The 10-year U.S. Treasury bond yield fell from roughly 5% to less than 4% by the end of the year. As Strategas Research Partners notes, “That single spark lit a prairie fire in risk assets, gaining strength when Federal Reserve Chairman Jay Powell signaled a pivot to a more dovish monetary policy in mid-December. The hunt for momentum had commenced in earnest.” The chart below clearly shows how the liquidity provided by the Treasury offset the monetary tightening provided by the Federal Reserve.
While the S&P 500 rally may have gone too far too fast, the U.S. economy has been very resilient, consistently growing every quarter in 2023. The growth rates in the rest of the world were slower or even negative.
Despite the strong market rally, valuations are not extreme from an historical perspective, as shown in the chart below. Even the top performing stocks – the magnificent 7 – are below their historical extreme because much of their price increase was due to significant earnings growth.
A Bull Market checklist provided by Strategas Research Partners doesn’t show any evidence of cracks yet.
And election years are typically good for equity markets…
Having said that, inflation has been and continues to be a concern for us as commodity prices are rising, and inflation has a history of coming in waves. The chart below shows the current trajectory of inflation in bright blue compared to prior inflation waves. While we don’t have the same economic conditions as these prior time periods, the Federal Reserve does expect a bumpy process in bringing inflation down to their target.
While the inflation rate on goods (ie. food and energy) has declined dramatically since the pandemic, services inflation has remained sticky as shown below. As we have pointed out previously, the Fed cannot directly control the lack of labor supply due to demographics and immigration policy, the cost of financing our ballooning debt, or the price of commodities, such as oil, copper and food. However, recent increases in immigration and worker productivity have started tempering wage inflation.
We continue to like equities and favor large over small cap companies. Although many pundits have argued that small cap companies are cheap, their earnings recovery has lagged large caps (see chart), and they tend to underperform when interest rates are rising.
Within equities, we continue to favor energy and materials. We view them as an inflation hedge and their earnings contribution to the S&P 500 far exceeds their market cap weighting in the index. Both Apple and Microsoft, for example, are each worth more than the entire energy or material sectors.
We also like healthcare, but with specific focus on biotech, drug and device companies. Biotech companies are providing drug discovery for big pharma. The use of GLP-1 (weight loss) drugs and the concomitant health benefits is nascent. Delayed orthopedic procedures due to the pandemic should resume as our population continues to age, benefiting a number of device companies.
At the end of 2023, we increased our exposure to technology, but remain underweight relative to the S&P 500. As a result of the sector’s outperformance in 2023, tech is now about 30% of the entire index and we believe that will be a smaller percentage going forward. Having said that, stock prices follow earnings, and we believe a number of tech companies will continue to post good results. As the stock prices of these companies come down, we plan on taking advantage of any dislocations.
In the first quarter of 2024, expectations of falling inflation, moderate economic growth, and Federal Reserve rate cuts were initially positives for bond buyers. However, as inflation numbers proved stickier than expected and the Federal Reserve delayed rate cuts, bond prices declined later in the quarter and into April.
Looking forward, bond yields will be heavily influenced by three factors… inflation, treasury supply, and Federal Reserve policy. Unlike 2022, intermediate maturity bond portfolios currently have high enough yields (over 5%) to offset a certain amount of price decline. Further, Fed Chair Powell announced his intention to end quantitative tightening (QT) in the near future, offsetting some of the impact of increased Treasury supply coming later this year.
In the case of 10-year Treasury yields heading to 5% in response to continued strong economic growth and resurging inflation, not only bond but equity performance is likely to suffer.
Like the Fed, we are adopting a wait and see approach to the market, with hedges in place to stabilize portfolios.
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