Annual Market Review 2023

Overall Market Backdrop 2023

• Bank of England raised interest rates to 15-year highs of 5.25%.

• UK inflation eased to 4.0% at year-end, down from yearly highs of 10.4% in February.

• Global equity markets (14.7%) were driven by the “magnificent seven”.

• The downfall of several U.S banks spooked markets, but swift intervention by the Fed averted a broader catastrophe.

Table showing Equities and Bond performance in 2023 in GBP.

Source: Morningstar (MSCI ACWI IMI; Bloomberg Global Agg)

Drivers of Market Conditions in 2023

Equities

In 2023, stock market expectations were surpassed as the economy successfully steered clear of a recession, and a remarkable surge unfolded as the year came to a close. Initially, investors were bracing for challenges following the turbulence of 2022 and the stock market’s prospects appeared uncertain, with the Federal Reserve (Fed) and other central banks persisting in their unprecedented sequence of interest rate hikes. Many investors were convinced that the much-anticipated recession, widely publicised as “the most-predicted recession in history,” was imminent, and even those with more optimistic outlooks foresaw, at best, modest single-digit gains by the end of the year. Contrary to expectations, 2023 evolved into a strong year for stock markets, with global equities up 14.7%.

• “Magnificent Seven”

The spotlight shone particularly bright on mega-cap technology stocks and other growth-focused companies that bore the brunt of substantial losses during 2022. Driving the gains were the “Magnificent Seven”, a group comprised of Nvidia, Tesla, Meta, Apple, Amazon, Microsoft, and Alphabet. At the forefront of the 2023 rally stands Nvidia (NVDA), a semiconductor chip designer whose stock soared by a staggering 239% over the year, driven by the emergence of artificial intelligence (AI) technologies, marking a notable reversal from 2022 where Nvidia’s value experienced a 50% decline. During the concluding months of the year, the market’s rally expanded beyond the magnificent seven. Nevertheless, this select group of stocks continued to play a significant role in driving substantial portions of the gains in both U.S. and global markets across the year.

Source: Morningstar

• Banking Crisis

In March, sharp declines in the value of bond portfolios, commercial real estate holdings, and aggressive withdrawals from bank deposits led to the downfall of Silvergate Bank, Silicon Valley Bank, Signature Bank, and First Republic Bank. Stock prices for U.S. regional banks experienced a widespread plunge as investor confidence in the banking industry waned, with concerns mounting about the potential contagion effect on other banks. A more extensive and severe banking crisis was averted by intervention from the Fed, in part through the introduction of its Bank Term Funding Program. The Fed also extended emergency loans to distressed banks and assured customers that their deposits would be fully recovered, even if they exceeded the $250,000 insurance guaranteed by the Federal Deposit Insurance Corporation (FDIC). Several larger banks, including JPMorgan Chase (JPM) and New York Community Bancorp (NYCB), stepped in to acquire the assets of the failed banks and the brief banking crisis ultimately ended with relatively little disruption to equity markets, despite initial concerns.

• Sector Performance

Unsurprisingly, the technology sector (41.3%) leads the year in performance, fuelled by the Magnificent Seven, with the group’s average return surpassing 110% for the year, the lowest being Apple (48.9%) and Microsoft (58.0%). On the other hand, the energy sector’s performance in 2023 saw a slight negative return of -0.5%, representing a significant shift from the previous two years. Despite major players such as Russia and Saudi Arabia announcing a cut in oil production which caused a spike in oil prices earlier in the year, concerns arising about an anticipated decrease in crude oil demand, particularly in China, where there are ongoing signs of a weakening economy, contributed to relatively subdued performance for the sector. The responsiveness of energy stocks to price trends is evident, with rising energy prices typically benefiting the sector, while falling prices can dampen investor enthusiasm. This was observed in 2021/22 as the upward trend in oil prices, reaching over $120 per barrel in 2022, catapulted the sector.

