“Enthusiasm is common. Endurance is rare.” – Angela Duckworth
Investors fell victim to the behavioral bias of extrapolation in 2023. After a historically poor 2022, they anticipated an equally bad, and possibly worse, new year. With expectations at rock bottom, most economists forecast a recession. Instead, years of easy monetary policy and tremendous fiscal spending supported the economy and led to an unexpected stock market rally, one that investors believe will continue in 2024. But is their optimism misplaced?
Notwithstanding a still difficult environment for bonds, stocks and diversified investment portfolios performed solidly in 2023. The S&P 500 Index has soared by more than 19% and the 60/40 portfolio has returned a commendable 11%.1
Plenty of bad news could have derailed both the economy and markets. The Federal Reserve (Fed) and other central banks continued to raise rates throughout the first seven months of 2023. Several US bank failures were the collateral damage from more restrictive monetary policy. Dysfunction in Washington, combined with the US’ deteriorating fiscal health, routinely stoked investors’ fears. US companies suffered through an earnings recession — three consecutive quarters of negative year-over-year earnings growth. And, despite considerable progress made on lowering inflation, it still remains too high.
Bigger picture, China’s disappointing emergence from COVID-19 restrictions led to a weaker than expected European economy. In the battle for world supremacy, elevated tensions between the US and China persist. There’s still no resolution in the Russia-Ukraine war. And the Israel-Hamas war risks entangling additional countries into a wider Middle East conflict.
Yet, years of seemingly endless easy monetary policy and massive fiscal spending, especially in response to the pandemic, combined with historically low investor expectations to start the year, created the perfect environment for a resilient economy and an unexpected rally. Rather than contracting as most economists anticipated, the US economy expanded in every quarter of 2023, culminating in a robust annual increase of 4.9% in third quarter GDP.2 Bolstered by the strongest labor market in more than 50 years, the consumer continued to be the engine of exceptional US economic growth.
More than a decade of ultra-low interest rates enabled consumers and businesses to lock in cheap financing costs on growing debt obligations. Now, after 11 Fed rate hikes, they are able to earn a competitive return of 5% or more from money market investments. This differential between low financing costs on debt and practically risk-free income from money market investments has allowed the economy to weather the impacts from higher interest rates better than the Fed or anyone else thought possible.
Further aiding the economy’s resilience, consumers and businesses lined their pockets with extraordinary government stimulus funds, incentives and tax breaks enacted to combat the negative effects of the pandemic. Beginning with the CARES Act in March 2020 and ending with the Inflation Reduction Act in August 2022, the US government signed into law more than $6 trillion in fiscal stimulus legislation that’s been positively flowing through the US economy.
To investors’ relief, inflation cooled considerably as benefits from fiscal spending faded, monetary policy tightened, and global supply chains were restored. Softening economic data and shrinking inflation have convinced market participants that the Fed’s tightening cycle is over and that a soft landing is probable. In fact, the Fed has raised rates just once since June 2023 and stood pat in three out of the last four FOMC meetings.
According to FactSet, the earnings recession ended in the third quarter. Year-over-year earnings for S&P 500 companies are on pace to grow by 4.3%, marking the first quarter of earnings growth since the third quarter of 2022.3 And S&P 500 companies continue to be highly profitable. After bottoming early in 2023, net profit margins expanded to 12.1% year-over-year in the third quarter — above the previous quarter, one year ago, and the five-year average.4
But will lofty investor expectations for future earnings growth, cooling inflation, and an end to the Fed’s tightening cycle be enough to sustain the rally?
As investors begin 2024, healthy skepticism has transformed into dangerous confidence. Market participants are certain that the rare soft landing is in reach. Convinced that inflation will continue to move toward the average 2% target, investors believe the Fed’s tightening campaign has ended — without a recession or a capital markets catastrophe.
Investors are confident that their willingness to pay a higher price for future earnings in 2023 will be rewarded in 2024 when S&P 500 companies are forecast to grow their earnings by 11%.5 But they are underestimating the risks to the economy as it transitions from monetary and fiscal policy aided resilience to durable organic expansion. Not to mention the potential for increased market volatility in a contentious US presidential election year.
Regrettably, 2023’s caution has turned into 2024’s courage. The economy and market were able to beat incredibly low expectations in 2023, but they were supported by the long and variable impacts from years of easy monetary policy and massive fiscal stimulus. In 2024, investor expectations are much higher. And the monetary and fiscal policy crutches have been removed from an economy that may not be able to stand on its own two feet.
With the range of possible market outcomes wider than normal, risks are firmly skewed to the downside. As a result, investors should consider these three strategies when constructing investment portfolios for 2024: