by Blaine Dickason
Senior Vice President
Portfolio Management and Trading
One irony from the bond market in 2023 was that the year started with near unanimous calls for a recession, finished with an over 20% return for the S&P 500 and consensus for a soft landing, yet the yield on the benchmark 10-year U.S. Treasury ended the year right where it started at 3.88%. The improved outlook for the U.S. economy led to outperformance in the corporate bond sector. A mid-single digit total return from bonds overall in 2023 included some price improvement in addition to the expected income provided by their semi-annual interest payments. To be clear, bond markets only appeared sedated if you took off in mid-January 2023 and didn’t return to your computer screen until New Year’s. It was only in mid-November that bond investors could have any confidence that a third consecutive year of negative bond returns might be avoided.
Looking ahead in 2024, it is likely that the Federal Reserve will begin to cut interest rates beginning this year, perhaps even by this summer. This would be an acknowledgement that the restrictive interest rates and policies needed to combat the inflation of the prior two years can finally begin to be rolled back. One key debate sure to take place will regard the appropriate pace the Federal Reserve should take when unwinding their prior rate hikes, as this will be the last step to achieving the soft landing remaining in their sights. At present, the Federal Reserve expects to cut the Fed Funds rate by approximately .75% this year while the market is expecting nearly double that. What will be more important when evaluating the likelihood of interest rate cuts this year is why the Fed is cutting, rather than when or how many they eventually deliver. Given the underlying strength of the consumer and the U.S. economy, we would favor a smaller number of rate cuts this year, which would be consistent with the desired soft-landing outcome.
The increase in interest rates over the last few years has at times felt scary, and certainly rising rates delivered a significant blow to bond market returns in 2021 and 2022. However, as you can see from the chart above, the rise in yields over the last several years has only just returned us to more normal levels, consistent with past periods when economic activity was also quite robust. Yields back to ‘normal’ also benefit the savers and bond investors who had been penalized by near-zero yields during the 2010s and throughout the COVID pandemic. A modest decline in interest rate set by the Federal Reserve this year should also lead to mortgage rates trending lower, although credit card and auto loan rates are likely to remain elevated. True to history, consumer-facing interest rates tend to go up like a rocket and come down like a feather. Given this new absolute level of yields available to investors, we increased our allocation to bonds in the fourth quarter last year. Bonds have earned a place back in most client portfolios and we have added to client allocations accordingly.
Takeaways for the Week:
U.S. inflation in December 2023 as measured by the Consumer Price Index (CPI) was released yesterday at +3.2% versus the prior year, demonstrating significant improvement from the +7.0% reported at the end of 2021 and +6.5% in 2022.
Fourth quarter earnings season kicked off in earnest today with several large financial institutions posting results. Entering this Q4 2023 reporting season, analysts’ estimates called for 3% revenue growth and a 1% earning growth for the S&P 500.