Graph showing crude oil spot prices (per barrel weekly) from 2018 to 2023

West Texas Intermediate (WTI), a global oil benchmark. Data as of December 8, 2023. Source: FactSet.

• Asia & Emerging Markets

Chinese stocks, in their third consecutive year of decline, observed a muted outlook among investors, due to a combination of slowing economic growth, persistent financial strains in the real estate sector, and increased apprehension among some investors regarding geopolitical risks associated with holding Chinese equities. Meanwhile, Japan demonstrated robust performance (12.8%) for the year, as negative interest rates remain a tailwind for economic growth and consumer spending, creating a favourable environment for domestic assets. Emerging markets experienced consistent but modest growth, and whilst initially hopeful for a rebound post-COVID, growing concerns about recession risks in developed markets, global banking sector conditions, and ongoing U.S-China tensions resulted in relatively weak performance (3.6%) for the year.

• Currency Markets

In 2023, the Mexican peso emerged as the top-performing major currency, which appreciated 14.8% against the U.S dollar, primarily driven by aggressive interest rate hikes by the central bank, currently standing at 11.25%, attracting substantial inflows as investors pursued higher returns. Despite its positive impact on the peso, sustained appreciation may adversely affect Mexico’s export competitiveness, making domestic products more expensive for consumers overseas. Consequently, cheaper Asian imports could pose challenges to the country’s domestic industrial sector, as foreign suppliers become more attractive (i.e., cheaper) over domestic ones. Across the Atlantic, the Swiss franc, British pound, and euro also strengthened against the dollar. Meanwhile, the Japanese yen, although down 7% in 2023, may hold a more promising outlook for 2024 as the Bank of Japan (BoJ) is expected to raise rates to counter inflation, providing some strength to the yen. The Russian ruble and Turkish lira faced significant devaluations, depreciating 17.5% and 36.6%, respectively. The Turkish lira’s prolonged decline, down 94% over the last decade, is attributed to political upheavals impacting both the economy and investor sentiment. In contrast, Russia’s economic woes stem from heavy reliance on fossil fuel exports, exacerbated by Western sanctions. With reduced demand for oil and gas, export revenue has dwindled, contributing to a decline in the country’s trade surplus.

Table showing the 2023 returns of major currencies against the US dollar.

Source: Trading View. Data as of January 4, 2024.

The pound’s appreciation against the dollar was a contributing factor for the UK stock market lagging behind other equity markets such as the S&P 500. Many of the companies listed on the FTSE 100 generate a significant portion of their revenue in foreign currencies, so when the pound strengthens, the overseas earnings of these companies, when converted back to pounds, will be lower. This currency impact can therefore lead to lower reported revenues and profits in sterling terms. Shown right is a global equity index denominated in U.S dollars (USD), euros (EUR), and pound sterling (GBP). As aforementioned, due to the pound’s strength throughout 2023, the returns have been lower for sterling investors.

Graph showing performance in US dollars vs euro vs pound sterling

Source: Morningstar Direct. Data as of December 31, 2023. Morningstar Global Markets Index (in USD/EUR/GBP)

• Central Banks

Commencing in March 2022, the Fed found itself compelled to embark on a vigorous campaign of raising interest rates in an effort to curb escalating inflation. Fed officials emphasised that a “higher for longer” approach was the probable trajectory for interest rates, but in the latter months of the year, investors observed indications that the Fed’s tightening of monetary policy was proving effective, tempering the upward trajectory of inflation without, at least at the time of writing, triggering a recession. The Bank of England (BoE) followed in the Fed’s footsteps, with a 1.75 percentage point hike to base rates throughout 2023, ending the year with interest rates at a 15-year high of 5.25%. Market sentiment evolved as the year progressed, bouncing from recession worries to ending the year focused on future rate cuts. The UK started the year with inflation exceeding 10%, surpassing the BoE’s target rate of 2% by more than fivefold, but as the impact of elevated interest rates appeared to take hold, economic data started to portray a more favourable picture, with inflation declining to 4% by the year’s end. A parallel narrative played out across the pond, as U.S inflation concluded the year at 3.4%, down from highs of 6.4% in January. Ultimately, after a sequence of rate hikes in the first half of the year, central banks shifted gears in the latter months, as both the Fed and BoE left rates unchanged in their final three meetings of the year. Following indications from Fed officials, this led to speculation among some investors that the first round of rate cuts could potentially occur as early as March 2024.

