After a shaky start to the quarter, US equities experienced a significant rally following the Federal Reserve's indications that interest rate cuts could be on the horizon.
Q4 2023 Market Commentary
After a shaky start to the quarter, US equities experienced a significant rally following the Federal Reserve's indications that interest rate cuts could be on the horizon. Concurrently, there was an easing in inflation, with the rate decreasing from 3.7% in September to 3.1% in November. This played a crucial role in shaping the narrative at the Fed’s December meeting. The meeting's outcomes reinforced the market's belief that the Fed is likely to conclude its “higher for longer” stance much sooner than anticipated and expects to cut rates in 2024. Additionally, we got the latest GDP figures which showed an annualized growth of 4.9% in the third quarter, a notable increase from the 2.1% growth observed in the second quarter. Nearly all equity sectors felt these positive impacts as Real Estate (+18.8%) and Technology (+17.7%) led the way due to their high sensitivity to the path of interest rates. Energy was the notable exception to the broad rally as the sector fell 6.4%. The S&P 500 was up 11.7%, the Nasdaq gained 13.8%, and the Dow Jones Industrial Average posted a 13.1% rally.
The MSCI ACWI ex-USA index gained 9.8%.
Like the US, the final quarter of the year in the Eurozone was positive after optimism erupted over stabilizing interest rates. Notably, inflation has dropped from a towering 10.1% last year to 2.4% in November. European Central Bank (ECB) authorities are currently engaged in a tug-of-war with financial markets regarding when to initiate its first cut in rates, following the pronounced decline in inflation. Investors expect the initial reduction in rates could occur as early as Spring of this year, yet most ECB officials suggest a mid-year timeframe is more likely. Christine Lagarde, President of the ECB, has repeated there is no definite date but said rates will start to decline when inflation is back to 2%. Despite the positive news on the inflation front, the Eurozone economy experienced a minor contraction as GDP dipped by 0.1% in Q3 while the Eurozone Purchasing Manager’s Index (PMI) dropped to 47 in December. Numbers under 50 signify contraction. Overall, the MSCI EAFE index rose 10.5%.
During the quarter, UK equities experienced a notable upswing, with small and mid-cap indices particularly outperforming the broader market. This uptrend was driven largely by the robust performance of domestically focused stocks, bolstered by growing expectations that interest rates might have reached their peak. Inflation in the UK fell to 3.9% in November, down from double-digit highs. As was the theme across the globe, the decline in inflation raised hopes that the Bank of England may be done in its interest rate hiking cycle. One small thing to note was a revision to the Q3 GDP number, showing the economy was in contraction compared to stagnant growth. The MSCI United Kingdom index was up 7.8%.
In the economy, Japan showed signs of improvement. Although Q3 GDP data indicated slight weakness, primarily due to higher inflation and slower wage growth, a Bank of Japan (BOJ) revealed a continuous improvement in business sentiment across both manufacturing and non-manufacturing sectors. The BOJ, having begun to normalize its exceptional monetary easing policy at the end of October, hinted at the likelihood of further steps in early 2024, suggesting a cautiously optimistic economic outlook. The MSCI Japan Index was up 8.2%.
Despite achieving robust returns, Emerging Markets did not quite match the pace set by their developed market peers. A closer look reveals that Taiwan stood out as a top performer, significantly buoyed by a surge in the technology sector. On the other hand, the largest weight in the index, China, is having a tepid recovery post-Covid. Furthermore, the persistent challenges in the real estate sector continue to cast a shadow over market sentiment. MSCI Emerging Markets Index was up 7.9%.
Fixed income markets were positive across the board in the third quarter. A more dovish path for interest rates signaled by the Federal Reserve and implied in market pricing, led bonds higher. Expectations of earlier-than-expected central bank cuts globally, tightening spreads and a weakening dollar further supported these gains. The Bloomberg Global Aggregate Index gained 8.1%.
Throughout the quarter, the Federal Reserve held interest rates steady. However, at the December meeting, they signaled a notable shift towards a surprisingly dovish approach, igniting a market rally. The updated dot plot, which visualizes the Federal Open Market Committee (FOMC) members' expectations for the federal funds rate, now forecasts three rate reductions in 2024, an increase from the two reductions previously anticipated. The pivot towards dovish language and expectations of a more accommodative policy stance forced rates sharply downward and propelled bond prices. The US 10-year Treasury yield fell from 4.6% to 3.9% over the course of the quarter. The Bloomberg Treasury 5-10 Year Index gained 6.0%.
The corporate bond market experienced a remarkable rally, fueled by optimism that a severe recession might be avoided due to relaxed financial conditions. Spreads, which indicate the perceived risk of credit instruments and therefore affect their pricing, tightened over the quarter providing a tailwind for corporates and leading them to outperform their government counterparts. Investment grade instruments outpaced high yield in performance due to their higher sensitivity to falling interest rates. The Bloomberg US Corporate Bond Index rose 8.5% while the Bloomberg US Corporate High Yield Index returned 7.2%.
Key central banks outside the US followed suit with the Federal Reserve and maintained stable interest rates. Still, many showed increased caution regarding inflation. Despite the inflation nervousness, yields across these markets fell and bond prices rallied. The European Central Bank advanced forward with its strategy to gradually reduce the support provided under its Pandemic Emergency Purchase Program. The Bank of England's Monetary Policy Committee showed a split opinion on additional tightening measures to come. The most recent inflation data, which came in lower than expected, further fueled the rally in the gilt market. The Bank of Japan disappointed investors who expected them to take more action on adjusting their yield curve control policies, leaving returns in their fixed-income markets muted.
In Q4, traditional commodities exhibited mixed results. Energy markets struggled mightily in the third quarter as prices for natural gas and oil sharply declined. This weakening came even without action from OPEC+ signaling a deterioration in demand for energy products. The S&P Precious Metals Index continued to rebound, registering an 11% increase, as investors sought safe-haven assets amid market volatility. The S&P Industrial Metals Index, however, saw limited growth of 0.8% due to the slowing in industrial activity across the world. The S&P Agriculture Index held steady in Q4 2023, decreasing by 0.8%.
Private credit continued its upward trajectory reinforcing itself as a key component of private markets. With interest rates stabilizing, the sector continued to benefit from the higher-yielding environment. Investors focused on differentiated exposures with seniority in the capital stack and collateralized hard assets continuing to be a key sourcing theme. Looking forward, the increased investor allocations to private credit may dilute returns as more capital enters the space.
Private equity fundraising slowed as Limited Partners have reduced commitments to new vintages due to the lack of capital distributed from prior private equity investments. Institutional investors often have high private equity allocations and as underlying managers struggled to return capital in 2023, allocators are limited in their ability to re-up or make new commitments.
The cryptocurrency market experienced a significant increase in Q4 with Bitcoin rallying 57% and Ethereum increasing by 37%. This rebound was partially driven by a more favorable regulatory environment, following significant legal victories for crypto firms in the previous quarter. The expected approval of a Bitcoin ETF and the successful launch of Ethereum Futures ETFs bolstered investor confidence, leading to increased institutional interest in digital assets. However, the market remained cautious, as investors closely monitor regulatory developments and market trends.