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Market Commentary: December 2023 – Charting the Course

Charting the Course:
Navigating Market Complexities and Shifting Scenarios as the New Year Unfolds

December 2023

By Robert F. Taylor, CFA


As we approach the new year, we find ourselves at a critical juncture in the market with various scenarios shaping the investment landscape. With the Federal Reserve’s interest rate hiking cycle now fading in the rearview mirror, we consider three potential scenarios and the likely path of the S&P 500 under each.

Since the October 27th low, the S&P 500 has rallied ~15%, almost entirely on the back of rising equity valuations.

The rise in valuations has coincided with a decline in “real” interest rates, calculated as the 10-year treasury yield minus 10-year inflation expectations. As real rates decrease, the discount rate applied to future earnings diminishes, enhancing the present value of those earnings. Furthermore, the reduction in rates can lower the cost of borrowing for companies, fostering increased investment and spending. Consequently, this can positively impact corporate earnings, making stocks more attractive to investors and contributing to Price-to-Earnings (“P/E”) expansion.

As illustrated in the chart above, there is a notable and inverse correlation between stock market returns (left-hand side, red line) and real interest rates (right-hand side, blue line). The equity market experienced a robust rally from April 2020 to December 2021, marked by a period of negative real rates. Conversely, stocks declined throughout 2022 as real rates turned positive, reaching 1.5%. A subsequent rally occurred in early 2023 as real rates stabilized, only to reverse direction when real rates surpassed the 1.5% threshold. Real rates reached a peak near 2.5% in late October but have since declined to the current level of 2.04%. This aligns with the 10% expansion in the P/E ratio observed in the initial chart and a strong equity rally over the past six weeks. The key observation here is the significant impact of real interest rates on market dynamics. As Fed Chairman Powell noted in yesterday’s post-FOMC meeting press conference, “[real yields are] something that we’re very conscious of and aware of and monitor, and it’s certainly a big part of—it’s a part of how we think about things.”

With a focus on real yields in 2024, we outline 3 possible trajectories:

Scenario 1. Decrease in Real Yields Amid Declining Inflation and Dovish Fed Policy
Backdrop: A combination of lower inflation and a dovish Federal Reserve policy sets the stage. The growth environment remains robust, but heightened Fed cuts lead real yields to fall to 1.5%.
Potential Outcome: P/E Multiple expands to 20x. Based on the current FactSet consensus estimate for S&P 500 aggregate earnings of $250 in 2024 implies an S&P 500 price level around 5,000, or a mid-single digit gain from the 4,707 close on December 13th.

Scenario 2. Modest Rise in Real Yields Due to Enduring Economic Growth
Backdrop: Stalwart economic growth is the driver here, with a sturdy jobs market and stubborn core inflation. The Federal Reserve stays on hold until 4Q 2024, in contrast to the 130 basis points of easing currently priced in by markets.
Potential Outcome: A modest rise in the real 10-year US Treasury yield to 2.3% by year-end 2024 results in an 18x P/E multiple. Using current consensus this scenario implies an S&P 500 level of around 4,500 or a mid-single digit decline from the December 13th close.

Scenario 3. Decrease in Real Yields Due to Economic Growth Concerns
Backdrop: Incoming data disappoints, signaling an economic slowdown, rising unemployment and increased risk of recession. The Fed responds with aggressive rate cuts, causing real yields to decline to approximately 1.5%.
Potential Impact: Despite lower discount rates for equities, macroeconomic weakening leads to a contraction in the aggregate P/E multiple to 17x. Based on consensus S&P 500 EPS for 2024, this scenario implies an S&P 500 level around 4,250 or a high single digit decline from current levels.

In navigating the complexities of the market, we find ourselves standing at the crossroads of economic possibilities as the new year unfolds. The recent rally in the S&P 500 since the October 27th low reflects growth of approximately 15%, predominantly driven by escalating equity valuations. This surge aligns with the decline in “real” interest rates, demonstrating the noteworthy and inverse correlation between stock market returns and real interest rates. The interplay of these dynamics underscores the pivotal role of interest rates in influencing market behavior. As we navigate these and other evolving scenarios, it is imperative to remain vigilant and adaptable to the evolving economic landscape, recognizing that the path forward will be shaped by an interplay of economic data, central bank policies, and market sentiment.

Sources: Goldman Sachs, FactSet, Federal Reserve Bank of St. Louis (FRED)

Shannon Dermody

Shannon DermodyTEST

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