A surprising end to a volatile year

Article #832 by Edward Rizzo - Published Weekly

Given how eventful the year has been, when publishing a review of 2023, it would be amiss to simply show the annual performances across the major asset classes since these do not portray the huge volatility that was witnessed throughout the year as well as the very surprising end to the year.

Following the very sharp downturn across equity and bond markets in 2022 as the major central banks began raising interest rates from the unprecedented low levels over several years, there was evident caution at the start of the year on how financial markets will perform amid the tightening monetary policy actions in order to control the spike in inflation. With several economists anticipating a recession in 2023, investors were clearly worried at the start of the year. However, for the equity markets, 2023 can possibly best be described as a stock market rally that was very much unexpected as the S&P 500 index rallied by 24% ending the year just minimally below the previous all-time high of 3 January 2022.

The stellar performances of the so-called Magnificent Seven — Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta Platforms — was a major highlight of the year on evident excitement over the business potential from the rise of generative artificial intelligence (AI). In fact, the Nasdaq 100 index climbed by a remarkable 54% – its best annual performance since 1999.

As expected, one of the key determinants of market movements during 2023 was the interest rate decisions by the major central banks, the publication of economic data and inflation readings as well as comments by the central banks on future interest rate movements. Meanwhile, few investors may recall that we also experienced the collapse of Credit Suisse AG (one of the oldest banks in Europe) during the year shortly following the demise of some of the regional banks in the US in March 2023.

The European Central Bank (ECB) raised interest rates six times during 2023 with the deposit facility increasing from 2% at the start of the year to a record of 4% towards the end of September 2023. Interest rates were kept unchanged during the final two meetings of the year held in October and December.

The Federal Reserve raised the target federal funds rate on four occasions during the year with the target range rising to between 5.25% and 5.50% by the end of July 2023 from 4.25% to 4.50% at the start of the year. Interest rates in the US were kept unchanged since July 2023.

During the summer months, the major central banks were clearly advocating that they will keep interest rates ‘higher for longer’ in order to tame inflation. This had wide implications across all asset classes.

In fact, bond markets tanked as the yield on the 10-year US Treasury note jumped to above the 5.0% level in mid-October (the highest level since June 2007) from circa 3.4% in early April 2023 and 3.8% at the start of the year. Likewise, the yield on the German 10-year bund, which is the benchmark for the eurozone, surpassed the 3% level also in October (the highest level since 2011) from just over 2.1% in early April and 2.4% at the start of the year.

Equity markets also tumbled as bond yields surged, with the S&P 500 index in the US sliding by 11% from the July high of 4,607.07 points to a low of 4,103.78 points on 27 October.

However, with the most recent inflation readings across the world pointing to a remarkable slowdown and fresh expectations that the major central banks will cut interest rates multiple times during the course of 2024, there was a very sharp reversal in yields during the past few weeks which sent bond prices sharply higher and equity markets rallying.

The yield on the 10-year US Treasury note sunk towards the 3.8% level from a multi-year high of just over 5.0% only a few weeks ago while the yield on the German 10-year bund tumbled to below the 1.9% level from just above 3% in mid-October. This resulted in a very sharp upturn in bond prices across the worldwide.

Likewise, international equity markets also experienced a very strong rally although a noteworthy development was the outperformance of several sectors when compared to the Magnificent Seven stocks that propelled the upturn in the first half of 2023. In fact, over recent weeks, the Russell 2000 index, the leading index of US small-cap companies which contains none of the Magnificent Seven, strongly outperformed the S&P 500 index. Since the recent low in mid-October, the Russell 2000 index jumped by over 26%.

After such an unexpected end to the year with material movements in bond markets and equity markets, many investment banks are reassessing their projections for 2024. The timing and speed of interest rate cuts by the major central banks is a big factor that will impinge on future performance, coupled with geopolitical and political risks which remain elevated. One key risk for 2024 and the coming years is supply disruptions of commodity flows which could arise due to blockades of key shipping routes in the Red Sea and the Suez Canal. A sharp rise in global freight and shipping costs threatens to reverse recent falls in inflation following recent disruptions to transit routes.

However, one should not underestimate the continued excitement over AI and its potentially transformative prospects which could continue to have important bearings on performances of equity markets during 2024.

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This article was produced by Edward Rizzo, Director at Rizzo Farrugia, which is a company licensed to undertake investment services in Malta by the MFSA under the Investment Services Act, Cap. 370 of the Laws of Malta and a member of the Malta Stock Exchange. The company’s registered address is at Airways House, Fourth Floor, High Street, Sliema SLM 1551, Malta.