Federal Reserve Bank interest rate policy continued to have a disproportionate impact on the U.S. stock market over the final quarter of 2023. After raising rates in 2022 and the first eight months of 2023, the Federal Reserve paused in September, declaring that rates were likely to remain “higher for longer”. Equity investors took the pause to signal a conclusion of the rate hikes, and aggressively moved back into equities. The stock market generated positive returns for nine consecutive weeks at the end of 2023, with the benchmark S&P 500 generating a 11.2% return for the fourth quarter and a 26.3% return for the year.
Investors remain divided on the future direction of interest rates. Historically a period of rate hikes such as seen in 2022-23, along with a sustained period of inverted yield curves will slow economic growth, reduce inflation rates toward the Fed’s 2% target and eventually lead to the Fed cutting short-term rates. Countering this narrative for many market analysts is the dramatic increase in the Federal debt over the past three years. This debt recently passed $34 trillion, and the annual interest owed by the U.S. Treasury has increased to over $1 trillion annually. There are legitimate concerns that these burgeoning fiscal deficits will drive record Treasury issuance and lead to higher interest rates over time.
The market for interest rate futures is signaling expectations of at least three rate cuts in the year ahead, with some analysts anticipating an initial cut could occur as soon as March. Recent government releases relating to both job growth and inflation support the case that the economy is slowing but not yet in recession. We believe the economic impact of the rate hikes was delayed by the massive amount of pandemic stimulus supplied by federal and state governments in the 2020-2022 period. We expect to see further economic weakness in the months ahead.
Another trend signaling caution ahead is heightened geopolitical risk. Fifty percent of the world’s population will be electing new leadership in the coming year, and any of the current regional conflicts (Israel/Hamas, China/Taiwan and Russia/Ukraine) could evolve into a broader threat to global stability. Given the U.S. dependence on other countries to help finance our ongoing deficits, both interest rates and the value of the dollar could swing dramatically based on the outcomes of these conflicts.
For investor balance sheets, the dramatic increase in equity values during 2023 replaced the capital lost in 2022. The U.S. equity markets enter the new year with much higher valuations relative to a year ago, and given the economic, debt and geopolitical uncertainties cited above, we are looking to reduce portfolio risk in anticipation of more modest capital market returns in the year ahead. If our outlook plays out, there won’t be a high opportunity cost for emphasizing liquidity and cash flows over more speculative and illiquid securities. The yield on high-quality, short duration fixed income securities is comfortably above the current consumer and producer price indexes. At current yields fixed income investments will generate a real (after inflation) rate of return. This is particularly true in retirement portfolios where interest income isn’t subject to current tax and can compound on a tax-deferred basis.
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