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FA Blog Jan 24
John Bullman, CFA, CAIA5 min read

2023 Market Update

We're recapping 2023. From recession fears to a surprising market rally, we're unraveling the twists and turns that defined the year.

 

Equities

After poor market performance in 2022 (the S&P 500 Index fell about 18%), 85% of economists were calling for a recession in 2023, and there were good reasons for doing so. Interest rates had risen significantly and the Federal Reserve was shrinking its balance sheet in response to inflation, which peaked at 9.1% in June of 2022. Companies were coping with much higher costs (debt and labor), and inflation was squeezing the consumer. With higher rates allowing investors to earn a compelling return on their cash for the first time in more than decade, the consensus was to hold cash and wait for the “inevitable” recession to hit and take advantage of the upcoming “cheaper” prices on stocks.

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Source: Financial Times, University of Chicago. The 2022 survey did not include a 2025 category. Values do not sum to 100% due to rounding.

As it often goes, the advice, as well-reasoned as it was, was not profitable.

The S&P 500 was up almost 16% through June 30, 2023 as the same stocks that caused the poor performance in 2022 rebounded. This is an important point.

The S&P 500 has become extremely top heavy with the “Magnificent 7” (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla) accounting for more than all of the performance of the index, and making up about 28% of the index itself. Had you stayed in cash, you would have earned about 2.5% through June (half of the approximate annual 5% yield). After a tough October, the S&P 500 rallied an additional 10% as the consensus pivoted to a “soft landing” and recession fears began to fade. The S&P 500 finished 2023 up 26%. As it stands now, the expectations for a recession are much lower as compared to a year ago.

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With 2023 as a recent example, the portfolio management team at LGT does not try to time the market. The market can always surprise on both the upside and the downside, and it is very difficult to consistently and accurately predict. What history shows us is that owning equities pays off. Of course, in any one month, quarter, or year they can (and will) lose value. We believe that it is better to stay invested rather than attempt to time the market.

 

Fixed Income

Throughout the year there was significant volatility, especially in the longer end of the yield curve. The market attempted to predict future Federal Reserve actions and discount the likelihood of recession, even as the Federal Reserve held rates steady in 2023. Short-term rates moved up substantially in the early parts of 2023, which continued as the 6-month rate went from 4.75% to about 5.5% by year-end. The longer end of the curve flattened substantially (rates went up) in the 3rd quarter before falling again to roughly the same place that they began. It is interesting that, despite the volatility during the year, the 10-year yield as of 12/31/22 and 12/31/23 ended up right on top of each other at roughly 3.9%.FA Image 3

 

Performance in the fixed income markets was positive across the board with high-yield bonds (HYG) providing roughly double the performance of the overall bond market (AGG). Floating-rate bonds (FLOT) also performed well and still offer compelling yields, although those yields will fall in the event that the Federal Reserve cuts rates.

 

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Macro Environment

The U.S. economy has proven remarkably resilient in the face of both higher rates (currently 5.5%) and the Federal Reserve shrinking its balance sheet.

Recall that “quantitative easing” (using government money to buy bonds) provides liquidity to the market and greatly increased the Federal Reserve’s balance sheet.

So, shrinking the balance sheet takes liquidity out of the system (quantitative tightening). Despite these headwinds the economy grew, and unemployment remained low, ending the year at 3.5%.

The market is convinced that the Federal Reserve will cut rates in 2024, and our portfolio managers at LGT agree that rate cuts are more likely than rate increases. However, investors may be disappointed as the tight labor market could make inflation stubbornly high. Remember that the Federal Reserve has two mandates: Inflation and Unemployment. As it stands today unemployment is not a problem, so their focus will be on inflation – lending itself to slowing the economy with higher rates as necessary.

Globally, there are numerous reasons to be concerned. The wars in the Ukraine (now at the 2-year mark) and Palestine, China’s slowing economy, the 2024 U.S. election, and problems in commercial real estate.

Commercial real estate, especially office space, is a cause for concern as current valuations have wiped out or greatly reduced the equity supporting the properties. Problems in real estate could pose problems for the banks who are lenders on those properties as owners find themselves underwater if/when investors decide to cut their losses. Therefore, we are underweight on real estate assets and favor the fixed income markets and equities comparatively.

China is important as it is the second largest economy and the largest trading partner for many countries. They are facing structural problems that will be very difficult to solve including an aging population, high unemployment, and a real estate crisis destroying personal wealth (the biggest asset owned by most people is their home).

 

Positioning

“Prediction is difficult - particularly when it involves the future.” - Mark Twain

Even though predictions are difficult, we have no choice but to do the best we can with what we know now and to invest to the best of our ability. What’s different today as compared to the prior decade is the rates offered by the market, which makes fixed income investments more attractive. We favor both private credit (currently offers yields of ~10%) and floating-rate bonds in today’s environment, both of which offer yields higher than the long-term rate of returns of stocks. We are tactically overweighting credit in client portfolios to take advantage of these rates. In the event we do hit a recession, it is reasonable to assume that senior secured notes perform better than equities given their position in the capital structure, which we believe provides a favorable risk/return tradeoff.

In equities, we are overweight on U.S. markets and underweight on international markets with very little in emerging markets given the relative strength of the U.S. compared with the rest of the world.

 

Sources: The U.S. avoided recession last year. What comes next? | Capital Group; US Treasury Yield Curve; Today's Markets (koyfin.com); Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level (WALCL) | FRED | St. Louis Fed (stlouisfed.org); Civilian unemployment rate (bls.gov); Don't count on the Fed slashing rates given the inflation 'rollercoaster' risk, warns BlackRock (msn.com)

 


 

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John Bullman, CFA, CAIA

John is a seasoned investment professional who joined LGT Financial Advisors after an impressive tenure at the Rosewood single-family office. With a wealth of experience and expertise in investment management, John brings invaluable industry knowledge to the firm. His daily responsibilities involve developing investment strategies, analyzing market trends and economic conditions, performing manager due diligence and consulting with clients. John holds a B.B.A. in Finance and International Business from Baylor University and an MBA from Southern Methodist University. Along with his impressive education, John is a Chartered Financial Analyst (CFA) charterholder and maintains the Chartered Alternative Investment Analyst (CAIA) designation. Beyond his professional achievements, John enjoys spending time with family, cycling, weightlifting, and indulging his love for fast cars when he is away from the office.

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