For much of 2023, the financial markets feared a recession instigated by higher interest rates. And were it not for a technology-led surge in January, U.S. stock markets might have spent much of the first half of 2023 in the red. But the equity markets, like the U.S. economy, proved resilient throughout the year. Impressively, the benchmark S&P 500® Index only briefly flirted with a negative return at one point in the year at the end of the first quarter, when fears of a banking crisis followed two of the largest bank failures in U.S. history.
The second quarter saw a strong equity rebound as the more sanguine economic backdrop led to better-than-expected corporate earnings, and artificial intelligence burst onto the scene, boosting technology and technology-related companies. When the quarter ended, the NASDAQ Composite Index® had delivered its best first half of a year since 1983, while the S&P 500 Index saw its year-to-date gains rise to nearly 16%.
But the rosier outlook gave way to broad-based gloom in the third quarter as inflation turned higher and benchmark 10-year Treasury bond yields surged to highs not seen in more than 15 years. Real rates—the interest rate paid above the current inflation rate—spiked and mortgage rates lurched to 20-year highs. Interest rate sensitive sectors, such as banking, commercial real estate and the consumer, came under scrutiny. It was beginning to look like the U.S. Federal Reserve (Fed), which didn’t budge from its higher-for-longer mantra in the face of rising inflation, was going to force a recession, instigated by the high interest rates investors had feared all year.
But as the fourth quarter got under way, the clouds parted. Inflation resumed its decline toward the Fed’s target, while economic growth held up and jobs growth looked to be bottoming. Investors began to contemplate the possibility that the Fed—which had raised rates higher and faster than it had in decades—might have steered the economy clear of the once-inevitable hard landing and piloted it to the holy grail of central bank policy: a soft landing. The relief inspired the Bloomberg U.S. Aggregate Bond Index to have one of its best months in nearly 40 years and the S&P 500 Index to rally to a new all-time high.
As we look to 2024, we believe inflation remains the key indicator of Fed policy, and thus the key to the performance of both stock and bond markets. While inflation has retraced about two-thirds of the 2021-2022 surge, November’s U.S. Consumer Price Index (CPI), a common measure of inflation, was still up 3.1% from a year ago. This is a full percentage point above the Fed’s long-term average target, but gas prices have declined, mortgage rates have declined (helping lower the shelter component of CPI) and near-zero good’s price inflation suggests the supply-chain shortages and fading consumer stimulus may have finally found an equilibrium.
Since the post-COVID outbreak of inflation, Fed Chair Jerome Powell has been clear that rate hikes will continue until inﬂation is under control. While it is too early to declare that victory, 2023 ended on a more positive note, and we are optimistic that 2024 could see further moderation in inflation, and positive returns in both stocks and bonds.
U.S. stocks set new highs
The S&P 500 Index rose 24.23% in 2023, setting a new all-time high near year end. Stocks were supported by resilient economic growth, encouraging earnings and expectations that both inflation and interest rates had likely peaked. The total return of the S&P 500 Index (including dividends) was up 26.29% over the period.
The NASDAQ Composite Index was up 43.42% in 2023, supported by strong performance in technology and technology-related companies over the year, fueled in part by expectations that advances in artificial intelligence would boost growth.
Most sectors rose in 2023
Of the S&P 500’s 11 sectors, all but utilities and energy had positive returns in 2023. Information technology led the way, up an impressive 57.84% over the year, followed by technology heavy sectors such as communication services (up 55.80%) and consumer discretionary (up 42.41%). Despite rebounding in the fourth quarter (up 8.56%), the utilities sector was held back by higher interest rates over the period and ended the year down 7.08%. Weakness in the energy sector was largely driven by falling oil prices as global growth slowed.
The chart below shows the results of the 11 sectors for the past month, fourth quarter, and for calendar year 2023.