As we put the finishing touches on 2023, it’s instructive to look back at the year to observe how different it turned out from what most were predicting. This was expected to be a negative year for the equity markets, with most economies entering a severe recession. Yet we are ending the year with most equity indices at, or near, all-time highs, and recession talk is all but forgotten for the near term.
Another good check back on the year is to look at how sentiment has shifted throughout. The mood was bleak last January, coming off a difficult 2022, and by the time US regional banks began to collapse in March, it was pretty hard to find bullish investors anywhere as popular sentiment readings touched all-time lows. But as banks began to recover and central bankers began to get a handle on inflation, markets and sentiment improved through the summer. A stumble through October crushed sentiment once again, with markets lower and yields higher, but just when it looked most bleak, everything changed. Today, as we end the year, we are once again back near the all-time highs for bullish sentiment and markets. But is this too much of a good thing?
Every investing cycle is a little different, and this one may be best remembered for how the bond market reminded equity investors that, as always, they are in charge. With all the attention on fixed income, and, in particular, the US 10-year bond, it’s remarkable to see the year end with yields essentially unchanged. We entered the year looking at a recession, but as inflation and the economy stayed hot, central bankers embarked on more rate hikes than many had expected. On any rate cycle the fear is always that yields will stay high until something breaks. A policy error tends to end most Bull Markets, and that was the fear in October. At this time, it seems those fears have been pushed aside.
The collapse in bond yields from the cycle highs of October should be looked at as the main reason for the rally in equities we are enjoying to end the year. But the big question everyone is going to have as we enter 2024, is have we pulled forward all the good news? Bond markets are now pricing in over five rate cuts, beginning at the March meeting. Equities are in rally mode, and cyclicals are running as economic discussions have moved from a ‘mild recession’ to no recession at all. One may say this is “as good as it gets,” and any stumble on either of these assumptions could surprise markets that have enjoyed the “everything rally” from early November.
While broad markets and certain areas are looking risky, the good news is that the coming year might be setting up for an environment that will be very conducive for a reversion trade in the lagging areas. After a year in which the emergence of AI and the Magnificent 7 dominated the early part of the year, it’s a welcome change for many to see the year-end with a broadening out of the rally. As bond yields remain under pressure, we should see a continuation of this rally as companies that screen better on metrics such as Quality or Value begin to outperform. We may also see a resurgence in companies that have attractive dividend yields. When the money market is yielding close to 5%, many don’t want to take on equity risk to get a similar income stream, but that could change quickly if yields do take the path lower.
With a peak in yields, another theme that should take hold is the emergence of “peak dollar.” Like the US stock market, the US dollar has dominated for years. If a situation appears allowing for other economies to catch up, the dollar should weaken, which can help many commodities and material-producing companies and countries (i.e. Canada).
2022 was one of the worst years ever for the 60/40 portfolio, and by many metrics, 2023 might have been the best. Will next year go back to a more ‘normal’ time and be something in the middle? That may be the most likely scenario.
The rally to end 2023 is one for the history books, but we must remember that it's not a time to get complacent just because everything is looking good right now. We only must look back at the wild swings in sentiment we experienced earlier this year to realize things can turn quickly. We are entering January near record levels and with sentiment readings at all-time highs. The prospects of a positive year remain likely, but in the near term, the setup is looking riskier than this time last year.
— Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments
All data sourced from Bloomberg unless otherwise noted.
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