2023 caught the experts by surprise. Economists and market analysts alike started the year on a pessimistic note, anticipating recession, market declines, and overall weakness in the face of inflation and high interest rates. Yet the much anticipated recession never arrived, inflation eased from 2022’s highs, and unemployment remained low. Most notably, the financial markets had one of their best performing years, with leading equity indexes retracing lost ground and testing all-time highs set in 2021.

After two years of negative returns, the bond markets rebounded in late 2023 on expectations that central banks around the world would reduce interest rates in the face of lower inflation. US bonds rose just over five percent in 2023, but still remain nine percent below 2020 highs. European bonds rose 6.5 percent on average, with some countries across the continent posting double digit returns.

The Dow Jones Industrial Average (DJIA) and the S&P500 are up approximately 13 percent and 24 percent, respectively, in 2023, a good performance in absolute terms, but one which—when compared with the tech-heavy NASDAQ’s return of 45 percent—feels relatively anemic.

 

Gold, the traditional inflation hedge, rose over ten percent. After a nearly two-year-long bear market, crypto underwent a substantial change in sentiment in the second half of 2023, with Bitcoin (BTC) and Ethereum (ETH) up 164 percent and 84 percent, respectively, for the year.  Even real estate prices, which higher interest rates were supposed to most directly impact, rose each month in 2023.

Commodities, which soared in 2021 and 2022, underperformed as inflation expectations eased and global demand (especially China) remained soft. Energy in particular weakened, with oil down over six percent and coal by a third. Copper, a bellwether for industrial production, managed to eke out a four percent gain.

Takeaways from 2023

So what can we learn from this? The Federal Reserve’s target Interest rate (now above five percent) did little to slow the overall economy or temper investor enthusiasm. Massive fiscal stimulus under Bidenomics helped fuel GDP growth. Markets saw lower inflation as a cue that the Fed would ease. So on the one hand the markets were opening Christmas presents early, bringing forward potential future benefit from lower interest rates next year into higher equity prices today, while on the other hand ignoring the long-term economic costs and consequences of trillion dollar fiscal deficit spending and the rapidly growing debt pile and service costs that accompanies it.

 

Implications for 2024

Current investor sentiment is anchored on twin beliefs: first, that inflation will continue to fall, and second, that the Fed will lower rates in 2024. Neither of these events are a certainty. However, the final US GPD Core PCE price deflator (a gauge of inflation) came in at two percent for the third quarter, indicating that inflation has already fallen to the Fed’s target level. This is a signal that rate cuts are more likely than not. If rates do come down, then bonds would continue to perform. Equities still feel fully valued based on a historically high ratio of price-to-earnings. The markets are arguably still in the post-pandemic bubble that formed in 2021. Bubbles can persist, and in the absence of a triggering event, the market could remain strong at least through the first quarter. But a correction—or worse—is inevitable.

Crypto is similarly likely to continue its recent bull run. The SEC appears ready to approve Bitcoin ETFs, which will bring previously sidelined institutional capital into the market. The next Bitcoin halving (where mining rewards are cut in half) is set to occur around May 2023, and halvings have historically been very bullish for BTC. Interest in alterative coins is increasing as new products come to market, and easing monetary conditions will play favorably for the industry.

High government deficit fiscal spending will carry over into next year, which will continue to stoke economic growth, albeit of questionable quality as much of it is entitlement based. When required to choose between inflation and recession, governments always choose to err on the side of inflation. This truism will be all the more so in an election year. For this reason and others described below, I remain unconvinced that we have seen the last of high inflation.

What could pop the equities bubble, and bring down crypto and most other financial assets, is a credit crisis centered around the banking system and the U.S. government. I have previously described in these pages the idea of the deficit-debt-inflation doom loop. Trillion dollar deficits can only be funded by new debt, which can only be sold to the market by offering positive real (after inflation) interest rates that buyers find attractive. As the U.S. debt balance grows to unsustainable levels, at some point the market balks. When that happens, the Fed will be forced to monetize the debt, which will stimulate another, more serious round of inflation. And the banking system remains vulnerable, with record high levels of unrealized losses and utilization of Federal Reserve and other government emergency borrowing lines.

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