The investing world lost a legend, and masterful second-fiddle player, this quarter. Charlie Munger, vice chairman of Berkshire Hathaway and best friend and business partner of Warren Buffett for six decades, passed away in November, a month shy of his 100th birthday.
Warren nicknamed Charlie the “abominable no-man” for his propensity to set the bar so high for investments. Mr. Munger imparted much wisdom, but he also possessed a sharp wit. During the 2015 Berkshire Hathaway annual meeting, Charlie remarked to applause and laughter: “Warren, if people weren’t so often wrong, we wouldn’t be so rich.” It’s a good reminder to get comfortable being a contrarian when your conviction is high. Being value investors when the market is in a very “risk-on” mood certainly requires conviction.
The S&P 500 closed on December 29th at 4,770 representing a robust return of 11.69% for the final quarter of 2023 and 26.27% for the year. The benchmark index is just 0.56% below its closing record reached in January 2022 and has climbed 33% from last year’s low, helped along by the huge rally this quarter. The DJIA ended December at 37,690 for a comparative return of 13.09% in the past three months and a more muted, but still healthy 16.17% for 2023.
The disparity in returns for 2023 between the two major indices is squarely attributable to a rotation in investor sentiment and performance between investment styles and industry sectors compared to the prior year. While in 2022, Energy vastly outperformed every other category, up close to 65%, spurred by global supply and demand crunches, this sector is ending 2023 in negative territory, down 1.1%. Conversely, in the face of aggressive interest rate hikes, investors cooled on technology stocks in 2022, sending the sector plummeting over 25% for the year. But now that inflation is cooling and the Federal Reserve’s current tightening cycle is paused or ending, Technology has gained 58.3% this year in a reversal of fortune.
Likewise, Consumer Discretionary and Communication Services sectors, both 2022 laggards, have exhibited large double-digit gains in 2023, rounding out the top three S&P 500 sectors. This performance rotation largely accounts for Large Cap Growth being by far the standout investment style winner for 2023, outperforming Large Cap Value by a factor approaching four times. Here at Stolper Asset Management, with our disciplined approach of seeking value opportunities, we naturally felt the impact of this shifting investment landscape but, as the above figures help illustrate, during other periods we reap the benefits. Regardless, our bottom-up approach aims to identify long-term inherent value in individual investments rather than predict macro trends or sentiment.
Given the pace of change, it may be easily forgotten that the Federal Reserve was holding the fed funds rate close to zero as recently as the first quarter of 2022, as well as engaging in billions of dollars in monthly bond buying, both in service to stimulating the economy in the wake of acute impacts wrought by the COVID-19 pandemic. This was at a time when U.S. inflation figures were already hitting 40-year highs. But when the Fed decided to tackle rising inflation, it did so with enormous gusto, raising rates on eleven occasions all the way up to the current range of 5.25-5.50% by July 2023, the time of the most recent hike. Meanwhile, the Fed balance sheet has declined to its lowest level ($7.7 trillion) since April 2021.
At each subsequent meeting of the Federal Open Market Committee (FOMC), Chair Jerome Powell has announced that rates are being held steady, the rationale being that, while inflation has not yet reached the Fed’s 2% target, there is growing confidence that it is trending on a downward path. For November, the U.S. Bureau of Labor Statistics reported the Consumer Price Index (CPI) rose 3.1% for the twelve months ending November, a smaller increase than the 3.2% figure reported year-on-year for October. As a reminder, this CPI inflation rate peaked in the current cycle at 9.1% in June 2022 when post-shutdown supply and demand mismatches were still prevalent, and the shock of Russia’s recent invasion of Ukraine had sent WTI crude prices over $100/barrel.
Falling fuel prices have been a major catalyst with the energy index decreasing 5.4% for the year ending November. WTI crude, which started the quarter around $90/barrel following a large surge from summer lows, is now back down to about $72/barrel. Despite elevated geopolitical risk and weakness in the dollar, the price has declined as U.S. production remains high and OPEC+ countries, led by Saudi Arabia and including Russia, struggle to convince the market that voluntary meaningful production cuts will transpire.
The food index, which has been slower to cool, increased 2.9% year-over-year for November and the shelter component of CPI is also proving sticky, at a 6.5% increase in the same time frame, although this is the lowest increase since August 2022. Average mortgage rates, having touched a recent peak of around 8% in October, have since declined to just below 7%.
According to the Federal Reserve Bank of St. Louis, the pace of U.S. economic activity was exceptionally strong in the third quarter of 2023 with real GDP increasing at a 4.9% annual rate, although it is projected to slow sharply for this quarter while remaining positive for this year and 2024. More muted GDP growth next year, currently forecast around 1.3%, is linked to a predicted slowing in job growth and a modest increase in the unemployment rate, which was at 3.7% for November. Still, wages continue to grow at a rate that is too high to be consistent with inflation of 2%, even after accounting for productivity growth.
As Larry Adam, Raymond James Chief Investment Officer, noted in his mid-December analysis, Fed cutting cycles have begun before inflation hits 2% in nine of the last ten easing cycles. Even Chair Powell in his recent address stated in the context of borrowing rates that “we’re aware of the risk that we would hang on too long. We know that’s a risk, and we’re very focused on not making that mistake.” He fell short of declaring rate hikes over, but already Raymond James, in the same December analysis, is expecting the Fed to cut interest rates 3-4 times in 2024 (a Fed pivot), beginning in July on the back of a slowdown in consumer spending and a projected mild recession (perhaps the mildest in history) in the first half of next year.
