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Higher Interest Rates are Here to Stay

Jonathan M. Gardey, MBA, CFA®, CFP®

President and Chief Executive Officer

2023 Market Recap

Despite concerns over ongoing volatility, 2023 turned out to be a great year for the markets. Following the S&P 500, the U.S. stock market ended the year up 26.3%, while the MSCI EAFE Index showed non-U.S. markets up 18.2%.

The year began nicely with positive returns in January, which was followed by a series of down months in April and May, and again in August, September, and October. The year finished off strong, however, with investors enjoying significant positive returns in November and December.

Stock price changes in 2023 were primarily driven by the market’s outlook on interest rate fluctuations, which influenced bond market prices as well. For most of the year, bond markets treaded water. Investor sentiment did turn positive late in the year, however, which pushed bond returns up 5.5% by the end of 2023 (according to the Bloomberg Barclays Aggregate Bond Index). This was a welcomed change from last year’s record loss of 13%.

Magnificent Seven Stocks

For most of the year, a group of seven tech-focused stocks dominated the headlines and market returns. Dubbed the “Magnificent Seven,” this group includes Apple, Microsoft, Google parent Alphabet, Amazon, Nvidia, Tesla, and Facebook owner Meta. Their combined impact on the markets in 2023 can’t be overstated enough. For example, the S&P 500 Index, which includes the “Magnificent Seven,” generated a return of 26.3% (as mentioned earlier). Excluding just those seven stocks, the remaining 493 companies generated a respectable return of 12%.1

The “Magnificent Seven” stocks have grown to the point where they now represent 30% of the value of the S&P 500 Index.2

The risk in having such concentrated control over the entire index’s performance was evident, however, when these seven stocks lost over $1.2 trillion in value this past summer — causing the S&P 500 Index to drop between July and October.3

The questions investors are asking now include, “Will the ongoing market rally broaden beyond these seven companies?” and “Have the recent gains in these seven stocks gotten ahead of their underlying valuations?” Answers to these questions should become apparent in 2024. In the meantime, reducing exposure to the “Magnificent Seven” by further diversifying your portfolio may be prudent.

Thesis

Up front, my belief is that the low interest rates we’ve experienced since 2001 were an anomaly and will not be the norm as we look ahead to the future. This view has significant implications not only for investors but everyone who functions in our economy. In other words, we need to learn to live again with higher interest rates.

As humans, we have an inherent tendency to assume our most recent past will be our most likely future. Because interest rates have been low for more than two decades, people think it’s a reasonable assumption that rates will go back down to where they have been. Case in point, people right now are complaining about the “high” mortgage rates. Yes, they are high relative to the recent past, but not relative to history. Eventually, these “high” mortgage rates will be considered normal again.

Importance of Interest Rates

Interest rates play a vital role in the economy. When interest rates are low, the market’s cost discipline is lost. With no cost discipline, capital is misallocated and not put to productive use. Higher costs via higher interest rates “sharpen the pencil” as they say, forcing everyone to make more rational economic decisions. These forced decisions lead to more effective and efficient use of capital, which then leads to a faster-growing and more vibrant economy. Higher economic growth leads to more profitability which leads to higher stock prices and better market returns.

Role of Bonds in the Economy and Portfolios

Higher interest rates mean that bonds are back in business relative to the recent past. Bonds are now generating income, and investors are earning good rates of return commensurate with the level of risk being incurred. As they say, “income” is finally back in “Fixed Income.”

More importantly, bonds are back in a position where they can serve in their traditional role of cushioning the risk inherent in stock portfolios. Throughout history, sharp stock market declines have driven investors to shift assets into less risky bonds — thereby driving up bond prices.  This process works to cushion stock market losses in diversified portfolios, but that cushion was lacking in 2022 when both stocks and bonds suffered losses.

With extremely low interest rates, the Federal Reserve effectively lost the most important tool in its toolbox. It didn’t have room to lower interest rates to spur economic growth. This put significant limits on how the Federal Reserve could respond to economic distress. Today’s higher interest rates have returned the tool to the Federal Reserve.

Inflation

The ugly face of inflation faded throughout 2023. It appears that the aggressive actions taken by the Federal Reserve since 2022 are working, and market sentiment seems to now agree. The year began with high but declining inflation and a Federal Reserve aggressively raising interest rates to tame it. The year ended with inflation slightly above 3%, a rate much closer to the Federal Reserve’s inflation target of 2%.

After a shaky start, the Federal Reserve has gained confidence in its fight against inflation. Initially, they said that the growing inflation was going to be “transitory,” meaning it would fade away on its own. Inflation accelerated however, and pressures from the public to take action mounted. The Federal Reserve discarded its original views and got to work aggressively raising interest rates. These rate increases, which started in March 2022, contributed to the worst returns for bonds since 1794.4  As you may recall, I discussed this historically poor bond performance in my update last year. The Federal Reserve continued to raise rates into 2023, finally ending with a final rate increase in May. The market’s view of these actions changed dramatically during the year which resulted in significant market volatility.

The 2023 year-end stock and bond market surge resulted from the belief that the fight against inflation is succeeding, and any adverse economic impact is well contained. Financial news outlets and the market’s mood now proclaim that interest rates will be “Higher for Longer”.

Looking Ahead

I’m not a believer that the current “higher” interest rates are negative for market returns. On the contrary, reasonable interest rates indicate a properly functioning economy. They encourage borrowers to effectively and efficiently allocate capital to profitable projects that will earn a positive return for investors. Assuming inflation does not reignite, which I assign a low probability, the economy should continue to grow supporting stock prices. In these conditions, bonds will also be good investments and will serve to cushion stock market declines. While the “Magnificent Seven” dominated market returns in 2023, this can only last so long and many of the other 493 stocks will start to shine.  As I always say, prudence dictates investment diversification, which should be a core virtue of managing investment risk.

I wish everyone a great and prosperous 2024! If you have questions about any of my analyses or want to talk about preparing your portfolio for the road ahead, don’t hesitate to reach out. I’d be happy to put time on the calendar for us to meet.

Jon

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1 Equal-weight S&P 500 ETF's: Magnificent Seven Beaters? by Jamie Gordon, 1/8/2024, ETF Stream.

2 2023: In Review by Sarah Yakel, 1-9-2024, Meridian Financial Partners.

3 The Magnificent 7 Stocks are Struggling, Shredding a Strategy $1.2 Trillion in Value Since US Equity Peaked in July, by George Glove, 10/27/2023, Business Insider.

4 After a Terrible Year for Bonds, the Outlook is Better by Jeff Sommer, 12/9/22, New York Times.