Moving With Conviction: Year-End Rally and Broadening Participation

By TRG Advisors on December 20, 2023

Fourth Quarter Rally in Equity and Bond Markets.

Opposite 2022, 2023 is on track to produce positive returns across equity and bond markets. With the current rally, the S&P 500 is now positive since January 2022. It is almost hard to believe that it took until December 11, 2023, for the S&P 500 to make up for its 2022 losses. Since January 2022, the Dow Jones Industrial Average is outperforming all other major U.S. equity indices.

Chart 1: S&P 500 and Dow Jones Index Are Positive Since January 2022[1]

In the fourth quarter, performance across these same indices is tight. In fact, the Russell 2000 index, which represents smaller-cap companies, has outperformed all other major equity indices since the Fed’s December FOMC meeting. Small-cap stocks tend to be more interest rate sensitive and more economically cyclical – a good sign heading into 2024, with markets predicting easing interest rate conditions, stable economic growth, falling inflation and opportunities for companies to grow earnings.

Chart 2: All U.S. Equity Indices Rallying in the Fourth Quarter[2]

This is a healthy, broadening rotation that can continue. There is still significant mean-reversion that needs to catch up to the S&P 500’s +1,248 bps year-to-date outperformance over its equal-weighted equivalent. Most of that outperformance was driven by the first-half AI-hype that overwhelmingly benefited a concentrated group of mega-cap stocks. There are plenty of underlying thematic tailwinds, including AI, which will drive appreciation for attractively valued names in different sectors throughout the index.

Bond markets have been pricing in easing interest rate expectations throughout the past two months, and these expectations expanded rapidly after last week’s December FOMC meeting. Since its October lows, the Bloomberg U.S. aggregate bond index is up +8.6%. We believe that rates peaked in October.

Chart 3: Strong Fourth Quarter Bond Rally as Market Rates Fall[3]

U.S. Treasuries rallied between 25-30 bps across the curve after the Federal Reserve issued a fresh dot-plot forecast showing 75 bps of cuts expected for next year. The rally extended Wednesday as Chair Powell failed to push back against the market’s pivot toward more policy easing for next year and beyond during his press conference.

The 10-year Treasury yields hit 3.89%, which is 110 bps lower than the recent highs of 4.99% seen in late October. High yield spreads narrowed 15 bps to 394 bps over Treasuries, marking a new low for the year. Muni’s outperformed on the week, with yields lower by 21-23 bps across the curve.

Markets Interpret December FOMC Meeting as Strengthening Case for 2024 Rate Cuts.

It is important to put into perspective that heading into 2023, the market was predicting rate cuts and recession. Instead, 2023 has maintained economic growth and higher interest rates. The labor market has remained supportive of jobs, and inflation progress continues to trend lower. The Fed is now considering whether its restrictive monetary policy has successfully navigated a soft landing and when it might be appropriate to ease.

The Fed has already slowed its pace of rate hikes – it has left its target interest rate unchanged for the past three FOMC meetings. It is now determining whether rates are high enough to have substantially slowed inflation and how long until it can ease policy to support more robust economic activity without risking a return to high inflation. CPI peaked at 9.1% y/y; it is tracking at +2.8% annualized over the last six months.

Chart 4: Fed Policy Not Met With Recession, but Instead Strong GDP, Low Unemployment and Falling Inflation[4]

The Fed predicts that in 2024, the unemployment rate will rise to 4.1% and inflation will fall to 2.4%. It also predicts that quarterly GDP will remain expansionary, but will slow to 1.4%. If inflation continues to trend towards the Fed’s 2% goal, and if the Fed begins to see rising unemployment and slow economic growth, there could be a scenario for rate cuts in 2024. The bond market is anticipating rate cuts, and so is the Fed, which predicts its target rate will fall 80 bps to 4.6%. The 1-year U.S. Treasury bond currently yields 4.9%.

The U.S. banking system – specifically the big banks – is strong and well-protected by strict regulations, benign delinquency rates, tighter lending standards and healthy profits. As financial conditions ease, banks can benefit from the positive impact on capital markets activity and higher lending volume.

Overall, falling inflation, a resilient economy backed by a strong labor market and a healthy consumer should fuel earnings growth in 2024. If financial conditions ease, that will drive the more interest-rate sensitive parts of the economy like real estate and business capex projects. Normal supply chains and inventory will also reduce corporate headwinds, along with lower energy/freight/transportation costs. Currently, markets anticipate 2024 earnings to expand +11.4% y/y for the S&P 500, up from just 1.6% in 2023. Only in 2018 and 2021 has the S&P 500 experienced earnings expansion above 11% in the past ten years.

Return for Selected Indices^[5]

[1] Source: FactSet (chart). As of December 17, 2023.

[2] Source: FactSet (chart). As of December 17, 2023.

[3] Source: FactSet (chart). As of December 17, 2023.

[4] Source: FactSet (chart). As of December 17, 2023.

[5] Source: Bloomberg. As of December 17, 2023.