Navigating the Uncharted Terrain of 2023

December 18, 2023
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As we transitioned from 2022 to the unexplored territory of 2023, investors anticipated a challenging journey ahead, adjusting their positions in anticipation of an expected economic downturn. This anticipation was fueled by a convergence of factors, including the most aggressive rate hike by the Federal Reserve in recent history, multi-decade high inflation, the most severe yield curve inversion since 1981, and a deteriorated The Conference Board Leading Economic Index® (LEI) for the U.S. Investors did not anticipate the array of surprising events that would unfold, challenging their preconceptions and shaking the foundations of conventional wisdom. As we approach the year-end, major U.S. and global equity markets have defied predictions, delivering double-digit gains. In this analysis, we delve into the dissonance between most circulated Wall Street expectations and the reality of 2023, deciphering the emerging narratives and uncovering the unforeseen surprises that defined the year.

Rate Hikes and the Pause: A Strategic Pivot Unfolds

Expectation: At the end of 2022, there were divergent predictions. One group expected a continuation of the 75bps rate hikes, recalling 1970s runaway inflation and multiple waves of the inflation cycle and another anticipated multiple interest rate cuts due to a severe economic downturn.

The narrative of 2023 began with the Federal Reserve's strategic pivot. Initially set for a continuation of aggressive rate hikes, the central bank surprised investors by slowing its pace, opting for 25 basis point increases in four of the first five meetings, eventually hitting the pause button. Since the economic slow down never materialized, the anticipated Fed interest rate cuts faded in 2023. This unexpected caution sparked debates about the true state of the economy, leaving investors grappling with whether the central bank's pivot signaled confidence in economic resilience or a response to potential headwinds.

Reality: The Federal Reserve reduced the rate hike magnitude to 25bps due to cooling inflation trends and a given resilient economy.

March Bank Run: Idiosyncratic Unraveling

Expectation: Systemic risks and widespread bank failures after the most aggressive rate hike in recent history.

Consistent with long-standing beliefs that "something is going to break," investors anchoring their risk scenarios to the 2008 Great Financial Crisis predicted the worst. In March, three banks failed, and despite fears of triggering a broad banking system challenge, the event was considered unique to those particular banks rather than an indicator of a systemic problem. The collapse of First Republic Bank, Signature Bank, and Silicon Valley Bank resulted from deficiencies in risk management and a lack of proactive supervision. Importantly, this was distinct from the magnitude and practices that triggered systematic risks in the 2008 subprime mortgage crisis. Collectively exhaling a sigh of relief, investors witnessed a deviation from the anticipated systemic repercussions.

Reality: Bank failures were idiosyncratic, not systematic; panic reactions in yield spread and equity performance resolved in a few days.

Inflation’s Roller Coaster Ride: Unexpected Turns

Expectation: Sustained inflation, drawing comparisons to the 1970s and 1980s.

Contrary to expectations of sustained inflationary pressures, 2023 took a surprising turn. Annual Consumer Price Index (CPI) inflation, standing at 6.4% in December 2022, fell to around 3.2% in October. Energy became a disinflationary factor for six consecutive months, and core goods inflation subsided as the supply chain gradually normalized. The U.S. economy, resilient during the 2022-2023 rate hike cycle, delivered quarter-over-quarter GDP growth of 2.2%, 2.1%, and 5.2%. Corporate profits, the focus of cost-cutting efforts, remained surprisingly stable, instilling confidence that the Federal Reserve could navigate a softlanding for inflation without causing economic harm.

Reality: Inflation fell from 6.4% at the end of 2022 to 3% by the end of 2023.

The GenAI Renaissance: Revival of Tech Giants

Expectation: High interest rates would significantly reduce growth stock return perspectives.

Emerging from the ashes of a seemingly defeated U.S. Big Tech and Technology sector at the end of 2022, 2023 witnessed a remarkable comeback against expectations. The NASDAQ 100 Index, experiencing a 33% loss in 2022, the worst yearly return since 2008, rebounded in Q1 2023, rallying 20.5% and surging a further 21% through December 1st. This unexpected revival was attributed to investor enthusiasm for generative AI (GenAI) and strategic cost-cutting measures implemented by major tech players.

The potential economic contribution of GenAI became a catalyst for investment action, with McKinsey & Company's analysis projecting an annual addition of $2.6trillion to $4.4 trillion in economic benefits. GenAI, coupled with effectivetime redeployment, was anticipated to increase U.S. labor productivity by 0.5 to 0.9% annually, potentially contributing to a 3-4% annual GDP growth. In the face of concerns about the U.S. economy amid aggressive rate hikes, the estimated material economic contribution fueled a much-needed rally.

