The fourth quarter of 2023 brought a dramatic reversal from the previous quarter for equities and fixed income. The third quarter's declines were fueled by stronger growth, rising inflation and higher interest rates. Then, in this past quarter, weaker economic growth along with waning fears about inflation and rising interest rates led nearly all asset classes higher.
Perhaps counterintuitively, the primary catalyst for the market rebound was weakening economic growth. The Citigroup Economic Surprise Index, which measures whether economic data is beating or missing expectations, began faltering on October 31 and kept pushing lower until the end of the year. Not so coincidentally, the 10-year Treasury began a sharp descent from 4.99 percent on October 19 to 3.88 percent by year-end. The drop in yield corresponded with a similar drop in inflation expectations, with the 10-year inflation break-even dropping from 2.41 percent down to 2.17 percent. The fall in rates and pullback in inflation fears pushed equities significantly higher during the quarter. After stumbling from its then year-to-date high of 4,588 on July 31 all the way down to 4,117 on October 27, the S&P abruptly turned around in the second half of the quarter and surged nearly 16 percent to end the year. The S&P closing level of 4,769 puts it a mere 0.5 percent off its all-time high, set nearly two years ago on Jan. 3, 2022.
The portion of the S&P 500 that is concentrated in the "Magnificent Seven" stocks.
Ironically, as the economy faltered, the equity market rally broadened from its previous narrow advance that had been led by a select few mega-cap stocks known as the “Magnificent Seven.” During the quarter, interest rate-sensitive REITs, small caps and value stocks led the way with the equal-weighted index S&P 500 slightly outperforming its cap-weighted counterpart. For the year, the Nasdaq Composite and the S&P 500 led the major indices, driven by the Magnificent Seven’s 107 percent equal-weighted and median 81 percent return. These seven stocks now make up 28 percent of the S&P 500 index. Further showcasing some of the concentration of the returns that drove the S&P index during 2023, only three of the 11 sectors outperformed the index (consumer discretionary up 42 percent, technology up 58 percent, and communication services up 56 percent). International developed market stocks also quietly turned in a solid showing, returning just north of 18 percent. Both U.S. Small Cap and Mid-Cap stocks returned a healthy 16 percent each, thanks to a late-year rally.
Additionally, after a historically abnormal two years of negative returns, the Bloomberg Aggregate investment-grade index returned 6.8 percent. Indeed, the only major asset class that finished in the red in 2023 was commodities, which posted a 7.91 percent decline. Recall, however, that commodities produced strong returns for the two years prior to 2023. Indeed, in 2022, it was the only asset class that finished in the black. Performance during this period highlights why we recommend owning this as an inflationary hedge and a portfolio diversifier that can perform when both stocks and bonds struggle, much as they did in 2022.
These positive returns, coupled with still faltering inflation and an economy that seemingly hasn’t yet fallen into an overall recession despite the Fed’s aggressive rate hike campaign, have led many to conclude that the future will be much better than the recent past. Fed Chairman Jerome Powell further stoked that optimism when he said after the Fed’s December meeting that the board had discussed the timing of rate cuts in 2024 and would likely lower rates before the Fed reaches its 2 percent inflation target. As the quarter ended, the phrases “soft landing” and “Goldilocks” were commonly heard in both the financial press and in comments by investment strategists. This marked a dramatic shift from the dour mood that prevailed at the start of the year.
Our evolving inflation outlook
Much as we had forecasted, inflation faltered in 2023, with the core Personal Consumption Expenditures (PCE) Index and the Consumer Price Index (CPI) falling to 3.2 and 4 percent, respectively. We believed this would happen based on our research showing that the heightened inflation of 2021 and 2022 was heavily tied to the economic distortions and massive stimulus unleashed during the COVID pandemic. Indeed, our 2022 year-end commentary was aptly titled The Economy Turns the Page on COVID. Simply put, we forecasted that as the economy pushed further past the impacts of the pandemic, the price pressures that resulted from it would fade, and the markets would rise as those inflationary fears abated. This is exactly how 2023 played out, albeit with some heightened volatility.
However, during the second half of 2023 our inflation concerns and forecast shifted, largely because a recession, which we believed would be the final nail in the inflation coffin, did not occur. The good news is that COVID-fueled inflation has waned; the bad news is that the economy is showing signs of being in the late stages of the business cycle. Put simply, the economy has reached the phase where labor supply has run out of slack, and businesses are using wages to lure workers from competitors in an effort to meet still strong production demand. Historically, rising wages have led to heightened demand and threatened to create a wage–price spiral. In each economic cycle since the end of the 1966–82 wage–price spiral, this type of situation has ended in a recession.
