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Equities produced startling returns in 2023 and so far this year. Belying that success, though, is the concentration factor, combined with election-year politics, inflation concerns and high interest rates.
Savvy investors, especially those at the high-net-worth and ultra-high levels, are far too sophisticated to keep all their investment eggs in one basket, of course. But if they did throughout 2023:
Those who beat the odds would be living large. And dangerously.
Scott Colbert, chief economist for Commerce Trust, noted off the bat that clients are routinely advised to keep their portfolios diversified and never to chase after earnings. It’s also worth peeking behind the curtain on 2023’s performance.
“We believe 2023’s positive financial returns were driven by two primary factors: First, financial markets for much of 2022 had priced in an expectation that the U.S. economy would fall into a recession at some point in 2023,” he said. “That dovetailed 2022’s poor returns in balanced portfolios—nearly the worst calendar year ever, post-World War II—with the S&P 500 Index down 18 percent. At the same time, the bond market was hammered, down 13 percent.”
“The second,” he continued, “was the fact a recession never materialized in 2023 despite a number of headwinds.” Among those were the Federal Reserve’s rapid increase in short-term rates, which started in 2022, and its material reduction in the U.S. money supply, four major bank failures, a yield-curve inversion nearly two years old, and a rapid decline in leading economic indicators.
“Historically, a yield-curve inversion has been a tried-and-true recession indicator, preceding 10 of the past 10 U.S. recessions,” Colbert said. “This was a perfect setup for a financial market rebound in 2023 that has largely continued, although in a much narrower fashion, over the first half of 2024.”
Eric Kelley, UMB’s chief investment officer, pointed to “a powerful wave of household consumption, which was fueled by trillions of dollars in excess savings that accumulated from COVID stimulus. These excess savings helped forestall the recession everyone expected. The heavy consumption that has been driving growth is likely to taper off—excess savings from COVID appear to be depleted, and the labor market is softening.”
Mariner Wealth Advisors’ senior wealth adviser, Justin Richter, also cited consumer psychology for economic resilience. “With ample jobs and strong wage growth, Americans did what they do best: consume,” he said. “After heavy-goods purchase activity during the pandemic, that consumption pivoted significantly to services and experiences.”
Maybe most importantly, Richter said, “The public launch of ChatGPT in November of 2022 set the stage for exploding expectations of how artificial intelligence was going to change the world.”
Creative Planning’s chief investment officer, Jamie Battmer, noted that heading into 2023, Bloomberg’s annual poll of Wall Street strategies projected—for the first time ever—a decline in the S&P 500, on the order of 500 points. “That reinforces why you want to avoid prognostications,” he said. “Their crystal ball is as foggy as anyone’s—these are the same people in 2008 who projected the market would be up to 11,000 and missed by 50 percent. I say that because some people do listen to them.”
Anyone spooked by markets in 2022 who saw an opportunity in fixed income was also duped. “We were in full correction territory by the end of October, down 10 percent peak to trough, and we saw this huge pullout out from the stock market into cash. People were scared.”
The 5 percent they could make there was a pyrrhic victory: “It backfired, as it does 100 percent over the long run,” Battmer said. “Over any 20-year period, cash underperforming stocks is 100 percent.”
Meanwhile, markets soared, disproportionately driven by the performance of the Magnificent Seven: Alphabet (Google), Amazon, Apple, Meta, Microsoft, Tesla and AI powerhouse Nvidia. They were up, combined, more than 50 percent. The other 493 on the S&P? 1.3 percent.
“My concern is that people are chasing that now,” Battmer said. “That typically does not end well.”
Rates for 10-year T-bills declined about 42 basis points in 2023, one reason people were lured out of equities.
“It definitely pulled some investors back into the bond markets; 5 percent returns on government-guaranteed assets is something we hadn’t seen in a very long time,” Kelley said. “We encouraged our clients to move back to full fixed-income targets last year.”
Colbert, as well, said Commerce had seen a greater focus on investment-grade taxable and tax-exempt bonds among both private clients and institutional investors. Will that hold up? “While we do not anticipate interest rates to meaningfully decline over the rest of the year,” he said, “adding longer-duration assets to fixed income portfolios may present an opportunity to lock in some of the higher yields currently available.”
The bond market, said Battmer, “is not the dead-end street it was for so long. It’s a necessary shock absorber and element to fill withdrawal needs.” Still, he noted, over a nine-month run, “the stock market was up 30 percent since, and if you moved into cash at 5 percent, you underperformed by 6x, and that’s a delta you can never make up.”
