Balancing risk and reward in search of resilience

Following a tumultuous 2022, 2023 defied initial expectations that stubbornly high inflation and sharply rising interest rates would lead to market challenges from slower US economic growth and possibly a recession. Initially, the US Federal Reserve (Fed) was expected to shift toward reducing interest rates by midyear, but conditions warranted additional fed funds rate hikes through July. Corporate profitability surprised to the upside (through September) as analysts’ lowered consensus estimates proved overly conservative. Despite signs of resilience in the economy, the second half of 2023 also saw its share of mixed signals, including housing-market weakness, slowing manufacturing activity and possible signs of stress on consumer spending, even as the labor market remained strong. The S&P 500 Index surged, with a narrow group of its largest technology-oriented constituents driving robust gains. These market leaders benefited from investor confidence in their business models and ongoing potential to drive tech-adjacent megatrends, improved capital discipline, and the promise of emerging artificial intelligence (AI) and machine learning (ML) technologies to streamline business processes, consolidate costs and boost productivity. However, their collective rally has created a top-heavy US equity market, with the highest levels of concentration in the S&P 500 Index in over 40 years.¹ By the end of November, the seven largest companies comprised almost 30% of the index, and generated a median year-to-date return of nearly 67% versus approximately 4.7% for the index’s other 493 constituents.²

The Fed’s actions, designed to slow US economic activity and regain control over inflation, seem to be playing out in the latest indicators. The key question for 2024 will be whether or not the Fed can execute a so-called “soft landing,”—a situation that will require inflation returning to its pre-pandemic norm without a recession. General market expectations for a soft landing—a historically rare occurrence typically defined by slowing economic growth without a material rise in unemployment—is high given consensus expectations for 12% earnings-per-share growth in 2024,³ keeping in mind the S&P 500’s forward price-to-earnings ratio was running above its long-term average in December.⁴ Given those expectations, we think market volatility could linger if incoming data disappoints. Today, we are encouraged by easing inflation, solid corporate profitability, financially healthy consumers, and increased infrastructure investment supported by legislation. Continued improvement would likely see a broader range of stocks contribute to overall market performance in 2024 than they did in 2023. However, in light of the magnitude of Fed policy actions and mixed economic data, we continue to be mindful that the economy could weaken more than expected, potentially leading to increased market uncertainty.

Rather than issuing a specific economic forecast, we believe owning a balanced, diversified portfolio of market-leading companies can help navigate uncertainty and potential volatility that might occur until a clearer market direction is established. We believe that dividend growth-focused strategies have an inherent bias toward quality, given the demonstrated ability for these types of companies to generate cash and grow their dividends through various economic cycles. We think high-quality companies—those with profitable business models, disciplined capital allocation and proven growth in large, addressable markets—are best able to navigate market uncertainty.

As the scope of equity market performance broadens, we expect several attractive secular themes to drive strong performance. For example, we remain excited about compelling innovations within the medical technology space, including surgical robotics and bioprocessing systems. We see further potential in several companies that are playing leading roles in society’s ongoing energy transition and digital transformation. We also see opportunities stemming from the reshoring and retooling of America’s manufacturing base and expect enterprise technology companies to play a leading role in driving corporate productivity, which includes advances in AI tools and business solutions. We believe companies in these areas have the dual benefit of participating in attractive capital appreciation opportunities while also providing stability and downside protection if economic conditions were to worsen.