Allow us to recast a chart from our Q2 market commentary for visual clarity. As you can see, since 1982, each time wage gains topped 4 percent year over year, a recession followed. That’s because, historically, the Fed has stepped in and raised rates once wages are pushing toward 4 percent to try to cool the economy and prevent a wage–price spiral. The rise in rates has typically resulted in a weakening of the job market, a slowing in the pace of wage gains and, eventually, a recession.
The transition from transitory COVID-based inflation to more traditional wage-based price pressures is what we are worried about. The pace of wage gains has been receding from post-COVID highs. However, we believe wage increases are still above the level at which the Fed will feel comfortable that the potential for wage-based inflation is fully in check. While it’s unpopular to discuss, the Fed may have to keep policy tighter for longer and risk causing job losses in order to avoid a wage–price spiral.
If this COVID-based disinflation was happening against a backdrop of ample labor supply and an early to mid-cycle economy, we would be more optimistic; however, we believe the data is telling a different story. While there are ways wages and inflation could continue to retreat without job losses, we believe they are unlikely.
For example, a surge in the labor pool or a rapid increase in productivity of the current workforce that allows existing workers to create more output per hour could alleviate further inflation pressures. This is what happened in the late 1990s, when an influx of workers combined with a productivity (internet- and Y2K investment-driven) boom kept inflation low against heightened wages. However, as the chart above shows, that only briefly extended the economic cycle. While it is possible we could see a repeat of that period, It’s not a likely outcome.
The good news is that in 2023 the labor force participation rate (those looking for a job or employed as a percentage of the population over the age of 16 and available for work) rose from 62.3 percent to 62.5 percent. The increased participation translated to an additional 2.45 million civilians joining the labor market. The increase in labor supply has likely helped ease the pace of wage gains in 2023. However, as we look ahead at 2024 and beyond, it appears we are nearing the peak in the number of additional workers available to join the labor force.
U.S. demographics point to an aging population with slowing overall population growth. While the overall labor force participation rate of 62.5 percent is less than the pre-COVID level of 63.2, the reality remains that the population continues to age. This is a trend that has been in place for some time. After peaking in January of 2000 at 67.3 percent, labor participation has steadily declined, a trend that is projected to continue. This view is shared by the Congressional Budget Office and the Bureau of Labor Statistics (BLS), with their most recent forecasts suggesting the labor force participation rate peaked in 2023 and will slowly trend lower in the coming years. As a result, the number of new eligible workers entering the labor supply each month will be tied to overall population growth. This translates to roughly 50,000 to 80,000 new participants joining the labor force each month, well below the average pace of job growth throughout 2023.
The variable that the Fed will be watching to determine whether the economy has exhausted additional labor slack is the pace of wage growth.
Fortunately, productivity of the labor force has recently increased. Productivity gains could mute the impact of rising wages translating into higher inflation. Perhaps much as the internet boom extended the productivity boom of the late 1990s, maybe artificial intelligence is set to do the same in the coming years. While we are excited about the promise of productivity gains that AI could deliver in the coming years, we remain skeptical about its nearer-term ability to materially increase productivity of the U.S. economy and extend the current business cycle.
As with all forecasts, nothing is certain, but the above points help explain why we believe it will be hard for the Fed to slow demand for workers to exactly meet the monthly influx of new job candidates. This is tough task given the unknown and lagged impacts of rate hikes coupled with the sheer size of the U.S. economy. The variable that the Fed will be watching to determine whether the economy has exhausted additional labor slack is the pace of wage growth. That pace slowed during 2023 and has since plateaued in the low 4 percent range. This is above the 3.0 to 3.5 percent the Fed believes is consistent with 2 percent inflation.
The reality remains that wage pressures appear set to carry over into the new year. A recent National Federation of Independent Small Business Owners survey shows that 29 percent of owners were planning to raise wages in the next three months, up from a nearer-term low of 21 percent in July. In data going back to 1984 we have seen this level exceeded only during a few months shortly after COVID, and not surprisingly, this has a correlation with actual wage growth.
Perhaps as would be expected in anticipation of higher wage costs, the same survey showed that 32 percent of small business owners are planning to raise prices in the next three months, up from 21 percent in April. With the exception of a spike following COVID, we’ve only reached these levels a few times since the inflationary era of the late 1970s and early 1980s. Not surprisingly, price increase plans result in actual price increases and are another way a wage–price spiral evolves.
