By Ryan O’Donnell, CFP® and Mike O’Donnell, CFP®
Buoyed by the Santa Claus rally, expectations of Fed rate cuts, and a “soft landing” in 2024, the quarter ended December 31st was the strongest since early 2020. U.S stocks gained over 12% in Q4 to push their return to nearly +26% for the year. U.S. stocks easily outperformed international and emerging stocks (see chart below) for the period.
Meanwhile, U.S. bonds also enjoyed a significant rally in Q4, racking up a +6.8% gain for the three months ended December 31. That performance, which outpaced the global bond market by over 150 basis points, was one of the strongest quarters for U.S. bonds in 40 years, pushing bonds’ full year return for 2023 to nearly +6% (see chart below).
A closer look at U.S. equities
While U.S. equities performed extremely well across the board, value underperformed growth within large caps and outperformed within small caps. Small caps outperformed large caps (see chart below).
REITs on the rebound
Long beleaguered U.S. real estate investment trusts (REITS) turned in an extremely strong Q4, generating a return of 16.4% for the three months ended December 31st. U.S. REITs outperformed non-US REITs by 150 basis points as well as most other equity and fixed income asset classes in Q4. As with most real estate investments, REITs are highly interest rate sensitive. At the end of a rate tightening cycle, REITs tend to perform well on an absolute and relative basis. After the Fed has reached rate stabilization, REITs historically return 20%+ over that next 12 months.
Fixed income
Thanks to the bond rally in Q4, yields generally declined across the yield curve (see below), as expectations of Fed rate cuts in 2024 drove fixed income sentiment. On the short end of the yield curve, the 1-Month US Treasury Bill yield increased 5 basis points (bps) to 5.60%, while the 1-Year US Treasury Bill yield decreased 67 bps to 4.79%. The yield on the 2-Year US Treasury Note decreased 80 bps to 4.23%. At the longer end of the curve, the yield on the 5-Year US Treasury Note decreased 76 bps to 3.84%. The yield on the 10-Year US Treasury Note decreased 71 bps to 3.88%. The yield on the 30-Year US Treasury Bond decreased 70 bps to 4.03%. Despite the possibility of a soft landing in 2024, continued inversion of the yield curve (see below), keeps many economists and market watchers fearful of a recession.
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Recession in 2024?
Rarely does a day go by when someone doesn’t ask me what they should do with their portfolio if and when the long-feared recession actually hits. My response is to cite Paul Samuelson’s famous quip: “Economists have successfully predicted nine out of the last five recessions.”
Nobody knows for sure if and when a recession will hit so it pays to take the long-term view. Stay disciplined and well-diversified because there’s clearly no consensus from the experts. On the plus side, the U.S. economy remains solid heading into 2024. Inflation has cooled, labor markets have remained stable and the Federal Reserve has signaled the possibility of decreasing interest rates at some point in 2024. Many economists, including Federal Open Market Committee, anticipate a soft landing for the U.S. economy in 2024 that will include slowing GDP growth without a recession. However, it’s hard to ignore the two major recessionary risk factors for long: inflation and elevated interest rates. Any hiccup in Fed policy could easily slow the economy to the point that it contracts into a recession. Investors should continue to monitor the labor market in coming months as tight monetary policy often has a lagging impact on economic growth.
While the U.S. economy defied expectations by sidestepping a recession in 2023, Morningstar said the likelihood of a U.S. recession in 2024 is still probably around 30%, compared to 15% in normal years. The New York Fed's recession probability model suggests there is still a 51.8% chance of a U.S. recession sometime in the next 12 months. Bank of America is predicting a soft landing rather than a recession in 2024 and more than three-fourths of economists — 76% — said they believe the chances of a recession in the next 12 months is 50% or less, according to a December survey from the National Association for Business Economics. Again, no clearcut consensus.
Recession not necessarily bad for investors
Whether or not a recession occurs, it shouldn’t cause you to alter your financial plan significantly. Recessions are a natural part of the business cycle as we have to trim the excess in order to set up the next economic expansion. Since 1965, the S&P 500 has generated a median return of +8.5% in the 12 months that followed eight previous yield curve inversions (a longstanding recession indicator), according to data from LPL Research and the St. Louis Federal Reserve Bank. However, an inverted yield curve doesn’t guarantee that a recession will follow.
U.S. deficit
US government debt reached 121% of the value of the country’s gross domestic product (GDP) in 2023. Many investors are concerned that servicing this level of debt could have an adverse impact on the stock market. But as Wes Crill, PhD, Senior Investment Director and Vice President, Dimensional Fund Advisors noted at the conclusion of this report, historical data show little correlation between the national debt and the stock market. “Since 1975, there have been 153 observations of a country exceeding 100% debt/GDP for a year,” said Crill. “Stocks were up for that country/year in 104 of the 153, or about two-thirds of the time.”
As always, it pays to be well-diversified. You never know which company, asset class or sector will outperform and which will underperform. As the old saying goes: “Time in the market always produced better outcomes than timing the market.”
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