Embracing the Ride: Market Dynamic of 2023
If you stay fastened for the entirety of the ride, the odds are fairly good you will make it back to the start house. The markets last year proved to be a bit of a roller coaster ride, but for those who stayed securely buckled in, embracing the ride, and trusting the process, the returns were worth it for most.
When we last connected in Q4 2023, bonds were in negative territory yielding a mere -1.21% while global stocks presented a more optimistic picture with a 9.39% return. Then, the bond market staged an impressive rally to finish 2023 up 5.5% (Bloomberg Aggregate) and stocks soared to 21.58% (MSCI ACWI).
What changed you might ask?
This shift was likely fueled by a change in the economic narrative. The market had been dwelling on inflation, ballooning federal debt and uncertainty about the Fed’s next interest rate moves. During the final months of the year, the Fed tipped its hat that interest rate cuts could come as soon as March, inflation readings started to support a less hawkish interest rate policy, and finally it seemed the market just couldn’t resist 10-year treasuries paying nearly 5%.
So go rates, so go the markets — at least for now. Correlation between the performance of bonds (which typically increase in price when rates go down) and stocks has been at historic highs. During normal times, we would not expect this to be the case because bonds represent safety and stocks represent growth and risk. Ideally, they zig when the other zags. But, in our opinion, these are not normal times. We have spent the better part of the last 14 years with the wind of cheap money (low interest rates) at our backs. Removing this financial steroid can be tricky.
But Let’s Take a Look at the Asset Classes
The Bloomberg Aggregate 5.5% return in 2023 was likely driven by the hope for lower rates, with higher risk segments of the bond market leading the way. BSW client portfolios have little exposure to the lower credit quality spectrum of the bond market, we believe a bond allocation should be capital preservation first. In our view, we have plenty of ways to get risk and return through stocks, real assets, and private equity. In a landscape where the lines between safety and risk can often blur, BSW is committed to a higher quality bond portfolio.
So much of stock performance, even at a global level, was driven by the strength of the ten highest weighted stocks in the S&P 500 Index. This group accounted for 86% of that index’s return and represented 32.1% of its market cap by year end. While we welcome these gains, we recognize the transitory nature of such concentration.
BSW’s investment strategy attempts to emphasize global diversification which, we believe, can reduce the impact of market capitalization concentration such as S&P 500 currently shows. We see good relative value outside of the US and in higher quality, less widely owned segments of the domestic stock market.
We continued to see strength in well-run/located multifamily properties. Rent gains, albeit lower than in previous years, persisted and allowed our managers to continue making healthy distributions to investors. Our minimal allocation to the office sector has strategically shielded our investments from significant valuation downturns. Moreover, we’ve actively deployed client assets into infrastructure, a segment of real assets that should benefit from regulatory and tax tailwinds for years to come.
While still offering positive returns, private equity underperformed public markets last year. This is not surprising to us as the pricing mechanism for this asset class is more process-driven than the hubris and despair that comes through in public markets pricing. Over longer periods though, we can see the value of this disciplined pricing in less volatile higher multi-year returns.
The Bright Side: Economic Indicators and Consumer Sentiment
Inflation, as measured by the consumer price index, slowed from its June 2022 peak of 9.1% annual increase to 3.4% in December 2023. Despite this positive trend, the cost of living remains a concern, with everyday items significantly more expensive than they were just a few years ago. The basket of goods that you bought for $100 in February of 2020 now costs $119. If that only rises by 2% to $121 next year, the Fed would probably be doing backflips in celebration that inflation is closer to its target. Without the COVID-induced, transitory bump in inflation that basket of goods would cost more like $109 today. But such are the vagaries of sticky inflation because price increases are like spilled milk. The best thing to do is clean it up and move forward.
In the meantime, many individual and corporate balance sheets look great. While interest rates are high, they were not so for most of the last decade, particularly in 2020, 2021 and 2022. This allowed many households and companies to refinance and lower their debt burden for some time into the future.
Liquidity is high. It is hard for an economy to get backed into a corner when there is a lot of cash sitting on the sidelines.
Let’s look at this at three levels.
