Key Points 

• Unexpected Resilience: The U.S. economy defied recession fears in 2023 by achieving robust growth, exceeding market expectations, and steadying the labor market.
• Falling Inflation: Tightening by the Federal Reserve brought inflation down to a more manageable level, as Core PCE inflation declined significantly.
• Market Performance: Equity markets rallied in the fourth quarter, driven by optimism about interest rates and positive GDP growth. Mortgage rates eased after a sharp rise, boosting housing demand.

Thinking back to a year ago, it would have been hard to imagine where we’d be this January.

We’d experienced a dismal 2022 when the stock market had a double-digit negative return—its harshest since 2008—and the bond market suffered its worst year ever, declining approximately 13%[1].

We faced numerous challenges—high inflation, rising interest rates, and the possibility of a recession just around the corner. Rightfully so, we were concerned as the Fed had a tough job to do, and each decision could ripple its way to our personal finances.

Multiple times in 2023, market participants wondered if the Fed could strike the delicate balance of achieving price stability and lowering inflation without slowing down the economy too much. Making it even more difficult, the Fed also focused on maintaining maximum sustainable employment—the other side of its dual mandate.

Fortunately, even though last year started with despair, it ended with renewed hope for the economy and markets.

Concerns of an impending recession shifted to a more promising “soft landing.” The U.S. economy grew more robust in 2023, especially in the third quarter with a phenomenal job market and core inflation getting back closer to the Federal Reserve’s target of 2%.

The losses in equity from 2022 were reversed in 2023, with a 26.3% return for the Standard & Poor’s 500 Index (44.6% for NASDAQ and 22.2% for the MSCI All Country World Index). It was also a positive year for fixed income, with 5.5% return that restored confidence after two negative years in a row.

Results from 2023

Throughout the year, the market expectations flip-flopped between a soft economic landing and fears of recession, driven by higher interest rates. The U.S. economy proved resilient with a new regime and defied expectations from the beginning of the year when a recession seemed probable.

• The U.S. economy progressed at a significant pace, with real gross domestic product (GDP) reaching a robust cliff of 4.9% in third quarter of 2023, according to the most recent estimates.
• Full-year real GDP growth is expected to be around 2.6%, much higher than the Fed’s projection of only 0.5% growth in 2023.
• The growth is driven by increased consumer spending and inventory investment, especially in the manufacturing sector, as well as higher state and local government purchases.

Since the pandemic, the U.S. economy has faced two main shocks: production scarcity and supply chain shock, and worker shortage and imbalance in labor markets. In 2023, it healed completely from these shocks, thanks to:

• A structural shift to a new regime and changes in policy.
• Slower and steadier job growth (total nonfarm payroll employment increased by approx. 216,000, and the unemployment rate stood at 3.7% in December 2023).
• Sound household balance sheets and improved consumer sentiment.
• Productivity growth coupled with healing supply chains.

The other side of the equation for the economy in 2023 was falling inflation. Core PCE inflation declined from its high of 5.3% in February 2022 to 3.2% in November 2023 (December 2023 PCE will be released Jan. 26).

Focusing on the Fourth Quarter 2023

The fourth quarter of 2023 started with a surprising conflict in the Middle East between the Palestinian militant group Hamas and Israel. Even though the tension has been high for decades, the renewed conflict caused heightened uncertainty throughout the region as the potential grew for the war to spread.

Wars and regional conflicts like these often impact the global economy and outlook for the future. Yet, despite the conflict in the Middle East, equity markets rallied in the fourth quarter. A lot of the optimism came from the perception that the Fed has reached the peak of its tightening cycle and rate cuts could begin sometime in the first half of 2024.

Also, reported GDP growth for the third quarter was surprising on the upside, with the initial report at the end of October showing that the U.S. economy grew at almost a 5% real annualized rate.

In addition, the fourth quarter saw the easing of mortgage rates again, after more than two years of increases. The average 30-year mortgage rate rose from 2.8% on Aug. 31, 2021, to 7.6% on Oct. 31, 2023. Combined with rising home prices, it led to an all-time low in overall housing affordability in the U.S.

Higher rates have also had a role in keeping available inventory low. People are less likely to sell their homes with an interest rate below 3% if they’re facing a new rate of 7% or more. Fortunately, the rate at the end of December 2023 has declined to 6.6%, which has led to an increase in mortgage applications and more people searching for homes.

Looking Ahead to 2024

In our blog with the economic outlook for 2024, we stated our viewpoint that the U.S. will be able to avoid a deep recession and achieve a relatively soft landing. We expect real GDP to be around 2% and unemployment to remain tight at around 3.7%. The Fed is likely to cut rates in 2024 as inflation trends closer to 2%. Each of these projections are more optimistic relative to what the market expects. The reversal of the Fed’s restrictive monetary policy may lead to a more inclusive equity market with less dominance from certain sectors and stocks.

Of course, as always, we need to consider existing risks, too.

First, we remain in a state of elevated geopolitical uncertainty.

• The Russia-Ukrainian war continues to persist, and there is increasing political pressure within the U.S. to reduce the support we provide to Ukraine.
• The renewed conflict between Israel and Palestine increases the potential for additional conflicts in the Middle East, which could disturb markets and affect energy prices.
• Over time, the market has become more exposed to geopolitics as the concentration and dependency on technology increased.
  • The U.S. market is more sensitive to geopolitics than ever, given the “magnificent 7” companies that dominate a record-high share of the S&P 500 Index and source over 90% of their semiconductor chips from Taiwanese manufacturers.
  • Chip production is vulnerable because of mounting tensions in the region, Taiwan’s presidential election, and the U.S.-China conflict.

Also, as we all know, 2024 is a presidential election year. It could bring volatility to equity markets that dislike uncertainty. Current polls suggest a rematch between President Joe Biden and former President Donald Trump, but there is still a lot of time before election day in November. The nominating contests begin this month, with the Iowa Caucus on Jan. 15, followed by the New Hampshire primary on Jan. 23.

Finally, an elevated risk remains for another surge in energy prices that could keep inflation higher than anticipated.

The Organization of the Petroleum Exporting Countries (OPEC) announced production cuts for early 2024 following the onset of the Israel/Palestine conflict. Since then, oil futures have declined nearly 20%, down from around $100 a barrel.

According to a recent U.S. Energy Information Administration (EIA) estimate, global crude demand will reach an annual average of 103.7 million barrels/day in 2025, extending a long-term trend, with China and India accounting for much of the gain. Although oil consumption in developing countries is retreating, the transition away from fossil fuels likely may take longer, and any supply/demand gap may inflate oil prices.

There is always a possibility of the Fed staying the course with the current interest rate if inflation persists or gets elevated again. The economy is likely to pull through, but could shift from a more "definitive soft" to a "relatively hard" landing. However, it will all depend if consumer spending decelerates and corporations face higher financing costs, both things that could cause downward pressure in margin and weakening labor markets.

However, even given these risks, we remain optimistic about growth this year, which should serve equity markets well. As noted in our outlook, a relatively soft landing should allow the cyclical bull market to persist, with some moderation. As for our fixed income outlook, given the high starting yields and market expectations for rate cuts in 2024, bonds are likely to provide a better hedge against equity risks compared to a year ago.

For more information about interest rates, jobs, and the economy, visit the Markets in Focus archive for all of the news and commentary from 2023.

[1] Measured by Bloomberg Aggregate Markets Total Return Index