We believe the defining economic variable in the coming year will be the path of the labor market and wages, as they will determine whether the much hoped for soft landing occurs in 2024. While the labor market appeared healthy as 2023 ended, it is slowing, and cracks are beginning to show.
Preliminary readings of the Nonfarm Payrolls report from the BLS show that the U.S. economy gained 2.7 million jobs in total in 2023, with the private sector accounting for 2.02 million. This is well below the pace of 4.8 million total and 4.5 million private positions in 2022. However, as 2023 drew to a close, that pace slowed, particularly for the private payrolls (ex-government). During the final three months of the year, private payrolls grew on average by just 115,000 per month. The number of industries hiring has also shrunk, and non-cyclical areas such as education and health care/social assistance have done most of the recent hiring. We also note that the Household report from the BLS, which is used to calculate the unemployment rate, shows that 1.88 million workers were hired in 2023. However, this report shows that the pace of growth in the past nine months has slowed to just 40,000 per month. While these two reports produce numbers that are nearly identical in the intermediate to long term, they can deviate during shorter windows as has recently occurred. We acknowledge that the household report is much more volatile but note that many economists believe it is better at distinguishing turning points in the labor markets.
Certainly, the labor market appeared to remain resilient in 2023; however, we believe it continues to show signs of strain.
We find further evidence of potential labor market cracks in data on temporary employment, which continued to decline in 2023 after peaking in March 2022. Typically, companies let go of temporary help before permanent employees. Indeed, this measure has declined before each of the past four recessions and is part of eight data points that are combined to create the Conference Board’s Employment Trend Index. This is a leading index of the labor market, and it has declined before each of the past seven recessions. It’s currently flashing recession signals. Additionally, while initial jobless claims have remained low, which suggests a strong labor market, continuing claims are up 13 percent to 1.855 million from a year ago. This rise is consistent with prior recessions and indicative of the difficulty of getting rehired once an initial claim is filed. Lastly, as we ended the year the Institute for Supply Management services index joined the manufacturing index in showing that employment was contracting.
Certainly, the labor market appeared to remain resilient in 2023; however, we believe it continues to show signs of strain. While the Fed appears to be talking less tough given the decline in inflation, we think it is still on high alert for an inflation resurgence driven by rising wages. Put simply, we believe the Fed has not strayed from its inflation-fighting playbook of the past 40 years and still views wage growth as the final step in getting price pressures down to its target of 2 percent. We don’t believe the current market forecast of six rate cuts will hold unless wages soften, which will likely occur as a result of the labor market weakening, which is why we continue to forecast a recession. The following excerpt from the minutes of the December Fed meeting sums up our labor market and recession worries.
Several participants noted the risk that, if labor demand were to weaken substantially further, the labor market could transition quickly from a gradual easing to a more abrupt downshift in conditions.
This is where our fears lie. At least historically, once the labor market shows weakness, it tends to trend quickly—and even rate cuts don’t immediately stem job losses. Given our belief that the Fed is likely to err on the side of caution until labor market weakness occurs, we believe a recession is still likely.
A final word on the economy
We employ a “weight of the evidence” approach to economic forecasting tied into an overall narrative on how the economy has traditionally operated. We note that the sum of these variables plus a review of more traditional historical economic cycle dynamics points to a recession being the most probable outcome. The response from the crowd of naysayers during the recent past has been Yes, we see those, but this is an odd economic cycle because of the distortions from COVID.
We agree but believe the economy has pushed past COVID distortions as the pandemic continues to move further into the rear-view mirror. Did it impact economic data and year-over-year measures as well as sentiment? Absolutely. But how long does that last? A large variable that had us positive in late 2022 and early to mid-2023, when others were negative, was our disinflation forecast tied with our belief that the U.S. consumer and U.S. corporations were healthy and had termed out debt. As we have noted, consumer balance sheets remain in good shape and have been insulated from interest rate increases given that a large majority of consumers’ debt is in fixed-rate mortgages. But we note this dynamic is changing as rates remain elevated. Unfortunately, rates are beginning to have a larger impact on consumers, especially at the lower end. Rates remain higher, debt is repricing, consumers are exhausting excess savings, and the economy is slowing. Despite this slowing, the Fed and other central banks are not in any hurry to ease after the ugly reappearance of inflation. Borrowing one final comment from the Fed’s December meeting:
A few suggested that the Committee potentially could face a trade-off between its dual-mandate goals in the period ahead.