This would take the Fed Funds Rate midpoint from 5.375% down to 4.7%, or so, consistent with average expectations of polled FOMC committee members. Indeed, many economists having started the year predicting a meaningful recession, now believe America is on the brink of achieving a soft landing, or the cooling of inflation while avoiding economic decline.
Bond yields have already declined in anticipation of Fed cuts, prompting a price rally for existing bondholders. Going into the end of the year, the 10-year Treasury yield is at 3.9%, a decline of over 1% since a recent cycle peak in mid-October. Following December’s FOMC meeting this 10-year yield fell over 0.25% in about 24 hours, such was the market’s conviction that the current Fed pause is a harbinger of an imminent full pivot, meaning incoming rate cuts. Even before the meeting, the Bloomberg U.S. Aggregate Bond Index rallied for the first time in seven months and posted the strongest monthly gain since May 1985, up 4.5% month-on-month at the end of November.
With the Fed’s pause and mounting whispers of rate cutting, the question arises as to if this will trigger a global move toward monetary easing. In mid-December, the Bank of England Monetary Policy Committee voted 6-3 in favor of holding rates steady at 5.25% for a third consecutive meeting, with the dissenting members pushing for a quarter percentage hike. The UK inflation annual rate was 3.9% in November, down from 4.6% in the previous month, and well below the 11.1% peak in October 2022. Unlike the Fed, however, the BoE Committee remains wedded, for now, to its higher-for-longer mantra in order to return inflation to its 2% target over the medium term.
Similarly, The European Central Bank (ECB) pushed back in December against bets on imminent cuts to interest rates despite predictions of lower inflation expectations for the region. ECB President Christine Lagarde instead voiced concern that price pressures remain strong and inflation could soon rebound. The ECB’s deposit rate is holding steady at a record-high 4%. It was at negative 0.5% in July 2022.
Last quarter’s newsletter contained a political cliffhanger as a done deal had not been reached in Washington on a spending agreement to avert a government shutdown. Shortly thereafter, Kevin McCarthy, then the Speaker of the House, cut a deal by defying far-right Republicans in his party and relying heavily on Democratic votes to push through a short-term funding bill covering roughly six weeks. Marking a first in American history, Mr. McCarthy was then summarily ousted, or defenestrated, in a majority vote. His replacement, Mike Johnson, went on to employ similar political tactics, disappointing Republican hardliners, to also pass a temporary funding bill extending into the new year. Before its winter recess, Congress was able to pass the final $886 billion National Defense Authorization Act, ensuring military spending is signed into law on time.
The U.S. federal government’s deficit (the excess of spending over revenue) rose from 3.9% to 7.5% of GDP for the fiscal year ended September 2023 when adjusted for President Biden’s 2022 announced student debt relief program that was subsequently ruled unconstitutional. A decline in revenues (including a decline in capital gains realizations) and higher debt servicing factored into the increased ratio for this year. Total public debt as a percentage of GDP stood at 120% for the third quarter of 2023. As debt expires and rolls over we can expect louder calls from Washington for the Fed to hurry up and start rate cutting, especially if the polls-predicted Biden-Trump presidential rematch transpires and the strength of the U.S. economy looms front and center at debates.
Major international focus has been on Israel and Palestine following the horrific terrorist attack on October 7th by Hamas, the Islamist movement that rules Gaza, which murdered 1,200 Israelis and resulted in the capture of 240 hostages. In swift retribution, intending to expose and destroy the military capabilities of Hamas, the Israel Defence Forces (IDF) immediately began bombarding the Gaza Strip.
According to the Associated Press, over 20,000 Gazans, mostly civilians, have died and more than 1.9 million Palestinians have been displaced in Gaza, out of a population of 2.3 million. A weeklong ceasefire in late November saw Hamas release hostages from Gaza in exchange for Palestinians imprisoned by Israel, but since then the IDF has stepped up its operations. The U.S. State Department approved military shipments to Israel, and America was the sole nation to veto an emergency resolution by the UN Security Council on December 8th calling for an immediate ceasefire in Gaza. Britain abstained. The U.S. remains a strong diplomatic ally of Israel, but pressure is mounting for Benjamin Netanyahu’s government to navigate a path forward that addresses the mounting civilian humanitarian crisis.
In less than two months, Ukraine will face the anniversary of Russia’s invasion, and the conflict continues without victory for either side. Both countries have suffered immense casualties, but with Russia’s pool of potential soldiers about four times greater than Ukraine’s, Russia looks to have an overwhelming numbers advantage. In October President Biden requested $106 billion to fund Ukraine’s defiance, aid Israel’s operations against Hamas, and “counter malign influence” in the Indo-Pacific, but the package has been delayed over provisions related to domestic border protection policies.
Still, the U.S. will provide up to $250 million in arms and equipment to Ukraine in the final package of aid this year under prior authorized provisions. Also, in December, the European Union failed to approve a $54 billion package for Ukraine. A squeeze on both troop numbers and weapons funding places President Zelenskyy in a compromised position against the capabilities of his Russian adversary, President Putin.
In Raymond James’ festive poem serving as a look back at this past year and wishes for the next, some lines rang particularly true: “While mega-cap tech stocks rose evermore, The rest of the market felt somewhat of a snore,” and especially: “To build wealth, health, and joy with family and friends, It’s our wish to you as this year ends.” As always, we thank you for your continued trust and look forward to serving your financial goals in 2024!