The total money supply stands significantly above its long-term growth trajectory, approximately $3TN or 20% higher, a surge attributed to various initiatives like the Payroll Protection Program, supplemental unemployment benefits, mortgage forbearance, student loan forgiveness, or rental assistance programs to name a few.
While the growth of money supply has gone negative, with some analysts calling it historic, we believe this can be misleading because the aggregate supply of money is still so much above normal.
By the end of the third quarter in 2023, money market funds had accumulated over $6TN of assets, with Certificates of Deposits adding another $3TN, reaching an all-time high.
High money market fund rates are tempting, especially after 2022, which was notable for poor bond performance. One way or another, the cash is swirling in short-term instruments which could be used to buy assets should there be a decline in values.
Dry powder in Private Markets
In the realm of Private Equity or Real Assets, there is significant committed capital poised for deployment. Last year many investment managers in this space struggled to place capital as they waited for better deals and sellers refused to accept lower asset prices. We think this can change as deal postponement fatigue sets in for many companies.
It is harder to have a significant crash with so much liquid capital plump with anticipation.
Despite consumer sentiment not reaching the heights of historical standards, there’s a noticeable uptrend buoyed by factors like falling gas prices ($2.77/gallon most recent fill-up), a burgeoning labor force, climbing hourly wages, and general inflation slowing. Like it or not, 70% of the US economy is private consumption, so a happier consumer usually translates to a happier economy.
The Flip Side: Addressing Rising Rates, Geopolitical Unrest, and Real Estate Shifts
Rates were higher last year, not just because of the Fed’s fight against inflation, but also the ballooning federal debt. Until about October, the bond vigilantes vehemently expressed their distaste for the unsustainable federal budget situation by selling long-term bonds causing rates to rise.
However, they appear to have taken a nap for the colder winter. Like Fozzie the Bear, they will not sleep forever, which could renew upward pressure on rates.
In the short term, the Fed is backtracking its dovish tone that fueled last year’s late-inning rally in the markets. “Not so fast,” they say, and perhaps rate cuts will come later in the year. Economic growth is positive, and inflation is showing a slight second bump. Time will tell if these factors will keep the Fed from feathering down the brakes of higher rates for longer.
The unpredictability of global geopolitical events, from Ukraine to the Middle East, further complicated the economic landscape. Sadly, the visible ebbs and flows of the economic ecosystem do not drive these outcomes, instead, they are driven by the calculation and judgment of humans, which makes these things hard to forecast. Not knowing puts a damper on investor enthusiasm. Meanwhile, the human toll is heartbreaking to consider.
Office real estate has attracted attention due to record-high vacancy rates. COVID forced us to adapt to a more flexible working environment, which may not be good for offices that operate under an in-office five-day workweek paradigm. There are significant maturities of office mortgages in the next few years, many of which are on properties that are worth less than their debt. Barring a swift shift in how office space is used, both real estate investors and lenders will face challenges.
Lessons in Resilience
Reflecting on life’s roller-coaster journey, my mind often wanders to my sister in Lima, Peru, whose dream of becoming an actress was met with skepticism and dismissal from those around her, myself included. Despite the doubts and my calls for a backup plan, she remained committed to her craft. I think if you asked her what that roller coaster ride was like, she would probably tell you that there is not enough mechanical engineering available to build that ride. But she stayed committed, upside down, right side up, sick stomach, and more. Looking back on the last thirty years of commitment she would tell you it was worth it. Today, her dedication has culminated in a triumph, with her starring role in the film, Reinas being celebrated with a world premiere at the Sundance Film Festival.
Preparing for 2024’s Financial Landscape
For me, this narrative resonates deeply with the financial voyages we embark on with our clients. The investment journey our clients travel should not be as persistently terrifying as most roller coasters. The truth is, we work diligently to ensure expectations are clear and that when the ride is bumpy it is not outside the realm of what we already know is possible nor is it without a partner to provide perspective and hands-on care of the portfolio. There is no telling if this year will be upside down, right side up, or if it will make your stomach sick. No analysts we follow even came close to expecting the rally that materialized in stocks last year, but we will take it and bravely face the possibility of what lies ahead in 2024.
Thanks for reading.
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