Written as of December 15, 2023.
View the Nicola Wealth Investment Returns: November 2023.
Highlights this Month
- Standout performers in the equity markets.
- The market catalyst: immaculate disinflation.
- Challenges to market optimism.
- Setting the stage for rate cuts.
- The consumer’s role in the economic outlook.
- Year-end reflections and looking ahead to 2024.
November in Review
The bull market charged ahead last month, witnessing robust rallies in both fixed income and equities. Bloomberg's 60/40 index (60% equities and 40% bonds) marked one of its best months on record. A diversified portfolio of ETFs tracking U.S. Stocks (SPY - S&P 500), Investment Grade Bonds (LQD), 20+ Year Treasury Bonds (TLT), and High Yield Bonds (HYG) recorded its highest monthly gain since 2008. The S&P 500 notched over a 9% increase in total return (in U.S. dollars), ranking as its second-best November since 1980. For bonds, the Bloomberg U.S. Aggregate Index saw a +4.5% return, the highest since the 1980s.
Standout performers in the equity markets.
Equities markets experienced a broad rally, with Scotiabank reporting the MSCI Developed Market index up +9.2% and the MSCI Emerging Market index up +7.9%. The Canadian S&P/TSX index, while still respectable, saw a comparatively lower increase of 7.5% (total return in Canadian dollars). The S&P 500's performance was boosted by the "Magnificent 7" (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta), although to a lesser extent. According to Bloomberg's Magnificent 7 Total Return Index, these technology and communications giants gained 11.7% last month, compared to the S&P 500 Equal Weighted Index's +8.2%. Year to date, the Magnificent 7 have gained nearly 100%, while the remaining 493 stocks in the S&P 500 are essentially flat. This divergence is especially noticeable between value and growth, with the Russell 3000 Growth index +34.8% year to date, versus the Russell 3000 Value index up only 5.4%. Although value stocks had a relatively better month in November, with the Russell 3000 Value index +7.6% versus the Russell 3000 Growth index +10.8%, large-cap growth and the Magnificent 7 have been the standout winners in 2023.
While fixed-income product returns couldn't match equities, they were still broad. Treasuries gained 0.5%, the U.S. Aggregate Index +3.5%, U.S. Investment Grade +6.0%, and U.S. High Yield +4.5%, according to Stifel.
The market catalyst: immaculate disinflation.
The primary catalyst for these market movements was the belief that the Federal Reserve had successfully orchestrated an "immaculate disinflation," where inflation fell without the need for a recession. If proven true, markets anticipate the Fed may lower interest rates sooner than previously expected. Falling inflation without a corresponding drop in Fed Funds rates would result in rising real interest rates, perceived as unwarranted in a soft landing scenario. Hence, the market believes the Fed may be tempted to start cutting rates sooner than guided. A recent Bloomberg chart illustrates the relationship between Fed Funds expectations and stock prices. In early December, financial markets were pricing in 125 basis points of rate cuts by the end of 2024, 75 basis points more than at the beginning of November.
Challenges to market optimism.
After such a substantial rally, questions naturally arise about whether markets are in disarray, especially following significant losses the previous month. Bloomberg highlights that this marks the seventh time markets have priced in a Fed pivot over the past seven years. Wall Street Strategists were pessimistic entering 2023, anticipating a recession and the need for a Fed pivot. However, they were proven wrong on both counts, as U.S. growth remained strong. The key difference this year is the "immaculate" part of the disinflation story, where inflation can return to target levels without a recession—a soft landing. For the markets to be right and justify last month's rally, we feel lower inflation and a soft landing are crucial.
According to a recent Bank of America Credit Investor survey, the majority expect either a mild recession or a soft landing. Only 7% foresee a deep recession or hard landing in 2024. Soft landings, however, are rare, with the mid-1990s being the only clear-cut example in the last 43 years. The challenge lies in predicting economic paths, as recessions often follow a spike in interest in soft landings. Despite rising interest rates, the economy has shown surprising resilience, with economists underestimating U.S. economic growth. However, total leading indicators tell a different story, as Bloomberg's Total Leading Economic Indicator index has fallen more than in any other period claiming a soft economic landing.
Employment and inflation dynamics.
