady decline and labor markets cool. Chairman Powell came out of the last central bank meeting of the year with a much more dovish tone on the path for rates in 2024 and continued confidence in the possibility of a soft landing. While the final point of inflation reduction will likely be the hardest to attain, the economy is much closer to attaining the long-term 2% Central Bank target today than when we started 2023.
Inflation has declined to the low 3%’s from its 9% peak
Source: Simon Quick Advisors, YCharts
Fed targeting 4.75% in 2024
Source: CME Group
While the Fed seeks to maintain a modestly restrictive rate policy, where interest rates are still above inflation levels, the current 5.5% level is too high given inflation has fallen to the low 3%-range. The latest Dot Plot, which surveys where members of the Central Bank believe interest rates will be in the coming years, projects interest rates to settle at 4.75% by the end of 2024 (depicted by the light blue dots in the chart above), an additional 25 bps rate below what was previously guided. While the Fed may still be restrictive, the lower absolute levels of interest rates should alleviate some of the financing pressures on businesses and consumers. Both stock and bond investors took this as very positive news and further fueled this year-end rally.
What was particularly notable during the past quarter was the expanding breadth of stocks that participated in the market move higher. We had previously noted that much of this year’s equity market run was really led by the few “haves” of the Magnificent-7 (Mag-7) large tech stocks, with minimal participation of the much broader “have-nots” of the remaining 493 stocks. These Mag-7 names had driven the vast majority of market returns for most of the year. However, on the back of easing inflation and the dovish pivot by the Fed, we saw a much broader based rally across all asset classes. The Russell 2000 small cap index is of note, as these more financially levered, economically sensitive businesses enjoyed a 20%+ rally during the final two months of 2023,which was 10 points better than the S&P500. The equal-weight index for the S&P 500 is also outperforming the capitalization-weighted index that is heavily skewed towards the Mag-7. Both of these indices closed out the year behind the main S&P 500 benchmark, however have meaningfully outperformed in the final few weeks.
Despite these strong moves in 2023, the equal-weight index is only slightly positive over the past two years, with the Nasdaq and Russell 2000 still under their 2021 highs. In a benign economic scenario with steadily declining rates, we can see these indices catch up and set new highs early in the new year as inflation continues to alleviate and the Fed begins to bring down interest rates. We acknowledge that the economy is slowing and the strength of the consumer is moderating, however we believe recession risk remains further off on the horizon.
Despite a strong 2023, Nasdaq and Russell 2000 Indices are still below their prior peaks….for now
Source: Simon Quick Advisors, YCharts
On the back of strong performance, valuations on equity indices have expanded as well, with the S&P 500 returning to a 19.5x Forward Price/Earnings multiple. This is meaningfully off the 16x trough in 2022, but remains below the 22x prior peak in 2021. Corporate earnings have remained resilient through this inflationary period, seeing a 5% decline in earnings in 2022, but are expected to bounce back to over 8% through 2023 and further accelerate to over 13% in 2024. Improved earnings expectations have provided some support to current valuations. Excluding the Magnificent-7, which comprise approximately 27% of the S&P 500 index and currently carry a near 28x Forward P/E combined, equity valuations of the broader remaining constituents are more attractive at under 18x. This discount to the headline valuation metric provides a cushion for potential further expansion for stocks to catch up, especially as we see additional earnings improvement from these more economically sensitive stocks. We may see a slowing of stock returns from the Mag-7, but there is still a runway for performance for the rest of the market this year.
Source: Yardeni Research
Fixed income has also recovered after two negative returning years, as measured by the Barclays US Aggregate Index. While at its lowest point in the year, the index was down over 3% in October, but rallied over 9% in the final two months of the year to return nearly 6% for 2023. We expect interest-sensitive assets to continue to remain more attractive than cash and money market funds as the Fed gradually brings down interest rates.
