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Commentary - Q4 2023

In the fourth quarter of 2023, the stock market rallied as investors perceived the Federal Reserve's move to curb inflation through an increase in the Fed funds rate was reaching its conclusion. The broad market, as represented by the S&P 500 Index, returned 11.7%. Each segment of the size spectrum experienced favorable returns, The S&P MidCap Index produced a 11.7% return and the SmallCap Index rose 15.1%. The yearly returns were well above the long-term average.  The full year return for the S&P 500 Index was 26.3%, the S&P Midcap Index returned 16.4% and the S&P SmallCap Index 16.1%.   


Both growth stocks and value stocks rose during the quarter. The S&P 500 Growth Index rose 10.1% and the S&P 500 Value Index rose 13.6%. For the full year 2023, growth stocks returned 30.0% and value stocks returned 22.2%.


While the market experienced a well above average nominal return in 2023, returns after inflation over the last three years have been well below the long-term average. During the three-year period, the inflation adjusted return was 3.9% per year, and during the last two years the inflation adjusted return was -3.3%. The average annual inflation adjusted return in the post-war period is 7.0%. Inflation has transformed an apparent bull market into a disappointing episode. 


Bond returns were positive as well during the quarter and for the year. The Bloomberg Aggregate US Bond Index rose 6.8% in the recent quarter and returned 5.5% for the last year. When the Fed stopped raising interest rates as the rate of inflation declined, long-term bonds generated double digit returns. The Bloomberg US Aggregate Government-Treasury Long Index rose 12.7 % in the quarter, but for full the year long-term bonds underperformed shorter dated obligations, 3.1% versus 5.1%, as concerns about inflation weighed on the bond market. 


Over the last three years, long-term bonds like stocks, have produced after inflation returns well below their long-term average. However, unlike stocks bonds have produced negative nominal returns as well.   The Bloomberg US Aggregate Index produced a -4.2 % per year return for the last two years and a    -3.3% per year return for the last three years. Rising inflation and the Fed’s effort to reduce inflation have penalized those who hold bonds.


The yield curve remained inverted throughout 2023. At the end of the year, one month Treasury obligations were yielding about 5.5%, one-year obligations 4.8%, and ten-year bonds 4.1%.  The shape of the yield curve reveals investors’ expectations for both real growth and inflation. The yield on the ten-year bond is consistent with the expectation that real growth plus inflation will average about 4% per year over the next ten years. While expectations are not guaranteed to be accurate, the shape of the curve suggests market participants expect both real growth and inflation to be lower in the next ten years than both are currently.


In the fourth quarter, real growth is estimated to have been 1.3% at an annual rate. This growth rate is well below the approximately 5.0% growth in the third quarter (Estimates of real growth are often revised as more complete data become available.) For all of 2023 real growth is estimated to have been about 2.7%.  The consensus forecast for real GDP growth in 2024 is about 2.0% or slightly lower.



The market has been focused on near term readings of economic data. Measures of real growth, inflation, unemployment, and job creation are consistent with a favorable economic environment.  However, a longer-term perspective reveals some reasons to be cautious while forming expectations for economic conditions and the performance of the stock market going forward. The last reading of unemployment showed a rate of 3.7%, but the labor force participation rate was 1.0% below its level just prior to the implementation of the COVID-9 pandemic policies, which shut down many economic activities.  If the rate were to return to the higher-level, unemployment would be over 4%. Job formation has been robust recently, but the gains in employment have produced a less than 1% per year rate of growth in total employment over the period beginning in March of 2020 and ending in December of 2023. Industrial production was flat for much of 2023, and corporate profits appear to have risen less than 1% on year-over-year basis in 2023. If the consensus forecast of less than 2% for real growth comes to pass, it is likely corporate profits will increase at a modest pace in 2024.


The actions of the Fed have been the primary focus of investors as they await a reduction in the Fed Funds rate and a declaration that inflation has been tamed. The reality is the Fed may have little or no room to shape an anti-inflationary monetary policy in the future. The Fed has raised the Fed Funds rate from 0.25% to 5.25% over the period from May 2022 to August 2023. 


Inflation has declined from almost 9.0 % an annual rate to a rate of about 3.0%. The Fed has set a target of 2.0%, but that rate of inflation seems out of reach currently. Additional rate increases are possible, but looming budget deficits will constrain the Fed’s actions.


The CBO estimates Federal budget deficits will average $1.7 trillion per year over the next ten years. The CBO estimate may be revised upward should the decline in tax receipts on a year-over-year basis in recent quarters continue.  If the Fed behaves as it has in the past, it will step up and fund much of the deficit and increase liquidity as it does so. Increases in liquidity for the last eight months of 2023 indicate the Fed has ended its concern about rising inflation. Additionally, the Fed has been reluctant to not accommodate the Treasury in the past. As a result, the CPI has experienced a rise of about 900% over the last fifty years, oil prices have risen from about $7 per barrel to over $74 per barrel, and the price of gold has risen from $35 an ounce to over $2,000 per ounce. Inflation may reemerge as a destabilizing factor in the not-too-distant future.

Sources: S&P Dow Jones Indices, US Bureau of Labor Statistics, CBOE, Bureau of Economic Analysis

The information contained in this commentary represents the opinion of Affinity Investment Advisors, LLC and should not be construed as personalized or individualized investment advice. The analysis and opinions expressed in this report are subject to change without notice. The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. This report includes candid statements and observations of economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct.

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