December, 2023
Despite the volatility, stocks have performed well this year. Year-to-date through the end of November, the S&P 500 has gained 19%. With all the uncertainties facing investors at this time last year, many have been surprised by the market’s advance this year. It is not unrealistic to think that the coming year could see a similar pattern, one with reasonable gains despite investor uncertainty.
There is currently no shortage of issues for investors to worry over. Volatile energy prices, fighting in the Middle East, continuing war in Ukraine, labor strikes, possible recession, upcoming elections and government disarray, potential shutdowns and rising deficits all have the potential to roil the markets or capture the attention of investors in the new year.
However, it is likely that three issues will have the biggest impact in determining the direction of the market: the path of inflation, the level of interest rates and the growth of corporate earnings.
Inflation has been moderating and may turn out to be relatively transitory. The Consumer Price Index (CPI) was up 3.1% versus a year ago through November. Decision makers at the Federal Reserve, however, prefer to focus on the core rate of the Personal Consumption Expenditures (PCE) index, which strips out volatile food and energy prices that may give a misleading signal of where inflation is headed. Core PCE closely tracks core CPI (which came in at 4.0% and is reported weeks earlier than PCE). Both CPI and core CPI are down from their 2022 peaks of 9.1% and 6.6%, respectively, but remain well above the Fed’s 2% target. Shelter costs are a large component of both measures (35% of CPI and 44% of the core rate) and are incorporated with a lag. They have been steadily moderating and will likely reduce the index gains in the months to come. It is therefore possible the Fed may reach its 2% inflation target ahead of its 2025 projected timeframe. Excluding shelter, core CPI was up only 2.1% in November versus last year.
The Fed has been leading the fight against inflation by raising interest rates to slow the economy. Additional progress on reducing inflation will enable the central bank to move rates to lower levels. The Fed itself refers to future activity regarding the level of interest rates as being “data dependent.” However, it already appears that rates may be peaking. After very aggressively raising interest rates eleven times since March of last year by a total of 5.25%, the Fed has paused additional increases recently and even acknowledged that it may begin reducing rates next year.
Corporate earnings also appear to be at an inflection point and headed in a positive direction approaching the new year. In the first two quarters of this year, earnings were lower than the prior year but exceeded expectations. The declines versus last year reversed in the third quarter as 82% of companies reported earnings above estimates, exceeding both five and ten-year averages for that metric. In aggregate, third quarter earnings were expected to be roughly flat but grew 4.9% versus a year ago. This looks to be the start of a new trend, with earnings projected to increase 2.4% year-over-year in the fourth quarter and 11.5% for next year.
Focusing on the big picture for 2024, inflation should continue lower. That would open the door for the Fed to begin easing interest rates. Lower interest rates equate to higher multiples of earnings for stock prices (the P/E ratio) and simultaneously increase the attractiveness of stocks relative to fixed income investments as their yields decline. Additionally, significant growth in earnings would also naturally provide an incremental boost to stock prices.
Rapidly rising interest rates also made for extremely poor returns last year for fixed income, with investment grade bonds returning -13.0% in aggregate. Due to continued rate increases earlier this year, bonds have only gained 1.6% through the end of November. If interest rates do decline next year, or remain stable, bond investments will be more profitable again.
Many things could go wrong next year, some that we are aware of and others that have not yet surfaced. At the same time, the bigger pieces of the puzzle may already be in motion to create a positive environment for both stock and bond investors. Though it may not yet be obvious, odds could be tilted in our favor for another successful year.
