Financial Market Review

Global equities (+9.5%) rose in the fourth quarter. Stocks rallied in tandem with government bonds as falling inflation in developed markets (DMs) and weakening economic data across the globe bolstered views that policy rates have peaked and will begin to decline in 2024. The US Federal Reserve (Fed) surprised markets by signaling lower interest rates in 2024, sparking a stock rally that rippled across the globe and increasing speculation for sharp reductions in policy rates across DMs in 2024. The Fed’s policy shift was accompanied by steeper declines in inflation across many economies and a precipitous drop in bond yields, which significantly eased financial pressures on companies, households, and governments. More emerging market (EM) countries began to reduce interest rates in December, while the European Central Bank (ECB) and the Bank of England (BOE) pushed back against market forecasts of sizable interest-rate cuts next year despite concerns about weak economic growth. China’s economy rebounded, with third-quarter GDP expanding by 4.9% from a year ago. Nonetheless, a deepening slump in the property sector burdened the country’s recovery and investor sentiment, putting greater pressure on the government to intensify its policy support. Even with the Middle East conflict, the Brent crude oil price dropped below US$80 per barrel amid more US output and as OPEC+ countries struggled to agree on production cuts.

Global fixed income markets generated their strongest quarterly return in more than three decades, as measured by the Bloomberg Global Aggregate Index, bolstered by increasing confidence that central banks have reached the end of their rate-hiking cycles. Most fixed income sectors produced positive excess returns over duration-equivalent government bonds as dovish policy rhetoric drove spread compression. The US dollar weakened versus most currencies.

Commodities (-10.7%) declined in the fourth quarter. Precious metals and industrial metals generated positive returns, while energy and agriculture & livestock registered negative results.

Equities

United States
US equities (+11.7%) registered their largest quarterly return in three years as gains broadened beyond those of the “Magnificent Seven” stocks that dominated the stock market’s performance for most of the year. Financial conditions eased significantly after longer-dated Treasury yields fell sharply from their October peaks amid a faster-than-expected decline in inflation, moderating economic activity, softening labor market conditions, and views that the Fed had reached the end of its prolonged cycle of interest-rate hikes. Disinflation momentum gained traction during the quarter. In November, the Fed’s preferred measure of inflation — the Core Personal Consumption Price Index — rose at a 1.9% annualized pace over the prior six months, meaning the Fed will have achieved its 2% inflation target if the current trend is sustained. The rapid descent in inflation prompted the Fed to pivot from its “higher-for-longer” policy stance in December, sending Treasury yields lower and driving stocks higher. The Fed’s Summary of Economic Projections implied that policymakers anticipate 75 basis points (bps) of interest-rate cuts in 2024. Financial markets subsequently priced in 150 bps of cuts by year end, although Fed Chair Jerome Powell pushed back on the market’s aggressive forecast. Firming views that the US could achieve a “soft landing” were accompanied by concerns about extended positioning and sentiment, particularly given the headwinds to consumer spending, downside risks to corporate earnings, and economic growth uncertainty due to the lagged impact of previous rate hikes.

Economic data released during the quarter was resilient against a backdrop of elevated inflation and tighter financial conditions. Third-quarter GDP grew at a surprisingly robust 5.2% annualized pace. A cooling but still-healthy labor market, better-than-expected growth in retail sales, and continued personal spending in November helped dispel lingering pessimism about the economy. Job openings trended lower, but job growth remained solid. Stability in the unemployment rate and initial jobless claims indicated a relatively low level of layoffs. Consumer confidence strengthened as households grew more upbeat on the outlook for inflation and the labor market; notably, the Conference Board’s Consumer Confidence Index surged to 110.7 in December — the largest increase since early 2021 — with consumers signaling greater intentions to purchase big-ticket items. In contrast, the National Federation of Independent Businesses Small Business Optimism Index remained depressed in November, with respondents indicating a further deterioration in credit conditions and weak capital spending plans. Falling mortgage rates offered hopes of a revival in the housing market in 2024, although borrowing costs are still twice as high as they were in 2021, prices remain lofty, and inventory is limited. The Institute of Supply Management (ISM) Manufacturing Index contracted throughout the quarter but appeared to stabilize at a weak level, while consumers’ sustained demand for services kept the ISM Services Index in expansionary territory through November.

Within the S&P 500 Index (+11.7%), 10 of the 11 sectors posted positive results for the quarter. Real estate (+18.8%) was the best-performing sector. Information technology (+17.2%) outperformed, led by software (+18.9%) and semiconductors & semiconductor equipment (+21.4%). Financials (+14.0%) rose, as banks (+22.4%) and capital markets (+19.1%) contributed to the sector. Consumer discretionary (+12.4%) also outperformed, aided by broadline retail (+19.2%) and household durables (+29.6%). Energy (+12.2%) was the worst-performing sector. Consumer staples (+5.5%) and health care (+6.4%) also underperformed.

Europe
European equities (+5.7%) rebounded in the fourth quarter. In November, the European Commission (EC) downgraded its 2023 eurozone economic growth forecast for the second time this year, to 0.6% — 0.2% lower than its September forecast — due to the impact of elevated inflation, a steep increase in interest rates, and a slowdown in global trade. Subsequently, the HCOB Flash Eurozone Composite Purchasing Managers’ Index (PMI) continued to decrease in December as the manufacturing and services sectors saw further outsized falls in new business inflows, more declines of work backlogs, and a second consecutive drop in employment due to weak demand. This disappointing result increased the eurozone’s recession potential and posed risks to the ECB’s forecast of 0.1% economic growth in the fourth quarter. Against a backdrop of ebbing inflation and lackluster economic growth, the ECB left interest rates unchanged during the quarter and signaled an early end to its last remaining bond purchase scheme. A surprisingly swift decline in eurozone inflation from 2.9% to 2.4% in November — the lowest since August 2021 and only modestly above the ECB’s 2.0% target — intensified expectations that the ECB will begin to cut interest rates in the second quarter of 2024. In December, European Union (EU) finance ministers reached an agreement on the EU’s fiscal rules, allowing more time to reduce public debt and creating incentives for public investment. Third-quarter earnings for companies in the STOXX 600 Index are forecast to decline by 11.1% from a year earlier.

