Expect the Unexpected

“To expect the unexpected shows a thoroughly modern intellect.”

– Oscar Wilde

Markets rarely fail to surprise, and 2023 was yet another reminder of that fact. After an extremely difficult environment for portfolios in 2022, investors were expecting a recession, cracks in the labor market, an increase in the federal funds rate to 6%, and a collapse in corporate earnings for 2023. Compounding those concerns was a mini-banking crisis in March that included the largest bank failure since 2008, $15.8Bn Silicon Valley Bank. Such circumstances would normally portend dire equity market returns.

However, equity markets proved resilient and shrugged off a difficult third quarter to end the year near all-time highs. The labor market remained strong, corporate earnings fell but began to recover, the Fed paused rate increases short of the most extreme levels, and large-cap technology stocks that make up a large part of the S&P 500, sometimes known as the “magnificent seven,” benefited from investor optimism concerning artificial intelligence.

Fixed income markets had another volatile year as the benchmark 10-year US Treasury began the year yielding 3.83%, touched 5% in the fall, then fell rapidly in the fourth quarter to end 2023 at 3.88%. This round trip in yields was a remarkable ride as investors shifted between expecting “higher for longer” from the Fed to pricing in aggressive rate cuts in the next few quarters all in the space of forty-five trading days. This sort of manic behavior implies that even with continued growth and a return to positive returns from equities and bonds, investors remain skittish.

As the focus shifts to 2024, there is no reason to believe that this tension will subside anytime soon. Futures markets are pricing in six interest rate cuts this year, starting in March, while the Fed’s own “dot plot” says the central bank expects two to three at most. With the ten-year yield below 4%, this indicates fixed-income investors are expecting a slowdown in growth or even a recession on the near-term horizon. At the same time, the S&P 500 trades at a forward P/E multiple of 19.5, well above the historical average, with anticipated earnings growth of 11%. These two markets seem to be pricing in a diverging path, and this conflict signals the potential for more sudden shifts ahead.

Recent Market Returns

The fourth quarter of 2023 witnessed a dramatic rally to end the year. After a negative third quarter and a rough start to October, US stocks ended the year up over 11% in the quarter. The run was led again by the growth index, up over 14%, powered by the largest tech stocks that have dominated recent returns. In an indication that positive sentiment was broadening beyond the mega caps, small-capitalization stocks were also up 14%, and the value index returned over 9%. Given that the growth index now trades at a forward P/E of 26.4x, these other parts of the equity market will need to continue to perform to support additional gains in 2024.

The equity markets gained momentum starting in late October after the Federal Reserve announced a pause on rate increases and indicated they were open to a pivot to rate cuts in the near future. This change in tone also caused bond yields to drop quickly. This rally in bond prices (bond prices move inversely to the yield) was seen across the credit spectrum as corporate and high-yield spreads tightened. The possibility of a “soft landing” with inflation falling without causing a recession has gained traction with investors. A scenario where the Fed cuts rates while the economy continues to grow is favorable for less credit worthy borrowers, which means high yield bonds could perform well as the year unfolds.  This dynamic also helps the loan and private credit markets in the same fashion.

International equity markets had a strong year but trailed the US. The EAFE index tends to have more exposure to firms in value sectors such as financials, healthcare, and consumer staples than the technology-driven S&P 500, so it struggles to keep up when the mega-cap technology names are soaring. The broad non-US index was supported by 22% returns in Europe and 20% returns in Japan translated back into US dollars. Japan is one of the bright spots outside of the United States, and it is flirting with record highs in its broad market. It produced a 29% return when measured in Yen, but the US dollar-denominated return was hurt by currency weakness. Economic growth in Europe lags behind the US and has been hurt by weakness in Germany. Germany is the largest economy in Europe, and its critical manufacturing sector continues to be hampered by surging energy prices driven by restrictions on Russian natural gas exports and trade friction with China, a large market for its goods. These headwinds will likely remain in place this year.

Emerging markets had a solid 10% return but look relatively disappointing given developed market performance.  China is the largest allocation within the EM universe and dragged down returns for the index. The Chinese economy was expected to rebound sharply as their draconian COVID-19 restrictions were finally lifted in late 2022, however this did not come to fruition. Their economy is weighed down by non-performing loans in the housing sector, increased regulation on fast-growing technology firms, and persistent youth unemployment above 21%. The government still targets 5% GDP growth, but many economists believe their economy has not been hitting that mark. In contrast to China, India is in a strong position. The Indian equity market gained over 21% last year, and their GDP is growing at over 6% annually. India has a young, growing workforce and has been a beneficiary of some of the geopolitical forces that have hurt the Chinese export machine.

Great Expectations

2023 was not slated to be a robust year for equity market returns due to an anticipated recession, high inflation, tight monetary policy, and a drop in corporate earnings. The stock market obviously rallied in spite of three of those factors being true: inflation was still running hot, corporate earnings did decline, and the Federal Reserve raised rates above 5% for the first time in over 16 years. However, the economy did not tip into a recession, and the other factors did not bring the severe impacts that were anticipated.