It is notable though, that despite the volatility we saw in fixed income assets in the second half of this year, the Fed has been very patient and consistent, with only one 25-basis point hike in late-July, and an otherwise steady 5.5% target in the back half of 2023. It has been market participants taking into consideration the heavy US Treasury issuance after the debt ceiling resolution, and then a rapid readjustment to more aggressive rate cuts than what the Fed is currently guiding towards, that drove volatility in the bond market. We saw longer-dated bond yields whipsaw 100 basis points between the end of the second quarter to a high of about 5%, and then down to under 4% in 10-year Treasuries. Currently, the market is expecting as many as 6 cuts in 2024 to about 4% or lower, versus the Fed’s current target of 4.75%.
Bond volatility has been driven by investors, rather than by the Fed
Source: Simon Quick Advisors, ustreasuryyieldcurve.com
Reflecting on our Positioning in 2023 and setting up for 2024
We entered the year with relatively balanced allocations across asset classes, but with a view to deploy available cash into the market rather than hoard it. Despite the sell-off in both stocks and bonds in 2022, we saw an opportunity for recovery, led by equities and buttressed by attractive yields in fixed income. We agree that high short-term rates were attractive via money market funds and T-bills but felt that this was transient and such positioning precluded any opportunity for traditional fixed income to provide diversification benefits to stocks.
We moved to an underweight recommendation on stocks in the second quarter, on the back of strong first quarter performance from equities, despite the regional banking crisis and increasing economic uncertainties domestically and abroad. The narrowness of the rally was uninspiring as well. We recommended taking some of those equity gains and increasing exposure to credit opportunities, specifically floating-rate loans. Our view was that while the economy may be slowing, we didn’t see near-term recession risks, and collecting 10%+ in interest income was a way of achieving equity-like returns with lower volatility. This loan exposure notably protected well in the market volatility of the third quarter. Bank loans have delivered, as both broadly syndicated and private lending opportunities generated over 10% returns via appreciation and income in 2023.
While the final quarter of 2023 started off meekly, improving inflation data amid still solid economic growth, coupled with a more dovish Fed caused all assets to rally, but particularly stocks, and was notably more broad-based. The strength of this rally has likely pushed equity portfolios back closer to target weightings, and while this move was sudden and significant, overall encouraging economic data and a change in tide from the Fed has supported it.
Yes, the economy is slowing and consumer wallets are thinner, but there is no sign of a meaningful recession in the near-term. The Fed is now on a path of easing as inflation and labor pressures subside. As we look forward into 2024, we aren’t expecting as strong of an equity market as what we experienced in 2023, but the economic data supports continued earnings growth and valuation support as rates come down. Thus, we are taking a deep breath of patience and letting portfolios gravitate up towards target allocations rather than looking to take more gains, as the fundamental factors may be further supported by cash, that was previously sitting on the sidelines, moving back into stocks.
Fixed income and credit have overall performed well this year and we favor maintaining duration as a hedge to unanticipated economic risks. Floating rate assets remain attractive on an absolute basis, but will see some decline in yields as interest rates come down this year. Thus, we are commensurately reducing our overweight allocation to the asset class back to target. We are still positive on the long-term income opportunity that now avails itself in fixed income, but the rapid tightening, especially in longer duration bonds, causes us to take a pause in adding more capital here. We would continue to maintain a balance of higher yielding credit strategies and liquid high-quality, longer-duration assets.
For cash sitting on the sidelines, we continue to recommend measured deployment across both equity and fixed income as staying in cash and T-bills is not the long-term solution for maintaining or growing wealth, as exhibited by both stocks and bonds this year.We haven’t adjusted our weightings in alternatives for the new year. Hedge funds overall performed well in 2022 and 2023 and we expect the diversification of these strategies to remain complementary to traditional asset classes, particularly in fixed income. Illiquid assets have not seen meaningful improvement in valuations this year, but as long-term assets, should benefit from continued earnings growth and a reacceleration of transaction activity in a more favorable capital markets environment. Alternative investments should be accretive to portfolios, but tend to be relatively smaller, stickier allocations.
