The traditional Santa Claus rally began around six weeks ago, heralded by Federal Reserve Bank Chair Jerome Powell.
For the seventh week in a row, Wall Street and the US stock market are in a positive mood. The S&P 500 Index is now up by 23% in US dollar terms, and a significant chunk of those gains can be attributed to a handful of mega-cap technology stocks – companies we have come to know as the magnificent seven. Those companies have also been responsible for the spectacular NASDAQ 100 Index rally – it has registered a gain of 53% year-to-date.
But what is different about the rally we have seen over the past few weeks or so is that we are finally seeing a broadening out of the market leadership. In fact, while the S&P 500 was up by about 5% last month, certain sensitive parts of the market performed much better. Small-cap stocks, for example, have rallied over 11%, while the S&P 500 Real Estate sector was up by over 12%. High-quality dividend stocks, meanwhile, have gained 6%.
The primary reason for the US stock market having such a good run last week was the meeting of the Federal Open Market Committee earlier this month. All evidence would now suggest that we have seen the last of the current spate of interest rate hikes, and that rate cuts might even begin in 2024. Inflation is now cooling in the US – perhaps not quite to the degree that the Fed would like. But yields are definitely moving lower, the dollar has weakened against other currencies and the country's economy seems to be charting a course towards a soft landing. Indeed, the documentation published after the meeting suggested a more dovish tone. The implication is that the FOMC is forecasting three quarter-point cuts next year. The market, on the other hand, seems to be suggesting more.
Crucially, Jerome Powell also said that US inflation does not need to hit 2% for the Fed to start cutting rates. So if inflation continues to hover around 2.5% – as is projected for 2024 – the Fed could indeed begin a rate-cutting cycle. This makes sense to us: the central bank decided to keep rates at 5.25% - 5.50% – a 22-year high – in December, even though inflation is moderating. This would give it some room for manoeuvre so it could slowly start to cut rates and land the US economy softly.
In the UK, the Bank of England also decided to keep interest rates at their current level of 5.25%. The difference between circumstances in the US and circumstances in the UK, however, is that the Governor's tone was far from hawkish. Indeed, his announcement came packaged with a warning. Inflation, he cautioned, is higher and stickier than in other countries. Nevertheless, the UK’s manufacturing sector saw output surge in the fourth quarter, according to an industry survey.
Stock market performance has been disappointing this year. Investment returns in all categories – large-, mid- and small-caps – have been underwhelming. Many have deduced from this that the UK stock market is currently cheap. This is indeed likely to be the case, but UK pension funds in particular have spent decades switching out of UK equities into bonds and foreign stocks.
Significant international investment has left these shores in the wake of the Brexit vote and the devastation that followed. The asset allocation weighting in the MSCI World Index for the UK is currently 3.99%. This could explain why some investors have little or no investments in the UK stock market. In fact, we would even suggest that global investors take another look at this unloved region.
In Europe, the European Central Bank also left its key discount rate unchanged at a record high of 4%. But it has indicated that it has no plans to cut interest rates any time soon. Given that inflation has only been falling very slowly, this came as no surprise. Economic growth, meanwhile, has gone into reverse (because of previous rate hikes). The ECB predicts that its 2% target inflation rate will be met at some point in 2025. This suggests that it will not need to tighten its monetary policy any further.
On the bond markets, Treasury yields moved sharply lower as the market began to digest and price in several probable Fed cuts over the next year. 2023 has been an unbelievable year for the bond markets: the benchmark 10-year US Treasury bond hit a 16-year high of just over 5% in late October and currently stands at 3.91%. This sharp drop in yields has supported bond returns as well, with the Bloomberg US Corporate (investment grade) index up by nearly 11% since mid-October, outpacing the S&P 500 Index.
Over the next few trading days, and as we head into the holiday season, we expect this positive momentum to continue. The current backdrop of lower inflation, potential Fed rate cuts and a gradual cooling of the economy should all set the scene for a positive 2024 for the markets. But do be prepared for a pullback or some profit-taking at some point.
Over the course of 2023, some US$6 trillion of assets have flowed into cash deposits and money-market funds. And while “cash has been king” for part of 2023, this might not be the case next year. With rates likely to head lower, there may be a pause in this trend before it actually reverses as both equities and bonds begin to offer better risk-adjusted returns than cash instruments.
Whatever direction interest rates take next year will have a huge impact on economic growth and the markets. We continue to believe that carefully deploying cash to quality equity and bond markets will be rewarding. As the markets broaden out even further, opportunities will emerge in areas such as the cyclical sectors, value parts of the market and mid- and small-caps, as well as investment-grade bonds and commodities. We therefore intend to use volatility in the markets to make further tactical changes to our strategies so we can benefit from the uplift generated by lower inflation and interest rates.
I would like to close by wishing all of our clients and Lowdown readers a very happy New Year.