We still believe the Fed is likely to err on the side of price stability over full employment to ensure inflation is sustainably at 2 percent. The Fed does not want to repeat the mistakes it made by not finishing the job that led to one of the worst inflationary periods in this country’s history, the wage–price spiral of 1966–1982.
Calling the exact arrival of a recession is obviously a difficult task for forecasters, especially given the oddities of this COVID time period. However, we believe the economy is normalizing back to its traditional drivers as we move further past the pandemic. Unfortunately, it appears to be doing so when the economy looks late in the business cycle. Historically, this is a condition when slack has evaporated, and resources are being fully employed. Put in economic jargon, the output gap appears to be closed, which traditionally has led to inflation/wage pressures, which have been the precursors to the end of the business cycle or recession.
The good news remains that we believe any such recession will be mild in depth and short in duration due to the reality that balance sheets remain strong and excesses appear to be minimal. This is not 2007 to 2009.
Hopes of a soft landing have led to a massive shift in investment sentiment. The American Association of Individual Investors Sentiment Survey has seen readings since November at historically high levels of more than 50 percent bullish. Contrast that with December of 2022, when we were noting that the same survey had just finished its highest average bear reading and lowest bull readings for any full year going back to its 1987 inception. Indeed, December 2022 saw all weekly readings in the historically low 20 percent range.
We remind readers that this survey has historically provided strong contrarian signals. Last year it were flashing a green light. Historically, when the level of pessimism captured by the anemic bullish readings as seen in late 2022 occurs, they have preceded a higher probability of positive equity markets in the next twelve months with a double digit plus average and median return. Contrast that with this year where this survey is flashing yellow Bullish readings at the high levels seen at the end of 2023 have typically coincided with a higher probability of negative outcomes in the next 12 months with both the average and median return in the low single-digits
Talk of a recession understandably can be concerning, but our narrative is not meant to be a dire commentary.
Similarly, last year we pointed to valuations of the S&P 500 Index as additional evidence of widespread pessimism. At the time, the index was trading at a more normal 16.5 times expected 2023 earnings. Much like sentiment, that narrative has dramatically changed in recent months. At the end of 2023 the S&P 500 was trading at more than 20 times forward 12 months earnings—earnings that are expected to grow 8 percent. While the bar was low last year for positive earnings surprises and market returns, it’s now a high bar this year given this starting valuation.
Talk of a recession understandably can be concerning, but our narrative is not meant to be a dire commentary. Not every part of the market is expensive, and we believe broader equity markets still possess ample opportunity for those who are patient and remain diversified among many different types and styles of equities. For example, U.S. Small Caps, Mid-Caps and value stocks trade at compelling valuations today. While economic disruption could cause them to decline in the short term, we believe they offer the opportunity for compelling returns in the coming years. Finally, after years of offering low to no yields, bonds once again offer real income and will likely serve as a hedge to potential equity market downside.
As we consistently stress, this is not a call for a dramatic shift in one’s asset allocation. We believe that making significant changes to an overall strategic long-term asset allocation in hopes of capitalizing on short-term timing calls is a fool’s errand. Understand that embedded in any asset allocation recommendation and financial plan is the aforementioned reality that recessions occur, and markets are volatile. It’s in the plan, and if the analysis shows that you will meet your goals and objectives, why would you risk making changes?
The reality is that, historically, the ends of economic cycles (recessions) are temporary disruptions that lead to the beginnings of the next economic cycle. The same applies in the financial markets. Staying invested and true to one’s strategic asset allocation in a diversified manner during these disruptions has proven time and again to be the best path to attaining and keeping financial security.
Instead, this is a call to action to make sure you are ready for the possibility of a recession and further market volatility and won’t be tempted to sell at what could be exactly the wrong time. If you are concerned about the impact a recession could have on you, we advise you to have a conversation with your advisor now.
Happy New Year.
Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.
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As the chief investment officer at Northwestern Mutual Wealth Management Company, I guide the investment philosophy for individual retail investors. In my more than 25 years of investment experience, I have navigated investors through booms and busts, from the tech bubble of the late 1990s to the financial crisis of 2008-2009. An innate sense of investigative curiosity coupled with a healthy dose of natural skepticism help guide my ability to maintain a steady hand in the short term while also preserving a focus on long-term investment plans and financial goals.
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