Newsletter
Dear Client,
Very few predicted the strong performance in U.S. equity markets that we witnessed in 2023. The S&P 500 posted a 24% return, and the Nasdaq Composite surged 43% thanks in large part to a mania surrounding artificial intelligence. The majority of 2023 was characterized by extremely narrow leadership in stocks, with only a handful of mega-cap technology companies accounting for most of the gains. However, the year was not without turmoil. The 30-year fixed rate mortgage rate rose above 8%. The Federal Reserve raised rates four times, culminating in 525 basis points of rate increases since the start of their hiking cycle in March of 2022. These soaring interest rates caught a number or regional banks wrong-footed. At Silicon Valley Bank, deposit outflows and a sale of its Treasury bond portfolio at a large loss eventually triggered a bank run. First Republic Bank and other lenders also collapsed and bank stocks swung wildly. The Fed was forced to step in and establish a Bank Term Funding Program, shoring up confidence and averting the risk of broader contagion.
One of the larger surprises of the year was that higher bond yields did not turn out to be the bugaboo that many investors feared. A historic bond rout which drove 10-year Treasury yields up over 5% in October for the first time in 16 years sparked a stretch of volatility in equities, but did not stifle the rally for long. The Federal Reserve raised interest rates at the fastest pace since the 1980’s, a regional banking crisis shocked the system, a war broke out in the Middle East, and yet stocks kept climbing. The economy was supported by a range of fiscal and liquidity measures to offset the drag from higher rates and the Fed’s ongoing quantitative tightening program (QT). The Inflation Reduction Act (IRA) and CHIPS Act led the fiscal support measures partially offsetting the economic slowdown.
While the Fed had been signaling for months that investors should not expect rate cuts anytime soon, they “pivoted” to a more dovish stance in their last meeting of the year on December 13th, holding rates steady and indicating that the inflation outlook has improved more quickly than anticipated. The new dot plot, which graphically depicts each individual committee member’s estimation of monetary policy, suggests that there could be 3 rate cuts in 2024 (although the market has quickly priced in more than that). This pivot was a minor change in messaging, but the subsequent easing in financial conditions has been striking. It highlights the rapidly shifting outlook for both growth and inflation. An “everything rally” on the back of this pushed up prices of assets on everything from gold to bitcoin. The S&P 500 ended the year on a nine-week winning streak, its longest since January 2004.
Persistently sticky inflation, however, should remain a concern. Rising oil prices and a resilient housing market could complicate the Fed’s path back to the 2% inflation target. With core CPI inflation hovering at 4%, the risks are rising that easier financial conditions induced by the Fed pivot could reignite inflationary pressures. This in turn could force the Fed to scale back the rate cuts, and much of the soft- landing narrative (slowing down economic growth and reducing inflation while avoiding recession) has already been priced into markets. Because monetary policy operates with long and variable lags, the full impact of aggressive monetary tightening may not yet be known. According to Deutsche Bank, in the past 11 Fed rate-hiking cycles, recessions have typically started about two years after the central bank begins raising interest rates. This hiking cycle started in March 2022.
Although a soft-landing has become the consensus view, there are a number of factors that can keep upward pressure on rates. The ballooning U.S. budget deficit, the Bank of Japan loosening its yield curve control over its own bond market prompting investors to rotate out of the U.S. and bank towards the Japanese bond market, and less overall Chinese demand for Treasuries could all keep rates higher than many are prepared for.
Looking forward to 2024, the geopolitical overhang could play a potential spoiler. The war in the Middle East, fresh tension with China over Taiwan, and key elections globally in more than 50 countries will test investors’ appetite for risk. While the Fed may not deliver on the market’s expectation for over five rate cuts priced by year-end, the hiking cycle is widely seen to be behind us. Last year’s outperformers could come back down to earth in favor of the recent rotations into small-cap and previously underperforming sectors. We continue to favor large cap domestic stocks and Agency mortgage-backed securities via an intermediate bond fund. The net supply of Agency mortgage pass-throughs that had to be absorbed by non-bank entities surged in 2022 and 2023, creating a significant drag on the sector. This was a product of the Fed’s QT program and the commercial banks selling mortgages due to a flight from deposits, forcing banks to shrink the asset side of their balance sheets. We expect this excess supply overhang to abate, and Agency mortgage bonds to perform well as a result.
We thank you for your continued support and wish you all a healthy and productive new year.
Regards,
Edge Wealth Management
Past performance does not guarantee future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product directly or indirectly referenced will be profitable, equal any corresponding indicated historical performance level, or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. This content does not serve as the receipt of, or as a substitute for, personalized investment advice from Edge Wealth Management, LLC. If you have any questions about the applicability of any content to your individual situation, we encourage you to consult with the professional advisor of your choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request or by selecting “Part 2 Brochures” here.