Reality: The rise of generative AI revived investor enthusiasm, triggering a tech sector revival.

Deciphering the GenAI Paradox: Skepticism Amid Celebration

Expectation: A frothy market reminiscent of the dot-com bubble.

While the rise of GenAI was celebrated, a paradox emerged throughout the year. Economic benefits appeared disproportionately concentrated in select businesses, revealing a nuance dreality. Efficiency gains within GenAI's competence were evident, but the technology faltered when faced with challenges beyond its predetermined capabilities. Investors, drawing from past experiences, exhibited skepticism toward widespread enterprise adoption of GenAI. Rather than placing all bets on technology's end-users, the market favored toolmakers and distributors, echoing the wisdom that investing in infrastructure often yields more consistent returns. This preference resulted in widespread leadership by semiconductors, tech hardware & equipment, and software & services to media platforms, delivering returns ranging from 40 to 80% YTD.

Reality: Investors exercised caution, diversifying their investments across a broader spectrum

“Magnificent 7” and Concentration Risks

Expectation: An unsustainable market rally driven by narrow market breadth – namely “seven stocks.”

A striking revelation surfaced as global equity returns proved heavily concentrated in a handful of tech giants. S&P 500 return data indicated that the top 7 major stocks, including Apple Inc, Microsoft, Google, Meta, Amazon, Tesla, and Nvidia, contributed an astounding 101% to the index's year-to-date gain. Wall Street prognosticated those gains were not sustainable, anticipating a correction to follow.

Little has been talked about a global perspective mirrored this concentration, where ten names, including Taiwan Semi, SAP, and ASML, were responsible for 87% of all global equity returns in 2023 thus far, in contrast to over 2,300 stocks in the ACWI ETF tracking the index.

Despite the surprise in stock contribution to index return, these results are not uncommon and align with long-term market dynamics. Academic research by Bessembinder, titled "Long-term Shareholder Returns: Evidence for 64,000 Global Stocks, " revealed that from 1990-2020, just 2.4% of U.S. listed companies generated all stock market returns. Outside the U.S., the number dwindles to 1.4%. This historical pattern, though surprising, underscores the inherent concentration within equity markets.

Nevertheless, the Large Cap S&P 500 Index has delivered an average 11% annual return for the past 50 years. When market breadth narrows below historically significant levels, the next 12 months have historically yielded positive returns 83% of the time, with an average of 23% for market-cap-weighted S&P 500 and 28% for equal-weighted S&P 500. This counters the widespread narrative heard throughout the year, emphasizing the importance of considering historical trends.

As of 12/13/2023, MSCI U.S., which measures the broad U.S. stock market, and MSCI ACWI, which measures global equities return, delivered +27/+21 return, respectively, with more evidence that the positive return broadened to other stocks in different sectors.

Reality: The market return, propelled by a minority of stocks, aligns with historical norms and is not predictive of a broad market downturn.

Earnings & Interest Rates: Unraveling Disparities

Expectation: Small-Cap stocks would outperform Large-Cap Stocks to confirm a market uptrend.

The narrative surrounding “earnings & interest rates” finds reconciliation by examining return disparities between Small-Cap and Large-Cap stocks. In the twelve months leading up to November, Small-Cap stocks demonstrated a 16% under performance compared to their Large-Cap counterparts, falling below a statistically significant threshold. This trend is rationalized by the unprofitability of over 45% of companies within the Russell 2000 (which measures the performance of Small-Cap Stocks) at the conclusion of Q2 2023. In 2023, Large-Cap stocks are expected to maintain profitability levels similar to 2022, while their Small-Cap counterparts project an 11% decline in profits. This discrepancy introduces a distinct dynamic for those favoring a pro-trade stance.

At the end of October 2023, the interest rate coverage ratio for Small-Cap stocks stood at around 2.6x, in stark contrast to Large-Cap peers with an average interest rate coverage of 9.7x. Despite the double-digit market rally, investors remain cautiously optimistic, preferring quality and durability over speculative and deferred profits.

Reality: Small-Cap stocks underperformed for fundamental reasons, not just momentum and sentiment.

Closing Thoughts: Lessons from the Unforeseen

While my list doesn't encompass all the twists and turns of this year, it captures the essence. As we wrap up 2023, investors have gained invaluable insights from a year that exceeded expectations. Adaptability, strategic narrative approaches, and a sustained focus on underlying dynamics will be pivotal pillars in shaping strategies for navigating the dynamic and ever-evolving landscape of opportunities and challenges in the years ahead.

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