January 12, 2024
A strong fourth quarter in global equity markets capped a banner year for stocks. This was especially true for a handful of mega-cap technology+ stocks that dominated, and drove, the benchmarks higher throughout 2023 – dubbed the “Magnificent Seven” (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla). Importantly, during the quarter we saw a broadening of market strength following the dominance of the Magnificent Seven – including gains from small cap stocks and select cyclical and value plays. Robust returns were driven by the US Federal Reserve’s acknowledgement that the tightening of financial conditions during 2023 would likely reduce the need for further rate hikes, in conjunction with continued signs of disinflation, which gave the Fed room for a pause and ultimately led to multiple rate cut expectations in 2024. The Fed’s dovish pivot, coupled with strong indications of domestic growth powered by a resilient US consumer, solidified the soft landing narrative. The subsequent decline in interest rates not only favored investor risk appetites, but drove strong fixed income returns across the curve.
Despite the magnitude of the rally during the fourth quarter, we continue to monitor areas of potential concern. Geopolitically, concerns continue on several fronts; the Russian/Ukraine conflict continues to drag on, the acceleration of the Israel/Hamas conflict in the Middle East, and the increased sabre rattling from China over Taiwan. Given the weight and influence of US stocks on global equities, we are also cognizant of the risks of premature dovish pivots, the lagged effects of the tightening cycle, and the impact that disinflation might have on corporate profits – particularly at full valuations for US stocks. In contrast, international equites are trading at a deep discount to US equities, indicating a more favorable setup for an inflection in earnings – with support from a weaker US dollar. Inflation has also declined internationally, which could provide Central Banks the needed flexibility to allay growth concerns – including any potential fall-out from China’s struggles.
During the quarter, we eliminated the emerging markets position. Strong US developed performance and negative sentiment around China were headwinds for developing market allocations. The holding’s exposure to China and Taiwan represent approximately 45% of this allocation. In addition to the geopolitical risks, China’s incremental approach to support debt deflation in corporate and local governments and the balance sheet recession in the property sector means that longer-term headwinds to growth are likely to remain. We trimmed the strategy’s energy exposure, in part due to concerns over global growth and China demand, but also due to the fact that announced production cuts did not provide the support to energy prices that we expected. We used the proceeds from the energy trim to initiate a position in the S&P 500 equal weight index to take advantage of the broadening market environment. This allocation increases our exposure to mid and small-cap companies that are not only attractively valued relative to the cap weighted index, but should benefit from lower interest rates (soft landing scenario).
Over the course of the quarter, interest rates moved significantly. The 10 Year Treasury yield moved from 4.6% on September 30th to 5.0% on October 19th and then declined significantly to 3.9% by the quarter end. This move reflected the significant improvement in inflation, and expectations for a pause and an eventual easing in Fed policy. We used the decline in rates as an opportunity to reduce duration in the portfolio by trimming our long-term bond position and adding to the intermediate position.
In the US, while recession may have been deferred in 2023, we do not believe it has been diverted. We continue to believe that the full effects of the Fed’s tightening campaign, the most aggressive in 40 years, has yet to land. Weaker growth and declining pricing power could lead to disappointing corporate revenues and profit margins. Developed international markets, by comparison, may experience stronger profit growth and currently have attractive valuations relative to US markets. Inflation has slowed broadly and this coupled with any easing of demand may provide relief to Central Banks’ policies broadly. Although well diversified portfolios struggled in 2023 given the concentrated nature of the benchmark returns, we believe this diversified portfolio will serve clients well as market performance continues to broaden.