Happy New Year

2023 went out with a bang — maybe so much so that it “borrowed” some of this year’s return potential. Financial markets initially stumbled out of the gates this month; some indices have recently returned to trend. The S&P 500 hit an all-time high, driven again by a handful of tech stocks, while small and mid-cap, dividend, international and emerging stock indices are all slightly negative year to date.

The strong consumer, having apparently weathered higher interest rates, continues to fuel economic growth. Retail sales increased above forecast. For the consumer, there seems to be all blue skies ahead, as recent sentiment numbers rose to levels not seen since 2021. Income expectations are soaring to a degree not seen in at least 20 years, and inflation expectations are easing. Let’s review some of the major asset classes, starting with U.S. equities.

Chart 1: 1:12 — The S&P 500 finished 2023 well above 20%. As the risk of recession has receded, we have started a process to lower our defensive positioning and equity allocations. We continue to prefer U.S. quality companies with the right blend of offense and defense. After stronger than expected 2023 returns, we are expecting more moderate returns in the S&P 500 this year.

The S&P 500 may be a bit overbought and optimistic regarding rate cuts, but earnings season will be very important to determine the next course. A key secular theme in our equity strategy this year is the digital revolution. S&P defines a specific technology sector and a specific software and services sector to which we recommend allocations. In addition, our focus includes non-tech-specific industries that are beneficiaries of the digital revolution. As a result, recommended equity allocations will likely have ample representation in the digital revolution theme.

U.S. dividend stocks struggled last year, as 2023 was a perfect storm for historic dividend stock underperformance versus the S&P 500. This was due to 1) positive macro-outlook inflection; 2) rapidly rising interest rates; 3) bank sector turmoil; 4) reversal from dividend stock outperformance the prior year (recall that 2022 was a stellar relative performance year for dividend stocks); and finally, 5) AI-driven growth stocks driving broader markets like the S&P 500.

For investors seeking income, we see a potentially good buying opportunity for dividend stocks after the recent period of significant underperformance, supported by extended and historic valuation and dividend yield gaps versus the S&P 500. Further, for investors concerned about recession risk, we expect the dividend universe to be relatively more resilient this year should we have a recession.

Shifting to bonds: The Bloomberg aggregate bond index is lower to start the year, as resilient economic data caused markets to unwind some of the extreme rate cut expectations. This trend is priced into the fed funds markets this year, which pushed the 10-year treasury yield higher recently.

Expectations for rate cuts in 2024 have fallen sharply of late, and chances of a rate cut in March fell dramatically. The decline appeared due in part to recent comments by Fed governor Waller, who told a virtual conference that he sees no reason to move as quickly or cut as rapidly as in the past, given the healthy state of the economy.

Municipal bonds experienced a robust year in rally, and yields have backed up early in 2024. In 2023, Munis performed well vis-à-vis treasuries, and we maintain our message of considering extending portfolios to lock in attractive yields.

Higher-yield corporates and municipals, while potentially more volatile, offer attractive yields as well. Whether interest rates fall in 2024 or not, the current setup for fixed income is still attractive.

Chart 2: 4:25 — If we sound more optimistic, it’s because the risks to our outlook are more balanced. We continue to reduce our odds of a mild recession while increasing our expectation and probability of a soft landing.

It’s interesting — Google searches for “soft landing” have spiked recently. The full economic impact of the Fed’s tightening is still to be seen, but consumer spending and inflation’s path are better than expected. The labor markets are normalizing, but still strong. And importantly, the Fed appears ready to pivot potentially sooner.

In short, we are off to a good start with our strategies and allocations. There are no changes to our forecasts or positioning as of now. Watch for important inflation data to close out this month.