Crucial to the soft landing thesis is employment. Slowing wage growth without rising unemployment is necessary for lower inflation without a recession. Strategas points out that the U.S. unemployment rate has historically not stayed flat for extended periods and typically resumes its downward trend or rises substantially. Signs of a loosening job market are emerging, with jobless claims rising to a two-year high and October job openings sliding to their lowest level since 2021. The October Conference Board's confidence series suggests households are becoming less positive about the job market.
Consumers and markets diverge on inflation expectations.
While wage growth remains robust, other factors cloud the deflation argument. Consumers are still feeling the pinch of cumulative price increases, with overall price levels well above pre-pandemic levels. The University of Michigan's U.S. Consumer Inflation Expectations index indicates that Americans expect prices to rise 4.5% over the next year and 3.2% in the five to ten-year time frame—the highest since 2011. This contrasts with market expectations and hints at a potential divergence in inflation perceptions.
Current market expectations discount a quicker return of inflation to the Fed's 2% target. Core PCE inflation, the Fed's preferred indicator, has been below a 2% annualized rate for four of the past five months. Even sophisticated measures, like the Cleveland Fed Trimmed Mean and the Atlanta Fed Sticky Price indices, suggest inflation continues to head lower. If this trend holds and the economy experiences a soft landing, the stage could be set for the Fed to lower rates, achieving its immaculate disinflation. Bloomberg reports financial markets are already pricing in four or five 25 basis point cuts in 2024, with the first as early as March.
Setting the stage for rate cuts.
Traders might be disappointed if the Fed's pivot comes later and is smaller than anticipated. Markets historically perform better when the Fed is on hold than when it is cutting rates. Goldman Sachs highlights that post-rate cuts, market performance depends on whether a recession occurs, with varying outcomes. As for bonds, JP Morgan notes that 10-year yields historically decline three to five months before the first Fed cut, and the yield curve tends to steepen, as observed last month.
Corporate profits and economic growth.
The path of bond yields is crucial for asset returns. Lower bond yields push valuations higher, evident in the expansion of forward P/E multiples for the S&P 500 aggregate and the S&P 500 equal-weighted index during the past month. However, sustained corporate profits are essential for the current market rally. According to the US Commerce Department, before-tax corporate profits increased 1.1% year-over-year in Q3, rebounding from Q2's 6% decline. If the Federal Reserves banks' losses are excluded, Q3 profits increase to +6.7%. Strategas notes positive outlooks for big companies, with estimates for 2024 and 2025 earnings turning higher. Forecasts anticipate an 11% increase in earnings for 2025 and a 12% rise in 2026. Additionally, sales growth forecasts suggest a nearly 5% growth in the first half of 2024.
The consumer’s role in the economic outlook.
For these estimates to materialize, the U.S. consumer must continue carrying the economic load. The Conference Board reports an increase in consumer confidence in November, supported by a strong labor market. The New York Fed's monthly survey indicates that the average American worker's probability of losing their job in the next 12 months has decreased. However, inflation remains a top concern. The drawdown of pandemic savings, accumulated through government handouts and reduced spending during lockdowns, has likely boosted consumer spending. The challenge lies in accurately estimating how much excess savings U.S. consumers have left. Economists differ on this, with the San Francisco Fed estimating $433 billion left at the end of September, while Santander Bank offers a different perspective, especially after adjusting for inflation.
Year-end reflections and looking ahead to 2024.
With one month remaining in 2023, it has proven to be a challenging year to decipher. Stock and bond markets exhibited upward trends, albeit with significant fluctuations. Initially projected as the year of the bond, anticipating falling yields and rising bond prices, this narrative did not hold until last month. As we approach the end of the year, bonds seem poised for potential gains, contingent on convincing traders that a soft landing and low inflation remain plausible. As for stocks, Carson Investment Research suggests that substantial monthly gains, like those observed in November, are typically followed by continued market strength. December traditionally serves as a favorable month for stocks, especially in pre-election years. While the Stock Traders Almanac warns of historical weakness in the first half of December, the potential for a traditional Santa Claus rally in the last few weeks remains. As we look ahead, we hope for a smooth December with no major surprises, as we plan to delve deeper into our outlook for 2024 and beyond in next month's commentary. There is much to discuss!
Disclaimer
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required securities commissions. All values sourced through Bloomberg, unless otherwise specified.