Chart showing Fed funds policy rate and median FOMC dot predictions. From 2021 to 2026.

Source: Federal Reserve, Bloomberg Finance L.P. Data as of December 14, 2023. Federal Open Market Committee (FOMC)

• Bonds

In the bond market, yields fluctuated, starting with an initial rise succeeded by a sharp decline. The U.S. 10-year Treasury yield, a critical benchmark for various loans like home mortgages, started the year around 3.8%. During the first two quarters, it experienced variations within a fairly limited range. However, by early August, yields surged due to the new “higher for longer” regime and positive job market data. This increased the 10-year yield to a 17-year high, reaching approximately 5% from just below 4% in July. Following this surge, there was a swift reversal as markets anticipated that current interest rates had peaked, coupled with favourable inflation news that reinforced the Fed’s hiking campaign had been somewhat effective. As the year concluded with a more dovish outlook on interest rates, government bonds rallied, especially in the UK, which delivered robust returns exceeding 8% for the final quarter.

The U.S. Treasury yield curve, which compares short-term and long-term interest rates, has consistently shown an inverted pattern since July 2022. An inverted yield curve, where short-term rates are higher than long-term rates, is widely regarded as a potential precursor to a recession. While not all inversions lead to recessions, historical trends show that all recessions have been foreshadowed by one. Analysts believe that the longer the yield curve remains inverted, the greater the likelihood of a recession. The inversion in 2022 was a result of the Fed’s efforts to raise the federal funds rate, causing short-term yields to surpass long-term yields. Throughout 2023, the extent of the inversion fluctuated significantly. At the beginning of the year, 2-year Treasury notes yielded about 0.5 percentage points more than 10-year notes. Twice during the year, this gap widened to around a full percentage point, which is considered notably high based on historical standards. In October, amidst a bond market selloff, the yield curve flattened to approximately a 0.2 percentage-point difference between 2-year and 10-year treasuries. By year end, the yield curve showed an inversion of about 0.4 percentage points.

Graph showing 2021 to 2023 Treasury yield and Federal -funds rate.

Source: Morningstar. Data as of Dec 28, 2023.

Source: Morningstar. Data shown in GBP terms (annualised)

How did factors perform in 2023?

• The rapid technological advancements in the realm of artificial intelligence (AI), combined with expansive monetary policies implemented by central banks, have propelled the technology sector to significantly outperform the global market. Consequently, Value stocks have lagged behind, with the “magnificent seven” and other prominent tech conglomerates forming the core of Growth stocks, generally perceived as an inverse to Value. Contrary to the narrative of 2022, where Value emerged as the leading factor and the Tech sector suffered substantial losses, it highlights the ever-changing dynamics within markets, demonstrating that the top-performing factors are subject to continual change and resist easy prediction (shown below in the ‘Randomness of Returns chart’).

• Min Vol stocks underperformed in 2023, registering as the worst performer for the year (1.4%). Min Vol strategies typically exhibit heightened sensitivity to interest rate risk, primarily because of their structural exposures to companies, such as those within the Utilities sector, who generally require substantial capital investments for infrastructure development and maintenance. In a higher interest rate environment, as witnessed in 2023, the cost of borrowing increases, which can elevate their overall capital expenditure.

• Quality stocks, known for robust financial stability and consistent free cash flow generation, once again set the standard, emerging as the top performer for the year (24.9%). High-quality stocks are often perceived as resilient and better equipped to weather economic downturns, which can attract investors during times of uncertainty.