Many high net-worth investors—and especially ultra-high-net-worth families—”tend to view their time horizon as multi-generational, which leads to a lower long-term allocation to traditional fixed income relative to the Average Joe,” Richter said. But the expected path for longer-term rates is up for debate, he said. “There is concern that excessive government deficits may put longer-term pressure on the value of the dollar and increase risk-premiums tied to U.S. debt. Additionally, there are conflicting influences on longer-term inflation expectations.”
Potential inflationary concerns, Richter said, are driven by the impacts of deglobalization, near-shoring of supply chains and import tariffs. “The question is how much aging demographics and AI-driven technological advancement offset the inflationary factors,” he said.
Against that backdrop, the housing market has been roiled with higher interest rates coming on top of a run-up in prices since the pandemic. It’s an issue for average investors, for whom their primary residence often accounts for a disproportionate share of overall wealth. Not so much with those in the upper tiers, executives say.
“Housing continues to be in unique territory, with higher interest rates constraining buyer activity while the lack of available single-family units for sale is keeping home prices at lofty levels,” Colbert said. “At the end of 2023, home affordability reached an 18-year low due to the combination of soaring home prices and a doubling in mortgage rates.”
As a consequence, “many investors may feel they can’t afford to move even though their homes have risen in value. Should interest rates start to decline, we may see an increase in inventory that puts some downward pressure on home prices. In addition, time will help heal the supply-demand imbalance as new homes are built and a record number of new rental units hit the market in 2024 in some of the country’s hottest housing markets.”
What’s happening there, Battmer said, “reinforces the benefits of being an owner vs. a renter. “It works out in your favor over time. For lack of a better term, home ownership is a forced savings plan.” But, he said, “the headlines are getting it wrong. Yes, someone purchasing today may be over 7 percent, but the average paid across the U.S. on existing loans right now is about 3.7 percent, and 43 percent of homes today have no mortgage attached. The vast majority of homeowners are locked in at very attractive rates that allow more flexibility in other segments of their financial lives.”
In any case, said Kelley, “The primary residence probably shouldn’t be considered as part of your investment portfolio. It’s not a ‘liquid asset’ and likely not something you’re willing to sell in order to rebalance your risk profile.”
A number of factors suggest that the final half of 2024 could produce a bumpy ride.
“The election, the economy and the markets could all be relatively volatile in the latter half of the year,” Kelley said. “Remember that wealth management is a long-term project, and don’t get caught up in your emotions when the news cycle gets choppy. Stay calm and stick to your long-term plans.”
For long-term investors, Battmer says, “The only constant is change. The fallacy of current permanence in anything has led many an investor astray. This time will not be different over the long run. Fear of Missing Out is as dangerous as seeing negative numbers in a statement. So people chasing what’s done well recently, that has never worked out over time.”
For a decade, he notes, the average stocks in emerging markets soared as much as 200 percent. Some investors bit. “Money flooded in after great returns, but the same risk exists now with that FOMO trade of people being over-concentrated in the ones that have done well.”
U.S. economic growth, Colbert says, has already slowed a bit over the first half of 2024. “We expect gross domestic product (GDP) growth to average about 1.7 percent for the year compared to 2023’s 2.5 percent growth rate,” he says. “Driving this slowdown are the lagged effects of higher interest rates that have dampened manufacturing new orders and interest-sensitive industries like autos and housing. Job growth is strong, but slower as compared to last year and paired with cooling wage growth. The Fed also reports a steady uptick in consumer credit card and auto loan delinquency rates in 2024.”
While those are clear signals U.S. economic growth is cooling, he said, “They are not flashing any warning signs of a recession. Despite the unemployment rate climbing to 4.1 percent as of June 2024, job growth remains positive, and U.S. banking and financial systems are in a much sounder position than they were prior to the Great Recession in 2007.”
With all that under consideration, Colbert says, “We always remind investors to look at diversification, particularly as the stock market continues to narrow. Commerce Trust believes strong earnings fueled by the mega-cap growth stocks will continue to lead the S&P 500 Index in 2024, with positive returns reaching across multiple sectors. Mid-cap stocks will also likely benefit from broadening performance at the top of the domestic equity food chain, while small-cap stocks are likely to continue seeing modest gains in the current interest-rate environment.”
Across the economy, investors and consumers alike will bear some psychological scars for a while.
“Although the pace of inflation growth has eased, the aggregate impact of inflation over the last four years has had a disproportionate impact on the low-to-middle income consumer,” Richter said. “A grocery basket that rang up at $100 pre-pandemic is now $130. The upward pricing pressure has eased, but in most cases, those new base values are not going to move backward. Wage growth is also starting to slow as labor market dynamics improve. As a result, credit utilization is increasing, which isn’t sustainable long-term.”
