New Year’s Eve Hangover Sets In
US
Well, the 2023 party ended with investors having swallowed all the happy pills on offer, as the November rally just kept…on…going! Santa brought bond and equity investors everything they could possibly have wished for. US indices concluded the year with an impressive nine consecutive weeks of gains, marking the lengthiest winning streak since 2004. The S&P 500 index came within a smidgeon of its all-time high set on Jan 3rd 2022, back when investors (incorrectly) anticipated gradual interest-rate increases. However, just like a hangover must have set in for many New Year’s Eve revellers, so too for investors, and there is now a noticeable shift in the air, as stocks have registered a nasty first week of declines.
Is the party over?
While a bout of profit taking after such a blistering run is not uncommon, it does prompt the question of whether the scorching bull market has come to an end, or still has room to grow? During the initial ten months of 2023, the market’s upward trend primarily revolved around seven tech companies, with Nvidia leading the way as a producer of chips crucial for processing AI algorithms. However, after that period, the market’s momentum expanded and accelerated. Companies representing the broader economy, such as retailers and banks, smaller and mid cap stocks experienced significant upside. The S&P 500 index recorded a 14% rise in the last two months of 2023, elevating it to a level 31% above its most recent low, surpassing the commonly used 20% threshold that characterises a bull market.
UK and European equity indices are also nearing their levels from two years ago, but when viewed via the lens of USD, much of the world is still significantly lower. In fact, I find the following chart which shows market returns in USD over the last two years very useful as it places the recent run up in context. It hardly suggests a euphoric melt up, rather markets just back to where they were two years ago, arguably now on a much sounder footing?
What caused the Santa rally?
The market’s impressive performance can be attributed to; a favourable combination of robust economic growth, a well-managed reduction in inflation and a significant shift in expectations surrounding interest rates over the past two months. The American economy achieved an impressive, annualised growth rate of 4.9% in the third quarter and real-time estimates indicate a still-strong 2.5% growth in the final quarter of the year. Over the past three months, ‘core’ consumer prices increased at an average annualised rate of just 2.2%, only slightly above the Federal Reserve’s inflation target.
This shift in inflation data and interest rate expectations had a substantial impact on investor sentiment. In October, they anticipated one-year interest rates to be close to 5% in a year’s time. However, due to positive inflation data and dovish forecasts from the Federal Reserve, at year end, this expectation had decreased to 3.5%. Bond investors at the end of 2023 anticipated the central bank lowering rates as early as March, with the potential for rate cuts in nearly every meeting throughout 2024. This enticing ‘Turbo-Goldilocks’ scenario of controlled disinflation, strong economic growth, and the promise of accommodative monetary policy provided a solid foundation for the market rally, but…
Can it continue?
That question always pops up when markets are either at, or near, their all-time highs, so please move your hand away from the panic button! While the market is approaching the levels it reached during the prolonged frenzy of 2021, it’s essential to recognise that the current situation may not be as exuberant as it was back then. In real terms, equities are still below their previous highs, which means that valuations are not quite as inflated. Retail investor participation, a great indication of irrational exuberance, which peaked around a quarter of daily trading volumes in early 2021, has remained relatively stable at lower levels throughout 2023. Significantly, there is a record amount of money sat in money market funds that could yet be enticed back into bonds and equities, especially when rates (actually) head lower. Furthermore, although technology companies played a leading role in both 2021 and 2023, investors have been a bit more discerning this time around. They have supported Nvidia and Microsoft, but Alphabet, Amazon, and Tesla are all trading below their previous peak valuations, and Apple has come off the boil from a recent downgrade.
Much now hinges on the ‘Regular-Goldilocks’ scenario becoming reality, which I think it can, but it is only fair to point out that numerous uncertainties loom on the horizon, bull markets require uncertainty to ‘climb a wall of worry’. So, the Bears, (yes thankfully they haven’t all capitulated and are popping up again) highlight that US inflation might not be entirely subdued, especially with a robust economy and an unusually wide fiscal deficit. Potential conflicts in the Middle East could trigger another spike in commodity prices, and the temporary alleviation of supply chain disruptions resulting from the pandemic may only be providing a short-term reprieve in keeping inflation in check. A downturn may merely be delayed, not dodged. Rises in interest rates may not yet have fully fed through to borrowers. Indeed, history suggests that recessions are hard to spot in real-time and tend to catch out central banks. If a recession doesn’t arrive, it is still possible that the Fed will not move with as much alacrity as investors hope, and it will take investors a while to digest the slower pace of fiscal loosening.
‘Goldilocks’ is still intact!
So far, I would argue that the economic inputs we have received this year fit the Goldilocks “not too hot, not too cold” scenario. Last year when the glass was half full, we would probably have seen both equities and bonds heading higher on the recent data releases, but not so this year, as that end of year hangover has most definitely deflated the more extreme optimists.
Case in point comes from the early economic data this year with four key measures… Midweek, the JOLTS data suggested, that although job vacancies remain high, the rate at which people are confident enough to quit is falling sharply (not too hot). US manufacturing numbers showed a slight recovery (not too cold) although are still just in contractionary territory.
Then on Friday, we had the Non-Farm Payroll data with US employers adding a lot more jobs than expected, led by health care, government, construction and leisure and hospitality. But the participation rate (the share of the population that is working or looking for work) fell by 0.3% to 62.5%, the largest monthly drop in nearly three years. It’s also taking longer for unemployed Americans to find work and the number of full-time employees dropped by the most since April 2020. Moreover, the data indicated a decline in temporary-help employment, all in all ‘not too hot’. The fourth data point we got was the Services ISM where the gauge decreased 2.1 points, the most since March, to 50.6 in December. The index, while remaining above the 50 level that indicates expansion, was the second weakest of the year, falling in to the ‘not too hot’ camp of indicators.
Is the 2024 glass half full or half empty?
There are essentially two forces that drive markets over the shorter term. The first is actual economic releases, but the more important driver is the prevailing investor sentiment (or in other words) Is the glass half full or half empty? At the end of last year almost anything was treated as complicit good news, now in a matter of days, we seem to have moved to the opposite end of the spectrum. The cause of the very modest sell-off can probably be put down quite simply to a change in sentiment around policy expectations.
It is fair to say that investors got over excited at the pace and timing of rate cuts next year. Yes, cuts are coming but probably not as soon as hoped for and as investors adjust to this new reality, I think markets can and will make progress again.
I thought I would leave you with data from JP Morgan, from their excellent chart pack which puts the recent bull market in context.
Now, the crystal ball is well and truly covered up as this data shows the huge range of longevity and return from the bull markets we have had from US equities over the last 70 years. But, the average length has been 65 months and the average return has been 184%.
So far, this baby bull market is only 14 months in length with a return of 33%, suggesting that it could have quite some way to run…
Let’s hope so! All the very best for 2024 from the team at 8AM.
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