Investment Strategy Brief:
Turning the Corner to 2024

Below is a transcript of this week’s video.

Hello, this is Ilona Vovk with Investment Strategy at Glenmede.

As we officially enter 2024, let’s take a look of how we closed out 2023. The final quarter of 2023 showcased the resilience of the U.S. economy, defying recession fears. Small cap stocks led the way up 14.0% in the 4^th quarter followed by large cap stocks, up 11.7%. In comparison, foreign counterparts also posted positive gains in Q4 although underperformed those of U.S. large and small caps. On the fixed income front, investment-grade bonds performed well. Both taxable and municipal bonds were up 6.8% and 7.9%, respectively in the fourth quarter. So what happened in this 3 month period to drive returns?

Well abroad, war broke out in the Middle East between Israel and Hamas. The conflict remained relatively contained despite fears that it could spread into a wider regional conflict that would disrupt global energy markets. In the Middle East, the number one export for many countries is crude oil or related petroleum products. Israel largest exports are electronics, precious metals and minerals. The threat of escalation in the Middle East put global energy production at risk, but the conflict remained contained and oil prices declined in the quarter.

Domestically, after raising rates considerably over the last year and a half, the Federal Reserve opted against further rate hikes in Q4. In fact, the Fed appeared to set the stage for incrementally more accommodative policy next year. The latest update to its dot plot projections showed the median respondent expecting three rate cuts as the base case by the end of 2024, though this would still keep rates considerably above neutral through at least 2025. This caused equity markets to rally, interest rates to fall and financial conditions to ease on the news. That said, markets seem overly optimistic with expectations for 6-7 cuts in 2024 via fed funds futures. Fed officials stressed the possibility that the current level of rates may be sufficiently restrictive to quell above-average inflation, though many did not rule out the need for further tightening if it became apparent it was needed to restore price stability.

Now, let’s take a look at the performance for the whole year. In 2023, equity performance stood out. U.S. large caps were up 26.3%, U.S. small cap 16.9%, international developed equities up 18.2% and international emerging up 9.8%. On the fixed income front, core bonds returned 5.5%, Municipals 6.4% and Cash 5.3% to close out the year.

It is important to note that 2023 gains particularly as they relate to U.S. large cap performance were driven largely by just a handful of stocks that have come to be known as the Magnificent 7. While the broad index is up more than 26%, if you were to exclude the impact of those seven stocks, the return would be much more muted. That’s seven stocks in a 500-stock index that are responsible for a large share of the gains experienced.

Now after the Fed meeting in December, 10-year Treasury yields fell below 4%, when just a few weeks ago they were bumping up against the 5% mark. What it took to get there was a pretty turbulent period for fixed income markets. Rising yields led to large losses in existing bonds that were forced to mark-to-market against higher prevailing rates which resulted in a challenging environment for bonds. Investment-grade bonds were facing their third-straight year of negative total returns, but the year-end decline in rates yielded positive total returns.

So given all of this, what can we expect in 2024? After years of shocks, abnormal events and dislocation. There is now a more normal cost of capital. Fixed income is now more fairly valued and set up to deliver more normal returns. At this point, the economy has yet to fully adjust to higher borrowing costs. Domestic and global politics may remain notably abnormal likely causing some volatility into the year. Equity valuations have moderated, but large cap needs further adjustment. Now the biggest implication of the new interest rate regime is that the longer that financial conditions stay tight, the more pressure the broader economy faces. Further recalibration back to normal is likely to favor fixed income, while providing a headwind or more volatility to equities.

We can start seeing those observations in 10-year expected returns particularly when comparing current estimates to long-term normal estimates. Fixed income may deliver more normal returns, though premium valuations may foretell below-normal equity returns particularly in U.S. large caps.

To briefly summarize 2023, in Q4 major asset classes rallied due to anticipated Fed rate cuts for the next few years, fueling a year-end rally in both equities and bonds. The Middle East conflict put global energy production at risk, but the conflict remained contained for the time being. In 2023 most major asset classes experienced a strong year, though a small set of companies were responsible for a large portion of market gains. Investment-grade bonds were facing their third-straight year of negative total returns, but the Fed pivot caused a year-end decline in rates that yielded positive returns. Looking ahead, there will likely be further recalibration back to normal. This should favor fixed income, while providing a headwind to equities.

And with that, thank you for listening! And please don’t hesitate to reach out with any questions.