Asset Allocation Recommendations
Equities: Move to Target-weight
The domestic economy remains resilient, as we see above-trend GDP growth and corporate earnings strength. Consumers overall remain strong, albeit at a moderating level than what we experienced over the past couple years. A path to rate cuts should support valuations and contain volatility as we start 2024. We believe the late-2023 market rally still has some room to run as cash moves off the sidelines and are thus moving to a target-weighing for stocks as equity allocations have organically grown. While the Magnificent 7 can still perform well in the new year, the current economic and Fed backdrop may favor the other 493 stocks in the index, in addition to smaller cap companies that are more levered to economic growth and lower interest rates. We remain domestically oriented as Europe appears to be lagging the disinflation trend and thus is maintaining a more hawkish monetary stance.
Fixed Income: Move to Target-weight
Fixed Income assets generated attractive yields and saw capital appreciation as target interest rate expectations fell. We remain constructive on the diversifying, income-producing nature of the asset class, but would pause on additional allocations given the rapid tightening we saw in longer-duration yields as the market is calling for more aggressive Fed easing. We maintain a balance between investment grade duration exposure and floating rate lending strategies, as recession risk still remains relatively low.
Liquid Alternatives: Target-weight
Hedge Funds: Hedge funds have shown their ability to be sources of portfolio diversification over the past couple years. While stocks and bonds still exhibit positive correlation in the current environment, we appreciate the contribution of alternative strategies with low directionality, but actively traded, dynamic portfolios that can take advantage of moments of disconnect between trading relationships of securities and asset classes in periods of transition. These opportunities can help funds generate steady returns with less sensitivity to market direction or the actual path of interest rate cuts in 2024. We continue to expand our multi-strategy allocation and complemented it with differentiated lending and volatility strategies to balance out the more directional small cap exposures.
Real Estate: We have been adding core-plus real estate opportunities, notably in residential assets for its inflation aligned properties and as a complement to stock and bond portfolios. We continue to remain cautious on the fundamental outlook of office buildings. Lower interest rates should ease some pressure on financing situations.
Illiquid Alternatives: Target-weight
2023 performance for illiquid assets was muted. While underlying portfolio company earnings have improved, transaction activity has remained light. Lower rates and a narrowing of bid-ask spreads should reaccelerate over the next couple years and committed capital for opportunistic deployment should make newer vintages highly accretive. Venture valuations have remained muted, thus making secondary opportunities in this segment of the market notably attractive for discerning investors.
About Wayne Yi, CFA
Partner / Chief Investment Officer
Wayne Yi is the Chief Investment Officer and a member of the Simon Quick Investment Committee. He sits on the Operating Committee which is responsible for executing on Simon Quick’s vision and strategy. Mr. Yi is also a member of the firm’s DEI Committee which aims to foster an environment of inclusion and promote diversity in the workplace. He leads the firm effort on all market research and manager diligence across traditional equity and fixed income strategies as well as in alternatives, including hedge funds and private equity allocations. Prior to joining the firm, Wayne was a Co-Portfolio Manager and member of the Investment Committee for SAIL Advisors, a hedge fund investment firm headquartered in Hong Kong. He also served as the senior analyst for their Credit and Event-Driven strategies. Prior to SAIL, Wayne was the Sector Head for Credit and Event-Driven strategies at Robeco-Sage, a hedge fund investment firm based in New York. Wayne started his career in investing at Delaware Investments as a Research Analyst for high yield and investment grade bonds across various industries. He then joined Goldman Sachs’ Investment Research department where he was the Senior Analyst covering high yield bonds in the Technology sector. Wayne is a graduate of the University of Pennsylvania where he received a B.A. in Economics and in International Relations. Wayne is a CFA charterholder.
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