CAPITAL MARKETS REVIEW January 2024

Bulls Run Wild: Markets defy headwinds

As the end of 2023 came to a close, a resounding sense of cautious optimism painted the financial landscape. Markets, having weathered the storms of the Covid era, closed the year with solid returns. Investors, finally casting off the shadows of high inflation, supply chain snarls, and labor deficits, focused on the future with the promise of monetary easing and the transformative potential of artificial intelligence. However, 2023 was not without its challenges, with investors having to avoid many pitfalls along the way. Early tremors shook the global financial system with a banking crisis, sending ripples of anxiety through markets. The specter of the United States teetering on the brink of debt default loomed large. To cap it all off, a new geopolitical flashpoint erupted in the Middle East, after Hamas's terrorist attack on Israeli. Yet, despite these unnerving headwinds, the final quarter of 2023 defied pessimism. As the chart below illustrates, a wave of positivity surged across most asset classes, propelling returns upward for the year.

U.S. stocks and bonds soared this year as investors re-evaluated their expectations for the Federal Reserve's interest rate policy. The Fed embarked on a rate-hike program in March 2022, steadily raising rates until July 2023. While Chair Powell remained noncommittal on the end date, hints in meeting minutes and public statements from November and December suggested the cycle might be over. This shift in sentiment caused U.S. Treasury yields to fall and boosted both stock and bond prices. Globally, similar policy shifts by other central banks also lifted international stocks. Commodity markets, however, lagged behind. Oil prices dipped throughout the year due to a combination of adjusted trading dynamics and weaker-than-expected demand.

From Doom to Boom: Stocks Defy Expectation

Investors braced for another brutal year in 2023 after the 2022 stock market carnage. The outlook was bleak, with most investors feeling that “the most-advertised recession in history” was just months away. Instead, 2023 defied all expectations, blossoming into one of the best years for stocks in a decade. The S&P 500 roared 26.3% higher, with mega-cap tech and growth companies, that suffered the biggest losses in the 2022 bear market, leading the charge. With inflation finally showing convincing signs of cooling as 2023 closed, the Fed's pivot from rate hikes to potential cuts for 2024 became a reality. This shift fueled the stock market's unexpected surge.

The chart above paints a picture of a booming year for stocks, with every region and sector finishing up double digits. Even US small stocks, which lagged for much of the post-pandemic recovery, finally soared in the fourth quarter. Two key factors fueled their rise: cheap valuations compared to their larger counterparts, and the increasing hope of a "soft landing" for the economy. Emerging markets, while still positive, saw less vibrant performance. This is partly due to their heavy reliance on China, which has faced a slower COVID recovery and ongoing challenges in its overleveraged real estate sector. Unsurprisingly, US growth stocks were the true stars of the year. Companies like Nvidia, riding the wave of artificial intelligence advancements, skyrocketed 239%, leading the charge for the entire growth sector.

Risk On, Rates Up, Bonds Finish 2023 with a Bang

Yields on the 10-year Treasury note, a benchmark for loans, began 2023 hovering near 3.8%. The first seven months were quiet, with yields bouncing modestly. Then, August brought drama. News of heavier government borrowing, Japanese rate hikes, and a booming job market sent yields soaring. From just below 4% on July 31st, the 10-year jumped to a 17-year high of nearly 5%. Then, just as quickly, that selloff was reversed as data showed the jobs market was finally moderating from the pace of hiring seen for most of the year. In addition, inflation news continued to be favorable. This backdrop helped drive the performance of bonds, especially during the fourth quarter.

While headlines chased Fed policy and Treasury yields, the real action was elsewhere in the bond market. Specifically, credit-sensitive sectors delivered stellar returns. Several factors fueled this success. First, the surprisingly resilient economy lowered default risks for riskier borrowers. Second, many had used low rates to lock in long-term debt, making cash crunches less likely even with higher rates. Finally, strong stocks and a Fed-friendly environment encouraged "risk-on" investing, pushing investors towards lower-quality debt. The result? High yield bonds, benefiting from improving credit conditions, were top performers.