While inflation rates remain above target, they have dropped quickly. Higher interest rates have not had the chilling effect that was expected due to 1) most homeowners being locked into long-term mortgages at exceptionally low fixed rates and 2) the wave of corporate debt issuance in 2021 that allowed many corporate borrowers to push out their maturity profile and fix debt costs at historically low levels. While some borrowers exposed to uncapped floating rate loans are facing distress, especially in certain real estate markets, most market players have not yet felt the pain of higher interest expenses. Finally, the Federal Government supported the economy by running a deficit of over 8% of GDP in 2023, exceeding the deficit of 3.7% of GDP in 2022.

The recent equity rally and drop in bond yields rests on the consensus view that we will not experience a recession, that inflation will continue to fall, and that the Fed will aggressively cut rates starting in March. These views seem to be in conflict as the Fed should only aggressively cut rates if the economy slows, yet equity markets have priced in corporate earnings growth of 11% this year, which would be hard to achieve in a recessionary environment. This narrative that a “soft landing” will be achieved dominates analyst expectations for the next twelve months, but the tension between interest rate expectations and earnings growth highlights a likely source of conflict. The market will either see significant rate cuts along with a mild recession or fewer rate cuts with a solid economy, yet it seems to be anticipating aggressive rate cuts and a strong economy, an outcome that is, unfortunately, the least likely one.

On the growth front, consumer spending, which is the main driver of GDP, remained strong last year due to sustained wage growth and a tight labor market. Households exited the pandemic with especially strong balance sheets supported by wages, reduced spending during COVID, various government support programs, and low mortgage rates. Consumers across all income levels built up savings, and those reserves supported robust spending when restrictions lifted in 2021. However, after several years of high inflation and the expiration of many pandemic-era government support programs, the US consumer may be losing momentum. Credit card balances have been growing; they were approaching $1 trillion in the fourth quarter, and with interest rates on credit cards at over 21%, servicing that debt will eat up more savings. If wage growth slows, as both the Federal Reserve and private economists expect, consumer spending could stall this year.

The path of Fed policy is also uncertain. The market is convinced that the Fed will lower rates six times in 2024, resulting in a drop of at least 1.5% this year. The dot plot of the Fed’s forecast of interest rates shows a more restrained path in 2024. The Fed expects to cut rates three times this year, starting at some point in the second quarter.  Economic data will drive Fed decisions, but, given the Fed’s focus on taming inflation and restoring its credibility after being late to act when prices first spiked, early, dramatic action seems unlikely unless there is a clear slowdown in growth.

Markets priced for perfection leave little margin for error. A disappointing earnings report from a key company, a signal that the Fed may hold rates at elevated levels, or an unforeseen geopolitical event can cause sentiment to turn negative quickly. The fundamentals of the economy do seem solid, but they may not live up to current robust expectations. Markets may have gotten ahead of themselves, and a period of consolidation would not be a surprise after the extremes we have seen in the past two years.

Positioning for the Unexpected

Given the current circumstances, we continue to favor the positions we have advocated over the past few quarters:

An appropriate cash buffer: Target a reserve to cover current distribution needs, meet capital call commitments, and provide liquidity to rebalance if an equity market correction occurs. In most accounts, this means an approximately five percent allocation invested in Treasury money markets that are currently yielding 5.25%.

Favor the US: We continue to favor US equity markets over international stocks due to better profit margins, higher return on equity, and stronger domestic economic growth supporting US stocks. While international markets trade at a discount to the S&P 500, this mostly reflects the value bias of non-US indices.

Balance growth & value within US equities: Given the recent outperformance of growth-oriented sectors such as information technology, now is a good time to rebalance towards less expensive parts of the US market.

Targeted Alternatives: Banks remain under pressure and have reduced new loans to many corporate clients and real estate assets. This creates an opportunity for private credit strategies that can take advantage of dislocations in these markets to provide flexible capital solutions with equity-like returns and a senior loan risk profile. Also, continued stress in multiple real estate asset classes should present opportunities in real estate equity.

The Path Forward

Markets will continue to surprise in 2024, and consensus will likely prove unreliable. In this context, it is important to assess what is currently priced in, where expectations are most extreme, and how to position portfolios accordingly.

These top-down portfolio allocation considerations should be complemented by active security selection in public market strategies to offset standard index exposure and a bottom-up assessment of specific themes in private markets, such as stepping into spaces where banks are pulling back, that have compelling risk and return characteristics with limited correlation to broad equity market moves.  This approach builds robust portfolios that can deliver attractive returns even when the unexpected occurs.

We hope you enjoyed a wonderful holiday season and are having a great start to your new year. Please contact us with any thoughts or questions, and we look forward to visiting soon.



Steve Sprengnether

President & Chief Investment Officer


Brad Bangen

VP, Head of Private Markets


Laurence Unger

VP, Head of Public Markets