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Written by: Steve Majoris | Advisor Asset Management
Everyone welcomes in the new year with a sense of excitement and optimism, ready for a fresh start and good times ahead. Heading into 2024 markets sure were optimistic about the outlook for the economy with one of the best “Santa Claus” rallies in recent memory, mainly due to increased investor optimism of a soft landing. The bond market is coming off monthly returns not seen in over 40 years as through the last two months of the year, the U.S. Treasury index is up 6.95%, the Bloomberg aggregate bond index is up 8.53% and broad municipals are up a staggering 8.82%, their best December in 20 years. Meanwhile in equities, the S&P 500 is up almost 14%, the Nasdaq has returned almost 17% and the Russell 2000 rallied over 22% the last two months of 2023. This recent stretch has undoubtedly provided returns that are usually seen in an entire year or longer. We believe at this point it may be important to temper expectations about what the market is able to accomplish as we embark on our 2024 journey.
“What’s done is done” as Lady Macbeth has said, but what about expected returns moving forward?
Equity markets may find it difficult to mirror returns seen in 2023, especially the +13% seen over the last two months of the year. In fact, the first three trading days of 2024 may be providing a bit of a wake-up call with the stock market down 1.70% and the broad bond market off nearly -1.0%. At elevated multiples, the track record for markets is much more “down to earth” than many of the multi-month moves we just witnessed. It is fair to say that the higher multiples become for stocks, the more limited potential upside is moving forward. The following chart summarizes the average forward returns across different valuations:
Source: Strategas Research Partners
For fixed income markets, after a strong year-end rally, many believe it is time for a breather. When looking at the treasury market there may be some clues with return assumptions in the year ahead. The inverted yield curve paints an interesting picture with the belly of the curve (5–7-year space) being the lowest yielding portion to be found. Taking on additional duration risk in this environment has become quite unattractive, as investors receive no additional yield compensation for a 7-year (3.99%) or 10-year (3.99%) bond than you would a 5-year (3.99%). The belly is the flattest it’s been in some time and this conundrum may prevent investors from taking on additional risk, which may impact performance in major indices like the Bloomberg U.S. Treasury Index, which has a 6-year duration. The Treasury forwards market can provide some degree of insight into bond investors expected return forecasts and one might find it interesting that a 1y10y forward (a contract to buy a 10-year bond one year from now) is currently priced at a 4.77%, implying rates could move higher (and bond prices lower). While returns from duration could be limited, it would be hard to argue credit will be any different. Credit spreads (the additional yield compensated for taking on additional credit risk) have tightened dramatically as of late leaving little to be desired, especially as chapter 11 bankruptcy cases are on the rise.
Source: Strategas Research Partners
Markets have acted all but certain that a “soft landing” is coming, but what if that is not the case? Wednesday morning Richmond Fed president Thomas Barkin gave a speech with some quotes that may have caught the “soft landing” crowd a little off guard:
“Rate hikes are still on the table.”
“A soft landing is not inevitable.”
“The recent move with interest rates could stimulate demand.”
He is, of course, talking about the move in U.S. Treasury rates the past two months, with the 10-year plunging 100 basis points from 4.80% to 3.80%. There are many, including President Barkin, speculating that this could spur an unexpected increase in future inflation as this results in easing monetary conditions.
Source: Strategas Research Partners
The recent easing of monetary conditions may take pressure off loans and refinancing activities, such as what takes place in the housing market. Housing/rent inflation, around 33% of the Consumer Price Index, may see upside based off this easing. Local brokerage and real estate firms from New York City just released data showing a rise in home prices for the 4th quarter (Q4) of 2023, the first time in over a year and the first annual increase since Q3 2022. Other cities may experience similar results which would most likely lead to higher inflation for this segment of the economy. Wages are another large component of the inflation picture and the labor market remains strong with Friday’s nonfarm payroll jobs report showing 216,000 jobs added and the unemployment rate remaining at 3.7%. Perhaps the biggest takeaway was that year-over-year average hourly earnings come in much hotter than expected at 4.1%. Both rents and wages could play a role in a potential second wave of inflation, something that based on history isn’t all too rare.
Source: Strategas Research Partners
Since returns could be limited, even if we get the perfect “soft landing,” we need to at least prepare for other outcomes. Throughout 2024 market performance could be negatively impacted by the ongoing battle with inflation and potentially a more “hawkish” Federal Reserve (Fed) throughout the year. Perhaps there could be a “delayed landing,” a scenario resulting in an extended fight for the Fed and the Fed Funds rate remaining in restrictive territory for longer than previously expected. This is another case which financial markets aren’t currently anticipating and may, if it comes to fruition, negatively impact performance. The Fed Funds futures market is pricing in Fed cuts in less than three months — a very rosy item on 2024’s new year’s wish list. If that does occur, the risk of inflation surprises later this year only increases and may result in adversely effecting market returns down the road.
We rarely quote grouchy old Uncle Frank McCallister from the Christmas classic Home Alone but for those betting on market returns similar to the latest Santa Claus rally, “You be positive, I’ll be realistic.” It may seem easy to jump on the bandwagon given all the hype about the market being on fire. Perhaps it might feel normal wanting to take on additional equity exposure along with more duration and credit risk, but we remain cautious against it at this time given recent returns. “Chasing” in investing usually doesn’t end well. Chase dreams, not markets.
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