December rounded out a strong 2023 for most financial markets with an additional rally into year end. This strength was largely attributed to the unexpected about-face of the US Federal Reserve, which is now focused on when, not whether, to cut interest rates.
On the 1st of December, US Federal Reserve (Fed) Chairman Jerome Powell had delivered a speech in which he appeared to brush aside any intention for interest rate cuts, suggesting that the Federal Open Markets Committee was not even discussing the subject. “It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease.”
Fast forward two weeks and all had apparently changed with the Fed now “very focused” on the risk of keeping interest rates too high for too long, noting that they would start cutting interest rates “well before” inflation reached their 2% target.
Investors appeared to take this as a clear sign not only that interest rates had reached their peak, but also that rate cuts would occur much sooner and faster. By the end of December, an additional 0.5% of rate cuts had been priced in for 2024 for both the US and Australia.
Figure 1. Implied monetary policy rates
Market Performance
Equities
All the major developed market indices reached new highs in the second half of December. Australia led the charge with performance of +7.3% for the month while the US continued its upwards march with a rally of +4.5% in December. Emerging markets also rallied +3.9% during the month, ensuring positive returns for calendar year 2023, but still well below their post-Covid 2021 peak.
Within equity sectors it was no surprise that the interest-rate sensitive companies performed strongest: REITs bounced strongly both here in Australia and in the US during the month, boosting their quarterly returns (US +17.7% and Australia +14.4%). The only negative sector for Q4 was energy (US -7.8% and Aus -9.1%), resulting in negative returns for the full 2023 year.
Government Bonds
Bonds also enjoyed a strong December, rounding out a very positive quarter. Interestingly, despite a wide range of 3.30% to 4.99% throughout 2023, the benchmark US 10-year maturity government bond ended the year exactly where it started at 3.88%! Elsewhere, most developed market (ex-Japan) government bonds rallied over the course of 2023 with large gains in December and the fourth quarter.
Figure 2. Year end US 10 year maturity government bond yield
Currency
Similar moves during December were experienced in currency markets as the safe-haven US dollar sold off -2.1%. Against this backdrop the more cyclically sensitive currencies gained strength with the Australian dollar rallying +3.1% during the month taking it back to 68.12c, nearly exactly the level it started the year.
Performance
Performance across our active models for 2023 was either first quartile or low second quartile, which is a very pleasing result. The stock selection impact of our underlying managers was significant, driving stronger absolute returns across all strategies.
A positive driver of performance, especially in the fourth quarter, were our asset allocation changes made during Q2 and Q3, removing our emerging market infrastructure exposure in favour of a combination of fixed income, REITs and infrastructure stocks.
Throughout 2023 we remained unhedged in our global equity exposures. Similar to the US 10-year yield, the fact that the AUD finished the year early where it started meant the overall impact on performance from this decision was minimal. However, it was a drag in Q4 as AUD rallied, giving back some of the positive performance from Q3.
Outlook
We are continuing to appraise the new expectation that interest rates may have peaked before moving lower in 2024. On the one hand, lower interest rates will create a tailwind for asset prices, some of which have seen material falls in prices making them more attractive in future. On the other hand lurks the indisputable reality that the combination of high consumer prices and high interest rates leads to less consumption, that is likely to persist over a longer period and will continue until interest rates actually start to fall.
If broad equity markets were not at record highs we would be more positive. However, with economic growth slowing and geopolitical risks continuing to rumble, lower interest rates might be enough to shrug off the potential risks.
We continue to look for investments with attractive entry points that are already pricing in a more pessimistic outlook than the market currently expects. In the meantime, we remain patient, relying on our chosen managers to pick quality companies and maintaining our overweight position in bonds, which offer a highlevel of income while retaining attractive defensive characteristics.
Sources: Performance numbers calculated using Bloomberg, peer group performance using FE fundinfo, https://www.federalreserve.gov/newsevents/speeches.htm.