Europe’s manufacturing sector remained stuck in contraction over the quarter; the HCOB Eurozone Manufacturing PMI registered 44.4 in December, a modest improvement from 43.4 in September. Output continued to fall, and factories shed jobs for a seventh successive month, while declines in new orders and purchasing activity eased. Encouragingly, business confidence edged up to an eight-month high, and input costs and output prices continued to wane. The HCOB Flash Eurozone Composite PMI in December showed that services sector activity contracted for the fifth consecutive month but at the softest pace in the recent sequence of declines, while prices rose at a pace not seen since July. The EC’s Economic Sentiment Indicator improved mildly to 93.8 in November; consumer confidence edged up, while industry confidence was broadly stable.

In Germany (+8.3%), Chancellor Olaf Scholz’s government coalition reached a deal with the country’s finance minister on a budget draft for 2024, resolving a political and fiscal crisis that was triggered by a constitutional court ruling in November. The last-minute agreement averted a financial shutdown in January and plugged a projected €17 billion fiscal gap. Despite the budget crisis, the ZEW Indicator of Economic Sentiment rose significantly over the quarter to a nine-month high in December, reflecting an improved economic outlook amid growing expectations for interest-rate cuts by the ECB. In the UK (+2.3%), a recovery in the services sector boosted the S&P Global/CIPS Flash Composite PMI to a six-month high of 51.7 in December, from 46.8 in September, signaling that the UK economy may have avoided a mild recession in the fourth quarter. Despite hawkish rhetoric from the BOE, an unexpectedly large drop in headline inflation from 4.6% to 3.9% in November — the lowest in more than two years — heightened speculation that it will cut interest rates sooner than previously believed amid a sluggish economy. In the Netherlands (+15.1%), a surprising victory by far-right Freedom Party leader Geert Wilders in national elections sent shock waves through Dutch and European politics, setting the stage for a lengthy period of uncertainty around the formation of a coalition government and unity within the European bloc.

Pacific Basin
Pacific Basin equities (+3.7%) ended higher. In Australia (+9.0%), the Reserve Bank of Australia (RBA) raised interest rates to a 12-year high of 4.35% in November amid persistent services inflation, record-high housing prices, and a still-tight labor market. However, the bank left interest rates unchanged in December to assess the impact of prior interest-rate increases, with cooling inflation and softening labor demand suggesting its policy tightening gained traction. Australia’s economy slowed more than expected in the third quarter as GDP expanded only 0.2% from the second quarter. A higher cost of living drove household-consumption growth year over year to its lowest since the first quarter of 2021, and the savings rate fell to a level not seen since 2007. These figures, along with a larger-than-expected drop in October retail sales, are likely to dampen concerns about demand-driven inflation pressures. Treasurer Jim Chalmers forecast sluggish economic growth over the coming year and anticipates unemployment to rise above 4.0%, from 3.8% currently. However, the budget outlook does not include a forecast for a recession.

Japan’s (+2.2%) economy shrank at the sharpest pace since the height of the pandemic, complicating the BOJ’s monetary-policy path amid speculation that it is closer to exiting its lengthy cycle of negative interest rates. GDP declined 2.9% annualized in the third quarter, worse than consensus estimates, as rising inflation started to adversely impact consumer spending. More recently, mixed economic indicators pointed to a patchy and fragile economic recovery, while core inflation rose by 2.5% year over year in November, down sharply from 2.8% in October. However, surprisingly upbeat sentiment among a wide range of Japanese manufacturing and services companies in the BOJ’s Tankan survey boded well for the economy and bolstered the government’s and BOJ’s hopes for wage increases, which could pave the way for policy normalization. Investors continued to wager that the BOJ will soon unwind its ultra-easy stimulus, but the recent rise in the yen reversed after the bank maintained negative interest rates and its yield-curve policy. BOJ Governor Kazuo Ueda offered no clues on the timing of policy normalization and indicated that more time is needed to ascertain whether a cycle of sustainable wage growth and inflation is in place. He alluded to various options to phase out monetary easing, adding that the BOJ is unlikely to issue an explicit warning of an impending rate hike. The government unveiled a ¥17 trillion (US$112 billion) economic stimulus package to boost consumption and cushion the impact of inflation.

In New Zealand (+8.9%), conservative National Party leader Christopher Luxon was elected prime minister, ending six years of Labour Party government. Inflation slowed to a two-year low of 5.6% in the third quarter, and the Reserve Bank of New Zealand (RBNZ) left interest rates at 5.5% in November, noting concerns that inflation won’t ease fast enough amid rapid population growth. Unemployment unexpectedly climbed to its highest level in two years, reaching 3.9%. In Singapore (+1.3%), core inflation edged lower to 3.2% year over year in November, giving the central bank more scope to extend its monetary-policy pause at its next meeting in January. Encouragingly, a preliminary estimate showed that GDP accelerated to 2.8% year over year in the fourth quarter, from 1.0% in the third quarter.