Looking Back and Looking Forward

The big surprise of 2023 – and one of the primary topics of conversation during the year – was the recession that did not happen. Looking back, many of the fears we had at the beginning of 2023 turned out to have been overstated: Economic growth accelerated into the third quarter of the year, before coming off slightly to end the year at an annual pace of 3.3%.

This paints a remarkably robust economic picture, behind which we identify three primary factors. Looking forward, we will be keeping an eye on these same factors as 2024 unfolds.

1. The labor market: This is a primary driver of economic activity, and as of November 2023 there is still an imbalance, with 2.5 million more job openings than available supply of labor. However, this gap has narrowed over the past year; when we gathered in January 2023 the gap between labor supply and demand was five million jobs. This narrowing was driven by a 2.4 million decline in job openings and a rise of 600,000 in supply of labor. So, while there is an imbalance in the labor market, it is relatively soft and can be interpreted as a tailwind to economic activity – albeit not as much of a tailwind as in 2023.
2. The relative durability of the housing market: In about two-thirds of the country, housing prices are up year-over-year despite the rapid rise in mortgage rates. The quick rise of interest rates dissuaded people from refinancing their homes, which in turn decreased housing market supply. Here, too, these trends are beginning to narrow. As people refinance, the actual average mortgage rate will rise; however, over the past couple of months the new mortgage rate has decreased slightly from 8% to approximately 7%.
3. The continued relief on inflation: Inflation in the consumer price index (CPI), which peaked in 2022 at 9.1%, has since come down to end 2023 at 3.4%. We believe that 2024 may see further progress toward the Fed’s “comfort range” of around 2%, as during the past few months the food and energy baskets – where people experience the everyday effects of inflation – have been deflationary. As 2024 unfolds we will closely watch CPI excluding food and energy, which is proving to be relatively sticky, especially the cost of shelter basket. We do predict further improvement in 2024, as the leading indicator – the new tenant rent index – is already down.

Various measures of inflation indicate that there is probably more improvement to come in 2024:

• The Producer Price Index (PPI) has been negative for five of the past seven months
• As of November 2023, the PCE Deflator (the Fed’s preferred measure of inflation) is already down to 2.6%
• The “misery” index (CPI inflation plus headline unemployment rate) shows a tailwind of consumer confidence

A Potential Pivot

Notably, the December 2023 statement from the Fed signaled the beginnings of a pivot toward a more balanced approach to monetary policy. For the first time in the cycle, the Fed is acknowledging a slowdown of economic activity and also that “inflation has eased over the past year but remains elevated.”¹ This is not a declaration of victory over inflation, but it is a significant observation.

Perhaps the most important edit in the December statement compared to their November 2023 remarks is the inclusion of “any” in “determining the extent of any additional policy firming….” This opens the door for the Fed to announce that they may be done raising interest rates, and we will be monitoring this in the coming months. The market, meanwhile, has concluded that the Fed is done raising rates, and 15 out of 19 Fed governors believe that the Fed Funds rate will be 4.25-5% at year end 2024.

All of this paints a relatively benign backdrop of economic activity for the year ahead, and we believe that the “soft landing” recession discussed in past webinars could be in sight.

What Could Go Wrong?

While a soft landing in 2024 is appearing possible, we are still remaining watchful of several factors, particularly around consumer debt levels. As of September 30, 2023, the U.S. had an outstanding consumer debt of approximately $17 trillion.

At first glance, this paints a dire picture; however, interest rates – while they have come up – are still relatively low. Therefore, the debt service on this debt is not yet overly burdensome. Household debt has also come down, and we have not seen a large increase in household debt delinquencies.

While neither the debt service nor household balance sheets dismiss the challenge of consumer debt, they do put it into broader context.

Economic Outlook for 2024

Overall, the path and pace of the economy in 2024 is largely about private consumption: As goes the consumer, so does the economy. Twin slowdowns in housing and labor markets are already beginning to weigh on growth, but the relative health of household balance sheets should act as a shock absorber, preventing a sharp downturn. As inflation continues to wane, the Fed ought to be able to respond to slower growth with lower interest rates, providing support for the economy as well as financial markets.

Market and Portfolio Review at Q1 2024

First, we would like to take this opportunity to thank Suzanne Brenner, who has provided unparalleled leadership as Co-Chief Investment Officer of the Investment Research Group (IRG) for the past six years. We are forever grateful for her partnership and counsel. As a BBH Partner, Suzanne will continue working closely with IRG in an advisory role and sit on its investment oversight committee. We are thankful to continue benefiting from her expertise.

What a Difference a Year Can Make

When comparing 2023 cross-asset classes market returns with 2022 returns, by and large what was down in 2022 was up in 2023 and vice versa. 2023 witnessed strong performance not just in equities but also in fixed income, with the “main show” remaining U.S. Large Cap equities – particularly technology stocks. The Nasdaq, which is comprised largely of tech-oriented companies, returned 44.7% in 2023, and the S&P 500 returned a little over 26%.

Over the longer term, 10-year returns for the Nasdaq and S&P 500 are up, at 14.9% and 12%, respectively. The 10-year results look impressive; however, we do think it is unlikely that the S&P 500 will continue to generate such a high return over the next 10 to 20 years. These types of returns are endpoint sensitive, and our focus remains preserving and growing your capital long term.

Market Overview: Equities

Looking closer at U.S. equities, we saw a strong rebound in equity class returns from 2022. Entering 2023, many investors were concerned about what appeared to be an imminent recession. During this time, we focused on the fundamentals and kept in mind that recessions are not predictors of equity market distress. Technology led the S&P 500 in 2023, followed by communication services and consumer discretionary – all three being 2022’s laggards. Utilities and energy, meanwhile, were the only negative performing sectors in 2023.

As fundamental investors, we always ask ourselves “How were these returns generated?”

In this case, multiple expansion was the primary driver of the S&P 500’s performance in 2023. The index’s 2023 performance can be broken down into four distinct periods, with the S&P 500 price closely followed by the forward P/E multiple in each.

1. Drawdown #1: Regional banking crisis
2. Recovery #1: Banking crisis containment
3. Drawdown #2: 100 bps spike in real interest rates
4. Recovery #2: Possible Fed pivot

The seven so-called “Tech Darlings” could not be ignored in 2023. They returned 86.7%; without them, the S&P 500 would only have returned about 10%. A question posed by 2024 is if their dominance will continue. We believe that they are getting stronger and improving with respect to their fundamental performance; however, we must also note that their dominance comes at a time of historically high market concentration.

Outside of the U.S., MSCI EAFE and MSCI EM generated returns of 18% and 10%, respectively. This is the MSCI EAFE’s highest annual return since 2019; its top contributors for 2023 were Japan, France, and Germany, and its top detractors were Hong Kong and Macau.

Meanwhile, the MSCI EM underperformed MSCI EAFE for the third consecutive year. Its top contributors for the year were Taiwan, India, and South Korea, and its top detractors were China and Thailand. Notably, our portfolios were meaningfully underweight to both China and Hong Kong, which helped our overall performance in 2023.

In fixed income, 2023 returns were almost a mirror image of 2022. Fixed income market also experienced a fair amount of volatility during the year, with 10-year Treasury and 10-year Treasury Inflation-Protected Securities (TIPS) falling in March, spiking in October, and falling to end the year close to where they began, at around 4%.

In 2023, we generated strong absolute and relative returns across our portfolios excluding private investments. Both our public equity and public fixed income portfolios outperformed their benchmarks. In public equity, we benefited from an overweight to U.S. equities and extremely strong returns within our U.S. Large Cap and Emerging Markets, offset by weak relative performance within our Developed International and U.S. Small/Mid (SMID) Cap portfolios. Key thematic drivers within our public equity portfolio during 2023 were:

• A continued focus on high quality companies and a bottom-up approach
• Early and meaningful artificial intelligence (AI)-related exposure

We were disappointed in our underperformance in developed international equities, entirely driven by our large exposure to, and weak performance from, Select Equity Group (SEG). Despite this result, we still have conviction in SEG and believe the fundamentals of their underlying companies and portfolio are strong. Within midcap, strong performance from BBH Mid Cap was offset by underperformance by Clarkston, our SMID-cap manager, which struggled in the 2023 environment favoring larger-cap technology companies.

While we did have exposure within our portfolio to the seven Tech Darlings, we are underweight the index’s exposure, which sits at an all-time high for name concentration. In 2023, this was a headwind to performance; however, our U.S. Large Cap portfolio did meaningfully outperform the S&P 500 due to strong stock selection and strong fundamental performance of our underlying holdings. Over the long term, fundamental performance is rewarded while multiple expansion often sees a reversion to the mean.

Thematically, what we decided in 2022 informed our 2023 results.

In public fixed income, outperformance across all fixed income strategies was a key asset class driver of strong absolute and relative returns. Thematic drivers were a timely duration extension throughout 2023, and a strong Q4 rally in interest rates and decrease in credit spreads. Finally, in private investments we expect Q4 uplifts in private equity, and it is unlikely that real estate, distressed, and private credit kept up with the S&P 500 return in Q4; actual returns are to be determined due to the standard quarter lag in reporting.

BBH Capital Market Expectations

We underscore the fact that rather than using our 20-year capital market expectations for top-down investment decisions, as some in our industry do, we instead create these assumptions to help with simulations that are used in financial planning. These are forecasts of index-level data, and therefore do not include any after-fee excess returns that our managers may generate.

This being said, our 2024 capital market expectations indicate that we are generally anticipating slightly slower returns across asset classes for the coming year and imply that even after the year we experienced, we would be surprised if the S&P 500 meets its 2023 return threshold over the next 20 years.

For investors with portfolios comprised of fixed income and equity market indices, we believe that it may prove challenging to produce a return greater than 6% nominally over the next 20 years. If your return goals are above that profile, you must introduce managers who seek to generate excess returns over a long period of time, and/or have exposure to alternatives, to your portfolio.

Evaluating Our Opportunity Sets

It is helpful to use where we stand from a valuation standpoint in determining what opportunities are available for us looking forward. Looking at the forward P/E ratios for the S&P 500, MSCI EAFE, and MSCI EM indices, the opportunity set for equities appears slightly less attractive than where we sat this time last year. For non-taxable and taxable fixed income, while yields in Q4 came back down they remain attractive by historical standards overall.

At BBH, we are lucky to have an internal fixed income team who have been able to generate yields above that of the broader market. Lastly, looking at fixed income credit spreads, we note that they narrowed in 2023 and remain below their long-term average. We remain careful about taking credit risk at this point in time.

BBH Portfolio Positioning

In 2024, we continue to optimize our portfolio to enhance expected returns and reduce risk with these five priorities:

1. Focusing on high quality companies (public equities): These are companies that exhibit secular growth, strong pricing power, and are run by exceptional manager teams.
2. Capitalizing on the new fixed income regime: We think of public fixed income as providing portfolios with stability, liquidity, and yield. In 2023, fixed income had not lived up to its expectations; however, with recent shifts in the fixed income environment we now have a more positive outlook for bonds in 2024.
3. Increasing allocations to alternatives: Over time, we expect the number of private investment strategies and the allocation to these strategies to increase for our clients. The wide dispersion of manager outcomes in private investments offers an opportunity to benefit from manager selection. We anticipate investing in the soon-to-be-launched BBH Alternative Credit Fund, managed by BBH Partner Neil Hohmann, which will focus on structured equity and asset-based lending opportunities. This fund is planned to launch in Q2 2024.
4. Increasing optionality to AI: We believe that if AI is going to change the world as much as many expect, our portfolios should be well-positioned to benefit from this shift.
5. Encouraging rebalancing: Particularly after a year like 2023, we believe that rebalancing can enhance long-term compounded returns.

Our 2024 outlook supports our portfolio positioning decisions, and we remain focused on investing bottom-up and worrying top-down. Key themes that IRG is monitoring for the year ahead include:

• Geopolitical risks (e.g., the Israel-Hamas and Russia-Ukraine conflicts, China, Eastern Europe, and Houthi attacks). These may lead to inflation and increased volatility.
• Market concentration. The last time the S&P 500 Index outperformed the S&P 500 Equal Weight Index by this wide of a margin was in 1998. This could result in a small cap rebound.
• Equity market valuations. The S&P 500 equity risk premium is at its lowest level since 2002, and developed international stocks are trading below historical multiples, potentially meaning strong fixed income yields and a rebound in international equities.
• Inflation. Core inflation remains elevated globally, specifically in services. We are watching its impact on consumer spending patterns, and are on the lookout for fewer rate cuts and increasing inflation.
• Interest rates. There is a difference in the magnitude of rate cuts in 2024: the Fed is projecting three cuts, while the Fed funds futures curve is projecting six. This may result in increased volatility.
• Artificial intelligence. AI and machine learning will continue to largely impact business models and employment trends in 2024, likely leading to a differentiation between “winners” and “losers.”

In response to these developments, our portfolio positioning is focused on preserving and growing capital. With regards to preserving capital, we are first and foremost focused on the importance of rebalancing and high-quality companies.

We also note that historically, the outcome of U.S. presidential elections has not had a large impact on S&P 500 returns; what matters overall is the fundamentals. The strong fundamentals of our top Domestic Qualified Taxable Balanced Growth (DQTBG) portfolio holdings show that we must remember to focus on value instead of price.

We expect the embedded value in the portfolio to be realized over the long term, and we see our portfolios as quite attractive in spite of the recent run-up in the broader equity market.

2024 and Beyond: Our Private Investment Program

We believe that private markets hold many features and benefits that make them attractive to some of our clients, including illiquidity premiums, a diversified portfolio, opportunity for alpha, and the reality that fewer U.S. companies are going public. Therefore, we recommend allocating across the private investment program. We select alternative strategies that serve different purposes to optimize the overall portfolio.

When thinking about private investments we discourage market timing vintages. Returns for a single private market strategy are cyclical and impossible to predict; rather, we aim to invest in the best managers consistently over multiple funds.

Finally, some reminders as we progress through 2024:

• Prepare for higher market volatility
  
• Rebalance your portfolios
• Remember that portfolios are built with complementary components
• Increase fixed income and alternatives exposure
• Never forget to focus on the long-term

Thank you for your continued trust in BBH, and we look forward to 2024 and beyond.