Markets rose last month, continuing November’s rally as interest rates pulled back even more on expectations of Fed rate cuts in 2024. Markets in the U.S. were up by mid-single digits, finishing a solid quarter and a very strong year. International markets were also up substantially for the month, quarter, and year. And while stocks were hot, even fixed income posted enough gains to close out the year in the black. 2023 ended with a bang.
Interest rates. The rally was, once again, due mainly to interest rates, which kept dropping in December. Better inflation numbers raised hopes the Fed would start cutting rates this year, and signs of slower but continued economic growth supported that idea. Between job growth moving closer to pre-pandemic levels, healthy consumer confidence and spending, and continued weakness in manufacturing, the economy seemed to be settling into a soft landing, which could keep pulling inflation downward. In response, the 10-year U.S. Treasury yield dropped back to levels last seen in August, driving markets higher.
Changing expectations. Looking forward, we may see a change in expectations in the new year. Markets have been choppy so far this month, and there is commentary suggesting that they may have gotten ahead of themselves. After a strong year-end, the seasonal factors can be less positive at the start of the year, which could be a headwind. In addition, the Fed may start pushing back on rate cut expectations, which would be another negative. Overall, in my view, conditions should remain positive in January, but perhaps somewhat less so than last month.
Current risks. While overall conditions remain positive, there are still risks. The Fed is concerned that inflation may return in some sectors, which must be watched for its effect on rates. The ongoing war in the Middle East shows signs of expanding and affecting trade routes and supply lines. And domestic politics remain a concern as the election gets closer. But with the fundamentals reasonably healthy and the macro picture stabilizing, many of the economic fears that pulled markets back last year may subside.
The markets and inflation. As we start the year, the key issues will be whether growth continues at a slower rate and inflation moves downward. Market expectations on rates have changed rapidly. If the Fed continues to act in a dovish manner, that positive reaction could continue. That said, there is a mismatch between what the market expects (six or more rate cuts) and what the Fed says (only three rate cuts). That mismatch in the past has given rise to volatility, so this is a risk to watch, even if conditions otherwise remain favorable.
That is the bottom line here—while conditions are good, volatility looks likely. The last two months were great for markets as rates pulled back, but conditions could change. Looking forward to the new year, we are still not out of the woods with inflation or growth. And while the trends remain positive, risks may pick up again over the next couple of months.
As of this morning’s jobs report, job growth is still healthy. The things to watch going forward will be consumer confidence and consumer spending. If they remain at pre-pandemic levels, then a soft landing looks increasingly likely, and the Fed should continue to send dovish signals. If not, we could see more volatility. Even in the case of volatility, the solid fundamentals should limit the damage and help set us up for more growth later this year. I believe this is something to watch for, but not to worry about too much.