AFMC - Three 2023 Lessons We Carry Into 2024

2024-01-03 12:40:00 ET

Summary

• We think 2023 stressed the value of adapting to a new volatile macro regime, and leveraging investment insight and structural forces to find opportunities.
• U.S. stocks surged in 2023, a reversal from their 2022 underperformance. Flip-flopping market views about the policy path stoked volatility in long-term bonds.
• December U.S. jobs data out this week should signal how much more the labor market needs to normalize. Slower jobs growth is a long-term supply constraint.

Transcript

As I look back on a very eventful 2023, three lessons jump out to me.

1) Macro is not your friend

The first is observing how market reaction to one piece of data, one comment from central banks is outsized in 2023, in an environment where macro uncertainty is very high given the interplay between the pandemic unwind and structural constraints. And also in an environment where central banks aren’t giving out as reliable forward guidance as they used to, but instead of haircutting them market reaction to them has been really outsized - and that, to us, is a recipe for this elevated rate volatility to continue, especially given the very sizable gap between what central banks say they will do and what market pricing currently points to.

2) Getting granular

Point two is looking at the very strong and positive correlation between equities and bonds, especially in the U.S., by some measure it is the highest since the '90s. So what does that mean? It means that government bonds are not as reliable a diversifier for portfolios as they used to, and of course, as we look ahead as focus shift(s) somewhat from inflation to growth, then some of that very positive correlation could walk back a little bit, but the key point here is that they are not as reliable as they used to be, and that means when we think about constructing portfolios we have to go a bit more granular than the broader building blocks.

3) Tapping mega forces

And then the third point, third lesson looking back at 2023 is just how important mega forces, structural forces matter for the here and now. AI is a key overweight that we have had in 2023, and that drove a lot of the return in the developed market and in the U.S. equity market, but themes, you know like if you look at other sectors healthcare, so themes and specifically, in our view, mega forces will matter and continue to matter a lot for 2024 going beyond macro insights.

_____________

We take three lessons from 2023 to shape our investment approach in the new year. First, markets flip-flopping between macro narratives does not reveal new information about where we will end up. This is not a typical business cycle, and context is everything. Second, greater dispersion is creating opportunities. That requires skill and granularity. Third, artificial intelligence buzz has underpinned U.S. stock performance - and shows mega forces matter now, not just in the future.

New regime = more dispersion

Past performance is not a reliable indicator of current or future results, and index returns do not account for fees. It is not possible to invest directly in an index .
Notes: The chart shows the 20-day average of dispersion in S&P 500 monthly stock returns (dark orange line) and the median level of dispersion from January 2010 after the global financial crisis through 2019 (yellow line), and from 2020 through to Dec. 13, 2023 (green line).

Looking back, 2023 largely saw a concentrated tech stock rally, with the Nasdaq up 55% from 2022. A market-wide rally since November also supported tech and led the equal-weighted S&P 500 to eke out a 12% return. Overall, we are seeing more dispersion in individual stock returns since 2020 (green bar in the chart). Macro uncertainty, geopolitics and structural shifts are driving volatility and dispersion. We think markets have stoked volatility, too, by viewing the new regime through the lens of a typical business cycle. Investors leaned into long-term bonds in early 2023 on hopes the Federal Reserve would cut policy rates by year-end. It then became clear higher government spending and labor shortages are set to make inflation persistent and keep interest rates above pre-Covid norms. Ten-year Treasury yields surged to 16-year highs near 5% in October as markets priced in this outlook. They tumbled back below 4% by year-end after the Fed blessed the pricing of rate cuts.

These volatile moves underscore the first lesson that was reinforced in 2023: the macro backdrop is much more uncertain today than during the Great Moderation period of stable growth and inflation. This is tough to navigate for markets, with them flip-flopping between macro narratives through 2023. In the final quarter alone, both stocks and bonds surged on news of lower inflation - with the November PCE report confirming a goods-led slowdown - and dovish Fed projections. Small-caps rallied on hopes for a soft economic landing. And markets have repeatedly priced in aggressive rate cuts just to walk them back. All this shows markets may extrapolate a lot from one piece of data or central bank comment. That’s taking a big bet on the macro outlook when the range of outcomes is wide, in our view. We don’t believe the prevalent market narrative tells us new information about where the macro will end up. Yet, we are cognizant markets can run with a narrative for some time. This is why we turned tactically neutral on long-term U.S. Treasuries last October. We think long-term yields will resume their rise over time as investors demand more compensation amid persistent inflation and budget deficits.

Our second lesson

The greater macro risk means the dispersion of returns has increased. The result: a wide divergence in performance across equity sectors - and greater opportunities for investment expertise to shine, in our view. The correlation between bond and stock returns has flipped firmly into positive territory, meaning stocks and bonds fall or rise simultaneously. As a result, the old approach to portfolio construction that relied on bonds to offset equity sell-offs won’t work, in our view. Instead, we advocate breaking up broad asset allocation blocks and digging deeper. All this is why our second lesson is that granularity is more essential now. We look beyond the macro to seek above-benchmark returns, or alpha, by being dynamic and selective.

Our third lesson

One example of going beyond broad asset class exposures is to harness mega forces. The artificial intelligence ((AI)) mega force drove 2023 stock performance to an even larger extent than we had imagined. The importance of AI and other mega forces hammers home our third lesson: structural forces matter now. Aging populations mean an ever-rising share of the population is past retirement age, resulting in worker shortages. That’s a key constraint fueling U.S. inflation now as a tight labor market keeps wage growth elevated. Others include the low-carbon transition and geopolitical fragmentation. The latter is evidenced by wars in Ukraine and Gaza and the intensifying structural competition between the U.S. and China.

Our bottom line

2023 emphasized the macro risks but also the opportunities on offer from structural shifts and getting granular in the new regime. Our 2024 Global Outlook outlines how we capture them.

Market backdrop

U.S. stocks surged roughly 25% last year, a near-mirror image of their downtrodden 2022 performance. That was partly driven by excitement over AI lifting tech stocks and carrying the broader market. Meanwhile, the 10-year Treasury yield ended the year where it started: It climbed from lows of roughly 3.3% in April to 16-year highs near 5% in October, before falling below 3.9% at year end. We think some of the sharp swings in narratives - and markets - reflect the new regime of greater volatility.

We will be looking to the U.S. payrolls data for December out this week to gauge how much further the labor market has left to normalize in the new year after the pandemic. Structurally slower labor force growth is one of several long-term production constraints we think will prevent the U.S. and many other major economies from growing at their pre-pandemic pace without sparking renewed inflation.

This post originally appeared on the iShares Market Insights.

For further details see: