4th Quarter 2023 Investment Commentary


  • U.S. Federal Reserve Bank paused interest rate hiking cycle in June and may finally be done with rate hikes
  • U.S. unemployment rate remains healthy at 3.7% as of January 2024
  • Fixed income and cash offering very attractive yields (>5% on cash)
  • U.S. inflation rate has declined significantly from its peak

Risks and Concerns

  • Wars in the Middle East and Ukraine significantly increase already high geopolitical tension
  • Equity risk premium at its lowest level in over 20 years
  • CPI inflation rose at a 3.4% annual rate in January 2024, but is down greatly from its peak of 9.1% in June 2022
  • Interest rates may remain higher for longer than markets hope as some inflationary pressures remain

The Year in Review

2023 began with low expectations for equity market performance due to concerns over high inflation, high interest rates, and a large equity market selloff led by the technology sector in the second half of 2022. A local bank crisis in March did little to allay fears of a recession, with high interest rates putting stress on small bank balance sheets due to a decline in value of their longer-term bond holdings.

In retrospect, the small banking crisis marked the low point for financial markets for the year, and as inflation continued to drop and most measures of economic performance improved, expectations of avoiding a recession began to rise. The Federal Reserve made their last interest rate hike of 0.25% in July 2023 and signaled then that they would pause their rate hiking cycle and may, in fact, be finished raising rates if inflation continued to decline. The following chart shows that all measures of inflation did, in fact, continue to fall after the July Federal Reserve meeting:

Personal-Consumption Expenditures Price Index, Annual Rate of Change

The Wall Street Journal. “Prices Fell in November for the First Time Since 2020. Inflation is Approaching Fed Target.” 12/22/2023

In the Federal Reserve meeting at the end of September, the central bank signaled it may begin to cut interest rates as early as the 1st quarter of 2024. This sparked a large 4th quarter rally in both stocks and bonds. The S&P 500 Index rallied 12% in the 4th quarter and finished up 26% for 2023, erasing 2022’s 30% decline in tech stocks and 20% fall in the S&P 500 Index. The Bloomberg Aggregate Bond Index finished up 5.5% for the year.

Current Investment Strategy

Our overall investment strategy during the 4th quarter was designed to slowly and steadily transition from a defensive strategy to a more balanced risk approach. While chances of avoiding a recession continue to increase, we remain cautiously optimistic, as the historical record on soft landings from periods of high inflation and high interest rates is poor. Regardless, we adjusted our portfolio model equity underweighting from roughly 10% to 5% underweight. We are not yet optimistic enough to do an across-the-board rebalance to buy 5% more equity but are likely to do so upon the occurrence of an equity market selloff of 10% or greater.

In our fixed income strategy, we continue to steadily lengthen bond maturity as we believe that interest rates have most likely peaked for the current cycle, and longer maturity bonds will outperform short maturities should interest rates begin to fall. However, our heavy allocation to short maturity bonds was primarily responsible for our outperformance of the overall bond market index during the past nearly 2 years of rising interest rates. Short maturity bonds continue to perform very well despite the expectations of flat or falling interest rates soon. We will continue to lengthen the maturity of our overall fixed income portfolio in expectation of falling interest rates in the future.

Within our equity strategy, the stocks within the U.S. S&P 500 Index continued to dominate, though at a lesser rate than earlier in the year. For this reason, among others, we have maintained a heavy overweight to U.S. large capitalization stocks relative to middle and small capitalization stocks. The positive return participation rate of other stocks in the index has begun to increase relative to the largest companies, which is another sign of increasing health in equity markets. However, the chart below shows that the largest seven stocks in the S&P 500 Index (known as the “Magnificent Seven”) drove the vast majority of U.S. large capitalization stock performance over the trailing year. These stocks are all technology stocks—Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Meta (Facebook), and Tesla:

Top Heavy Performance in the U.S.

Source: Litman Gregory Wealth Management. “Fourth Quarter 2023 Investment Commentary.” 1/17/2023

Future Asset Allocation Changes and Considerations

Over the coming months, we plan to continue cautiously increasing allocations to equities and longer-maturity bonds. We are unwilling to declare that “the coast is clear” and aggressively increase investment risk, but we do believe that the odds of achieving a soft landing (and avoiding a recession) have dramatically increased. Interest rates have most likely peaked for the current cycle, with inflationary pressures abating and the Federal Reserve signaling that they are unlikely to make any further rate hikes. However, it is also unlikely that interest rate cuts will come as soon as the market hopes. We believe that the “higher for longer” scenario is more likely to unfold as – barring a sharp economic downturn – the Federal Reserve is unlikely to risk rekindling inflation by cutting rates too soon. Furthermore, inflationary pressures remain in the form of strong consumer spending and geopolitical tensions constraining supply chains.

The overall U.S. economy has continued a trend of strong growth recovery from the pandemic of 2020 with a clear trend of declining inflation. The following chart shows historical U.S. GDP growth continuing solid growth with a 3.3% annualized growth rate in the 4th quarter of 2023:

Strong Finish for U.S. Economy at End of 2023

Personal spending exceeded estimates while underlying inflation held at Fed’s target

Source: Bureau of Economic Analysis – Bloomberg

We are cautiously optimistic that the trends of healthy economic growth and declining inflation can continue this year. We will continue to increase equity exposure and lengthen maturity in bonds as long as these trends continue, with the intention of slowly increasing overall portfolio risk in pursuit of greater returns. However, we are also fully prepared to halt (or reverse) these efforts should signs of a hard landing or recession become evident.

Key Investment Takeaways

  • We are currently moving from defensive to more aggressive strategies in both stocks and bonds
  • Stock and bond markets rallied in the 4th quarter as market expectations for interest rate cuts rose
  • We intend to continue an overweighted fixed income strategy until we see a stock market correction
  • High interest rates and declining inflation makes fixed income investments relatively attractive
  • As inflation recedes, the U.S. Federal Reserve Bank has likely ended rate hikes and may begin to lower them

We will continue to monitor the market risks of this rapidly changing and difficult environment, frequently adjusting to help protect and grow your investment portfolio. As always, please feel free to call or email us with any questions or concerns.

Your Capital Advantage Team

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