So far, the strong U.S. labor market has helped the economy escape a much-anticipated recession, with December's unemployment rate at only 3.7% and pay growth at 4%. Despite rising consumer optimism (as seen by retail sales of 0.3% and confidence polls), CPI inflation slowed to little over 3% annualized in November. However, discord persisted as both the Conference Board Leading Economic Index and the Small Business Optimism Index declined for 20 consecutive months, with the latter remaining at decade-lows.
Surprisingly appealing small-cap stocks (+16.9%) and real estate (+11.4%) drove U.S. equities to a nine-week winning run by the end of 2023, the longest such stretch in almost six years. The S&P 500 increased 13.8% in 2023 when all equities were considered equally weighted, while seven large tech companies accounted for 26.3% of the gain. The most important factor is the possibility of interest rate reduction by the Federal Reserve. Futures pricing suggests that there might be as many as six rate cuts in 2024, which is a significant improvement over the tailwinds of reducing U.S. inflation and strong corporate profitability.
Although they have lagged behind U.S. markets, non-U.S. shares have also gained during the last several months. China (-2.4%) and Japan (+4.4%), two major laggards, are largely to blame for Asia's region-wide underperformance. Concerns over corporate and family debt, as well as a fragmented labor market, have grown among investors in China, the world's second-largest economy, and are threatening to slow economic development.
An extraordinary bond rally of 8.9% occurred, surpassing performance in any other two-month period in the preceding thirty years and a half, when the yield on 10-year US Treasury notes plummeted from over 5% in mid-October to approximately 3.8% by year-end. Consequently, the conventional 60/40 stock/bond portfolio saw its greatest two-month return since 1990. As a result of their somewhat reduced interest-rate sensitivity, municipal bonds lagged behind, while debt from developing countries is outperforming owing to expectations of rate decreases.
Despite lowering inflation, portfolio returns were boosted by exposure to real assets, particularly infrastructure (+3.7%), even if commodities as a whole were down almost 2% in December. Office-heavy U.S. REITs (+8.9%) were the obvious winners once again as investors anticipated reduced interest rates leading to more borrowing and a revitalization of demand for real estate.
It is hardly surprising that in markets driven straight up by optimistic sentiment, hedge fund strategies usually underperformed conventional stock and bond investments. We expect portfolio returns from hedge fund strategies to be uncorrelated or very poorly correlated with those from more conventional markets. In market conditions when there is less consistent directionality, the absence of correlation is especially advantageous.
The most pessimistic predictions for the American economy have not materialized as we approach the year 2024. There has been no significant worsening of the labor situation, inflation is heading lower, and growth is continuing. The two world wars, the three worst bank collapses in American history, and the sharpest interest rate hike in the last 40 years certainly didn't help matters. Employers have been de-listing some job positions but not engaged in large layoffs, thus U.S. consumers have continued to spend owing to surplus savings from the COVID-19 period and considerable pay increases (over 5%).
Is it safe to say that the recession threat has been eliminated? Probably not. Weaker growth in 2024 is possible since the whole effect of interest rate hikes has not yet been felt. Nevertheless, we are in the midst of a U.S. presidential election year, so positive surprises are possible. The present government is making every effort to spur development in 2024, and the Federal Reserve may cut interest rates more sharply than expected.